Despite speculation about the potential for a bubble in the high yield bond market, industry specialists are relatively upbeat about the sector’s prospects. Average yields have gone to 8.5 per cent from 10 per cent at the beginning of the year, forestalling any further tightening in credit spreads, but the case for high yield stacks up on coupon alone, particularly when compared with investment grade at just 3.5 per cent, and in terms of risk adjusted returns, the high yield sector offers similar returns to equities for half the volatility.
“From a fundamental perspective most companies in our universe are performing well, have kept their balance sheets in good order and have refinanced any debt that has come through,” says Zeke Diwan, portfolio manager at Pioneer Investments.
“Even with low growth rates, companies in the European high yield universe are performing well as they largely remain cash generative as many continue to benefit from cost savings initiatives implemented during the downturn. Default rates will trend to the low single digits by year end (Moody’s December 2010 forecast 2.3 per cent) and remain at this level throughout 2011,” he explains.
“Last week, JPMorgan revised its European high yield default forecast to 1 per cent for the year end 2010 and set its forecast of 1 per cent for 2011,” adds Mr Diwan.
Some believe high yield is in its best position for 15 years, and argue that because the new issues coming through are largely refinancing rather than expansion-led, the market will avoid a re-run of the worst excesses of the loan sector in 2007.
Falling default rates
“Default rates are expected to fall because refinancing has become easier,” says Alexander Baskov, fund manager of the Pictet High Yield Bond. “High yield bonds have grown at the expense of leveraged loans, which were a popular asset class in 2007 when the size of the loan market tripled. But now it is shrinking because of the tighter lending conditions of the banks and the most likely venue for refinancing is instead the bond market,” he explains.
“Companies are not taking on more leverage; it’s not new debt, it’s replacing one kind of debt with another. That might create a bubble when debt is used for expansion in future and that future may not be all rosy – there will also be volatility because of the government debt problem in Europe – but corporates are in better shape than governments and in the near past that was never the case.”
Estimates for the volume of leveraged loan and high yield bond refinancing in Europe is massive, ranging from €300-500bn from now until 2017, according to Standard & Poor’s. This robust new issue calendar has produced issues that are more attractive than the last wave with substantially less leverage. Some issues have made an immediate trading profit, says Karen Bater, director of high yield at Standish Mellon Asset Management, citing an eight-year piece of paper that had risen by 3 points since issue two days previously.
Unlike some of her peers, Ms Bater likes CCC-rated bonds she believes stand a good chance of being upgraded, especially those companies that are moderately leveraged, generating free cash flow, and having some financial flexibility – primarily not much debt with a near-term maturity, good asset protection and not many bank loans higher in the payout hierarchy. B-rated bonds are currently on spreads of around 600 basis points, compared with over 900 for a CCC-rated bond.
Attractive pricings
“Right now there are a lot of opportunities in the fallen angel space and new issues are particularly attractively priced and have good credit fundamentals,” agrees Sandro Naef, portfolio manager of the Nordea 1 – European High Yield Bond Fund from Capital Four Management.
“Spreads have come in and there is less free money on the table, but we still see a lot of attractive opportunities.”
Others are more nervous about prospects for the lower quality bonds. The likelihood of default for an issuer rated B- over three years is about 15-17 per cent, while for a CCC-rated credit default risk rises to 20-30 per cent over the same period.
“We are very cautious on CCC, only taking positions where we think an upgrade is likely, as this is the sector that will rally most in a bull market but will drop more in a downturn,” says Alain Krief, head of L/O Credit Corporate Investments at BNP Paribas AM. “It’s all about picking the right names at the right time. With still a 20 per cent probability of a double dip embedded in market prices, CCC is not the place to be because there is still only fragile growth. However we try to grasp some opportunities in this segment through in house credit research as the ratings houses are lagging the economy and tend to wait for results, often waiting a quarter before upgrading/downgrading the issuer.”
