April 2011

FROM JUNK TO TRUMP: confidence in high-yield bonds

Recycling_signRecent fund data showed outflows from bonds. Yet the high-yield sector remains popular. George Mitton discovers how the financial crisis helped this asset class rid itself of a bad reputation Poor growth and low interest rates make it tough for European investors to find good returns. Volatility in the equities market is also a concern, especially given the risk of a breakdown in the Eurozone. Faced with these challenges, high-yield bonds – once viewed as a “junk” investment – are an increasingly shrewd option, one that investors are choosing in higher numbers than ever before. One reason is that issuers are offering more of these bonds than in the past. The high-yield market had a record year in 2010 with €44.4bn in issuance compared with €24.5bn in 2009, according to Standard & Poor’s (S&P). Disintermediation in the banking sector is one driver – corporates that require constant borrowing have turned to the bond market. This comes amid a growth in refinancing and a slow revival in M&A activity. So popular is this asset class that it is selling well despite a general move away from bonds. “High-yield bond funds have so far bucked the wider trend of European investors withdrawing from bond funds, with net sales into high-yield products actually rising in January, led by US dollar-denominated funds,” says Ed Moisson,  head of UK research at fund data firm Lipper. Could it be that high-yield bonds have lost their “junk” reputation and finally become a trusted asset class in Europe? Adopting the US model Many fund managers say Europe is belatedly adopting habits learned from the United States. “Europe has adopted a more equity-overweight culture historically. That’s proven to be a flawed strategy,” says Anthony Robertson, senior high-yield manager at BlueBay Asset Management. “The US model, where high yield has been a key component, is more stable and gives you a more predictable return profile. High yield has been anything from 5% to 15% of asset allocations in US insurance companies and pension funds, whereas in Europe it’s been 5% or less.” As well as the advantages over volatile equities and low-yielding bond funds, Euro high-yield has the benefit that many new issuers in the European market are offering attractive covenant packages, some with security comparable to bank loans. This is reassuring to investors who are seeking growth but do not want to take unnecessary risks. Given the appeal of high-yield bonds, some are asking why it’s taken Europe so long to adopt the model. Americans have been trading in them since the 1980s, while the European market has only existed in its current form since 2000. Part of the reason is cultural. European investors were historically suspicious of speculative-grade issuers – an attitude that the financial crisis helped dispel. “In Europe there has always been a bit of a phobia of being associated as a speculative or junk issuer,” says Robertson. “It’s almost like a cultural embarrassment. But as the market sees some of the bigger firms such as Continental entrenched in high-yield territory, they’re more comfortable that there’s no stigma associated with being a high-yield issuer.” Fallen angels The big-name firms which had their ratings cut during the financial crisis – Michelin is another example – are the so-called “fallen angels”. They have swelled the ranks of European high-yield issuers and inspired investors who are traditionally wary of junk bonds to play this market. Although the European economy continues to recover from the financial crisis of 2008, there are new fallen angels appearing all the time. “The Irish banks just fell into the Euro high-yield index so there’s more coming in than there is going out,” points out Arif Hussain, director of UK and European fixed income at AllianceBernstein. As general economic conditions improve, many of the fallen angels hope to get re-rated up to investment-grade status. However, the example of the Irish banks shows how others can quickly take their place. In any case, it will not worry investors if their fallen angels rise again. “It would be positive if some of these fallen angels began to be re-rated back to investment-grade. That would be a positive impact on high-yield returns,” says Ivan Rudolph-Shabinsky, also a director of fixed income at AllianceBernstein. “We’re more worried about a shortage of issuers on the investment-grade side.” Though the figures are encouraging, the recent enthusiasm for European high-yield should not blind investors to the reality that the pool of issuers in Europe is still limited. “Euro high-yield is still a fairly small market, one that doesn’t have a great deal of diversification,” warns Hussain. “Our advice to investors is that they should consider a global context. Even if you’re running a Euro high-yield portfolio you should allow some global high-yield within it as a diversifier.” Even within the Eurozone, risks can vary widely in this asset class. Many managers warn against taking a generic view, especially since growth rates vary between EU member states.   Sam Cowan, portfolio manager at Cairn Capital, says investors must “drill down to identify the business, sectors and regions that represent good value… a manufacturing company based in Germany will represent a far better opportunity for investors than a media company based in Greece”. There are other factors that could weaken investor confidence in high-yield bonds, namely a default rate increase. Defaults are steady for the time being – the global default rate among speculative-grade issuers remained unchanged at 2.8% in February, compared with the previous year, according to ratings agency Moody’s. But some research firms are warning of a possible resurgence.   S&P says the refinancing risk for highly indebted European corporate borrowers “could potentially generate a second wave of defaults in 2012 and 2013”. The macroeconomic factors that could influence this risk are the same ones that would trigger wider investor worries. Moves by the European Central Bank to reduce liquidity in the market and the end of the US Federal Reserve’s quantitative easing programme could force a rise in defaults. These could be exacerbated by austerity measures in the developed world. However, in the short-term, many high-yield bond managers are optimistic. “Default risk is a fact of life, but it’s well below average and set to be negligible for 2011 to 2012,” says Paul Reed, head of European high-yield at Aberdeen Asset Management. “I’m relaxed.” Mainstream asset class The result of this increasing investor interest in high-yield bonds is that they are becoming more trusted. “It’s become much more of a mainstream asset class,” says Phil Barleggs, senior fixed-income specialist at State Street Global Advisors. “People are comfortable with having it as a core holding within their portfolios… a fundamental component of an investment programme.” Most fund managers consulted by Funds Europe say investors can expect between 7% and 9% returns on high-yield bonds this year. A good year, although nowhere near as good as the end of 2008 when high-yield bond funds were yielding in excess of 20%. Then, it was the perception of high risk that drove the high returns.As the economy settles down the risks have abated, leading to the more modest returns. The financial crisis triggered the mass buying of high-yield bonds, but it also changed perceptions. “I’m not saying we are the new safe haven, but clearly there is not this dichotomy there used to be between government and high-yield bonds,” says Piero del Monte, portfolio manager at Franklin Templeton’s Euro High Yield Fund. A fertile environment It is clear that European investors are becoming more comfortable having a larger proportion of their portfolios invested in high-yield bonds. The asset class avoids the volatility of equities while offering better returns than investment-grade or government bonds. Against a background of poor European growth and inflation worries, this is a very appealing proposition. This is good news for companies that are increasingly relying on the corporate bond market to service their debt. “We see a fertile environment for mid-size companies that were previously reliant on the bank market to issue bonds in Europe,” S&P says, adding that in its view, the European high-yield bond market has become “ingrained”. These developments are changing corporate behaviour. As speculative-grade companies enter the bond market they realise they must disclose more information than is required to obtain bank debt. It seems firms are adapting to the new environment. To accommodate the investors in its high-yield bond, Towergate Insurance agreed to make public all the loan covenants included in the financing package to refinance bank debt and a portion of existing preference shares. This feeds back into demand by giving investors the impression they are getting a safer deal. High-yield bonds are no longer junk. They are a sensible, some would say essential component of every European investor portfolio. ©2011 funds europe

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