December 2010

HIGH YIELD: junk bonds remain attractive

dustbinHigh-yield bonds have been a successful asset class for the second year running and despite talk of a bubble in fixed income, managers expect money to stick, finds Nick Fitzpatrick There are currently 52 companies globally and two sovereign states (Hungary and Iceland) that are trying to avoid falling into the junk-bond pit. If they fail to defend their debt ratings against downgrades then their descent to junk would see them join 16 other bond issuers whose debt was downgraded to ‘speculative’ this year by S&P.

But why should companies want to avoid junk-bond status anymore? The vast sum of money that has entered the junk-bond sector in the past two years suggests that at least these companies would not struggle to find finance from investors who are only too willing to take the extra risk for the higher yield they earn from junk bonds.

As the year draws to a close and economic recovery still eludes much of Europe, high-yield bonds continue to be a sought-after asset class and issuance by companies is still on course to be record breaking.

At the same time, though, the large flow of money into high yield has led to talk of a bubble in the sector, and that wouldn’t be good for anyone.

“Some people say it feels like bubble territory,” says Ralph Gasser, senior product specialist of fixed income at Swiss & Global Asset Management in Zurich.

Yet high-yield fund managers say investors would be right to put continued faith in the sector. Maryam Muessel, head of global credit at BNP Paribas Asset Management in Paris, says that low global growth and a low-yield environment mean investors are looking to high-yield bonds more and more for income rather than just short-term tactical upside, as was historically the case.

“As such, we expect that long-term core allocation to high yield will rise and rotating tactical allocation will decline,” Muessel says.

Pension funds had better hope their managers’ confidence in the sector is well founded as many of them have more discretion to move into high-yield bonds at will.

Steven Birch, an investment consultant at Hymans Robertson, a UK pension fund adviser, says many fixed income mandates in recent times have accessed the high-yield sector through aggregate mandates that can switch between different bond sectors.

“The manager makes the assessment about what is the best time to get in and out,” he says. “The core of these mandates is still usually made up of sovereign debt and investment-grade corporates, but the high-yield component can typically go up to 20%.”

He adds: “There’s no doubt that pension funds have invested in high yield and have for a number of years, and there’s a reasonable case to expect that those allocations might rise in future years.”

Money flows into bonds, including high yield, have already been extraordinary.

To illustrate the point, Sabur Moini, high-yield portfolio manager at Payden & Rygel in the US, notes that the broad Merrill Lynch Global High Yield Index value was $700bn (€524bn) five years ago, but is now over  $1.1trn.

He adds that the Payden High Income Fund, a mutual fund managed in the US, had $250m of assets under management two years ago and today has $1bn.

“You can buy good companies and get a coupon of 6.5% to 7% every year. Meanwhile, dividends on the S&P 500 are sub 2%,” says Moini.

Swiss & Global’s high-yield Ucits fund – called the Julius Baer Global High Yield Bond Fund – held €170m of assets under management three years ago. Today it has €785m, says Gasser, with most flows from institutions.

“We think that, compared to government and money-market returns, high yield will continue to outperform over the next twelve months with high single-, possibly low double-digit returns likely under most market scenarios,” he says.

Gasser says the positive expected returns are partly because of supportive credit fundamentals as many high-yield companies continue to deleverage, while investment-grade companies will increasingly use their recently built-up cash reserves and balance sheet strength to raise dividends, accelerate share buybacks and re-engage in acquisitions, which is set to increasingly depress free cash flows.

Also, the market is more secure than perhaps many people think.

“A lot of high-yield buying has come from unleveraged institutional names. These are steadier investors who do not panic if they have one bad month. The market is well underpinned technically and the next 12-18 months should be good,” says Gasser.

Meanwhile, Ann Benjamin, lead manager of the Irish-domiciled $2.3bn Neuberger Berman High Yield Bond Fund in the US, says: “We are looking at a 15% return for 2010 and a 7-12% return for 2011.”

She points out that spreads are still comfortably above US Treasuries.

But clearly the best that high yield has to offer is over, at least for now. The amount of money chasing yield has pushed down those yields, and so if flows into high yield do increase in 2011, then the addition of new issuers to the market is to be welcomed, whether these issuers be new companies or the so-called fallen angels, as former investment-grade businesses are known.

The inclusion of the 52 corporate issuers to the S&P high-yield universe would, in theory, deepen the market by €130.03bn of rated debt and a total of €185.64bn if the two sovereigns are included.

The addition of these fallen angels has given the high yield bond markets an extra depth, even a celebrity glamour. Since ratings agencies like S&P and Moody’s began to downgrade well-known companies like Michelin and Lufthansa after the financial crisis, investors have been more than willing to invest in them. Not only have they been sources of yield in an environment of depressed returns from traditional assets, but defaults in the sector are at record lows, too.

At the end of last year Barclays Capital predicted a record amount of European high-yield issuance for 2010 of €40-45bn, and by November 2010 there had been €31.8bn worth of issuance compared to €38bn for the whole year before. Beyond the US
Across Europe, Middle East and Africa, Moody’s said $46bn had been issued through September 2010, which compared to $43bn in the whole of 2009. Steven Loubser, a Cape Town-based credit analyst for Investec Asset Management, told Bloomberg he expected the South African high-yield market to increase to R15bn (€1.6bn) from R1.5bn by the end of 2015.

As well as deepening the market, the record issuance of non-US high yield would help diversify the global market away from the US, which dominates global high-yield indices.

By November, there had been around $250bn of issuance in the US, according to Moini.

Todd Youngberg, global investment director for fixed income and head of high yield investments at Aviva Investors, says about 85% of the high-yield corporate bond market consists of US and North American bonds.

He adds: “When you compare high yield to US equities it’s a similar return but for less risk. A lot of institutional investors view the high-yield class as an equity surrogate. The asset class behaves very independently of fixed income, with a 0.1 correlation to 10-year treasuries. Investment-grade bonds have a 0.9 correlation to treasuries.”

High yield may well run into a third successful year if economies avoid the double-dip recession and government yields remain low enough. So what would it take to make them look unattractive?

Benjamin, at Neuberger, says: “For high yield not to look attractive you would have to have a forecast of high default rates and low spreads. Right now defaults are low and are expected to be for the next three to four years, while spreads are high. Spreads are still 600 bps over treasuries.”

As for Gasser, he says: “If spreads come down to 300 to 350 bps over governments, then it’s probably time to leave the asset class.”
Recently, spreads were at 610 bps.

©2011 funds europe

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