Investment opportunities in the high yield bond market - Global bonds and currencies
Newton Fixed Income
July 2011
Parmi Chadha
No. 315
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The high yield market1 fell sharply (by 1.5%) from 1 June to 21 June as uncertainty over the re-emergence of Greek sovereign debt concerns prompted investors to make a swift exit from riskier assets. It is an inherent feature of high yield bonds that they will decline in periods of risk aversion. We believe, however, that the extent of their decline will be less than that of equities, on account of two fundamental characteristics of bonds as an asset class: the coupon, and the seniority of the instrument within a company's capital structure. This expectation is borne out by a comparison of the -1.5% return from high yield bonds with falls in the FTSE World Index (-3.3%) and the S&P 500 Total Return Index (-3.6%). A similar situation materialised during both March 2011 and May 2010 (during the first Greek debt crisis).
High yield bonds as an asset class are a 'spread product': their yields are greater than those of government bonds (the difference between the two being the spread). The historical median spread of high yield bonds over government bonds is around 350-400 basis points (i.e. 3.5 to 4 percentage points). 2 Currently, the spread is at 560bps against underlying government bonds. When the underlying economic cycle is at an expansionary (high growth and inflation) stage, and is just about to tip over into a downturn (low growth and recession), the median level of 350bps is usually breached, as for example in June 2007, when spreads reached a low of around 250bps. However, rather than waiting for the lowest spread point, we prefer to start being cautious and to reduce exposure when spreads reach the 350bps watermark.
Current spreads are very attractive in relation to historical levels. Even if one chooses to look at high yield bonds not as a spread product, but simply in terms of yield, we believe the current yield may compensate investors in this environment.
Default rates
The default rate environment for the next 12-18 months appears benign: Moody's expects a default rate of just 1.5% over the next 12 months. This low default expectation is driven primarily by robust corporate balance sheets and the success of continued refinancing activity. As demonstrated by Exhibits 1 and 2, 50% of US loan maturities, and around 30% of bond issuance, to 2014 have been addressed. The fact that bond issuers have been able to refinance, as demonstrated by the upward slope of the blue bars in Exhibit 2, is evidence that there is sufficient liquidity in financial markets to allow high-yield companies to refinance their debt successfully. We believe it is likely that, over the next 12 months, almost 100% of the loan maturities to 2014 will be refinanced.
Exhibit 1: Leveraged debt maturities: loans
Exhibit 2: Leveraged debt maturities: bonds
Source: Bank of America Research, June 2011
The charts display the amount of debt outstanding for the given maturities as at 31 May 2011, compared to the amount of debt that was outstanding at Year End 2008.
Over the last two years, the proceeds of new debt issuance have been used mainly (in around 70% of cases) for refinancing, and not for general corporate purposes or acquisitions, as shown in Exhibit 3. This is positive for credit as it helps to maintain sound corporate balance sheets.
Exhibit 3: Use of new issue proceeds
20 May 2011
The optimum scenario for high yield bonds is real economic growth in the 1-2% range. Economic expansion of above 2% usually leads to an increase in underlying government yields, and is usually inflationary; both of these contingencies start to erode the credit spread available on the asset class. Furthermore, in such an environment, there is an asset allocation shift away from high yield bonds towards equities, which is clearly unfavourable for the former.
By contrast, a sustained real economic growth rate of below 1% will usually result in a rise in default rates, which is negative for high yield bonds. A level of 1-2% real economic growth is the 'sweet spot' for high yield bonds, as income is very attractive and growth is not low enough for default rates to increase. Moreover, such low-growth periods tend to result in a high level of volatility in financial markets, which discourages leveraged buyout activity and heavy capital expenditure, and forces company management to maintain strong balance sheets. Additionally, such an environment forces investment grade companies to pursue growth through acquisitions, an activity which is usually beneficial for high yield bonds. In conclusion, even if credit spreads do not contract in this environment, we believe high yield coupons appear to have the potential to offer sufficiently attractive investment opportunities.
Index explanations
The FTSE 100 Total Return Index This index comprises the 100 most highly capitalised blue chip companies, representing approximately 81% of the UK market. It is used extensively as a basis for investment products, such as derivatives and exchange-traded funds. A Total Return index tracks both the capital gains of a group of stocks over time, and assumes that any cash distributions, such as dividends, are reinvested back into the index.
The Merrill Lynch U.S. High Yield Master II Index is representative of the U.S. high yield bond market. The index includes domestic high-yield bonds, including deferred interest bonds and payment-in-kind securities. Issues included in the index have maturities of one year or more and have a credit rating lower than BBB-/Baa3, but are not in default.
The S&P 500 Index Total Return Index is an index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe. Companies included in the index are selected by the S&P Index Committee, a team of analysts and economists at Standard & Poor's. The S&P 500 is a market value weighted index - each stock's weight is proportionate to its market value. A Total Return index tracks both the capital gains of a group of stocks over time, and assumes that any cash distributions, such as dividends, are reinvested back into the index.
1 As represented by the ML US High Yield Masters II Index
2 Ibid.
Important information
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