High-yield bonds: Beyond the benchmark
Investors will need to take into account shortcomings in high-yield benchmarks and the idiosyncratic nature of markets when selecting a strategy, writes Joseph Mariathasan
At a glance
• There are strong sector differences between Europe and the US.
• Europe demonstrates the idiosyncratic risks of valuations and sector concentrations.
• There are differing views on emerging corporate debt, where some issuers can be seen as quasi-sovereign risk
The global high-yield bond markets can certainly offer opportunities to invest in higher-yielding assets but it is worth taking care to determine the investable universe. Focusing on just a single geographic area can lead to high sector concentration and, certainly in Europe at least, high idiosyncratic risk. The US and European high-yield bond markets do look very different, with the US having a much higher exposure to energy and commodities, and a zero exposure to financials.
The US and European high-yield markets have experienced a divergence in performance that is not just attributable to very different sector weights. “As well as the impact of the energy sector and a few other sectors in the US, including manufacturing and commodities, Europe is also being affected by ECB [European Central Bank]-driven flows of money,” says Alex Veroude, head of credit at Insight Investment. “As the ECB undertakes QE by purchasing investment grade debt, it is pushing other investors into higher-risk markets.”
The European high-yield market has, in aggregate, better credit metrics than the US, says Kevin Corrigan, head of fundamental fixed income for Lombard Odier Investment Managers, but he sees two problems – valuations and concentration.
Corrigan does believe that European high-yield is cheap, a view that many managers appear to agree with. The multi-asset manager CQS had a 65% allocation to Europe a year-and-a-half ago, but has shifted to holding 50% in the US currently, according to CIO Simon Finch. Insight Investment also favours the US: “We take a top-down view of the US versus Europe and have currently hit our 50% maximum exposure limit to the US,” says Veroude.
However, as Zak Summerscale, CIO of European high yield at Babson Capital Management argues, making comparisons of markets based on index spread levels is highly misleading: “The US index may be giving a yield of 9% but the tightest half of the market is yielding 5.7% whilst the widest half is yielding 13%.”
The dispersion is huge and managers are, of course, not buying the index: “We are actually buying better spreads in Europe than we are in the US,” says Summerscale. “If you dissect the two markets down into equivalent credit buckets there is not much in it. We think Europe is misunderstood in terms of people looking at indices and not actually looking at risk.”
More importantly, Europe is a concentrated and distorted market where the top 10 borrowers make up 25% of the market. This gives rise to high idiosyncratic risks exacerbated by fallen angels – former investment grade companies that have been downgraded to high-yield. In September 2015, for example, there were two individual stories – Glencore and Volkswagen – where investment-grade issuers suffered markedly and contagion spread to high-yield.
Corrigan does not think Glencore will be downgraded to high-yield; Volkswagen is unlikely to be but Anglo American might: “Anglo American bonds are trading at 12% yield whilst European high-yield is trading at 5.5%. It is likely to be downgraded from investment grade to high-yield, but it is not likely to default. So you have to ask yourself how rational is pricing in the high-yield market?”
Idiosyncratic issues were a feature of 2015 in European high-yield and will continue to be a source of concern for investors. There were several specific difficulties with Spanish issuers, particularly in the capital-goods sector where the construction company Isolux faced increased investor scrutiny following renewed corruption allegations and poor operational and strategic/financial performance, according to James Gledhill, head of European high yield at AXA Investment Managers.
Another problem arose with the energy company Abengoa, which announced in November that it would seek creditor protection as a result of failed negotiations with its banks. “The healthcare sector has also seen some volatility recently, with Four Seasons Healthcare looking to sell some assets to meet 2019 debt maturities,” says Gledhill. Such stories mean European high-yield investors need to tread carefully.
Deciding on whether emerging market hard currency corporate debt should be part of the universe is also an important portfolio decision. Babson, like many fund managers, excludes emerging market debt completely from its high-yield strategies with a separate emerging market debt team and set of strategies explains Summerscale.
But the line between developed and emerging is blurred, though, with Greece CCC-rated and Poland A-rated. Excluding emerging market high-yield means leaving Poland out while including Greece. In 2010-11, a wave of Asian and Latin American fallen angels with dollar bonds became part of the high-yield universe. But the addition of Gazprom and Petrobas in 2015 has also fuelled an increase in the allocation to emerging markets in the European high-yield index.
As Gledhill explains, while emerging-market issuers have been excluded from US high yield, investors voted in July 2015 to keep emerging markets issuers in the Bank of America/Merrill Lynch European High Yield indices. With substantial downgrades to Brazilian and Russian issuers in 2015, the share of emerging market issuers in European high-yield almost doubled from 4.8% at the beginning of 2015 to 9.3% currently.
“Importantly, over 25% of the market capitalisation of the emerging market high-yield index is in energy issuers and this has added volatility to the asset class,” says Gledhill. Emerging market bonds account for around 18% of the global high-yield index and almost 11% of the euro high-yield index.
“Energy accounts for 12% of the global high-yield index, but the problem is that 2% is Petrobras,” adds Greg Hopper, head of global high yield at Aberdeen Asset Management. “Petrobras is a sovereign story more than anything else. It is a cheap version of Brazil. If you are constructive on Brazil for the longer run, Petrobras offers 12% yields for an eight-year bond rated Ba3/BB.”
The challenges and opportunities in the global high-yield market make portfolio construction and investment strategy more of an art than a science. The standard benchmarks are riven by problems ranging from over-concentration, differing views on the inclusion of emerging market stocks and, most importantly, the inability to take account of illiquidity, which reduces their effectiveness as benchmarks of comparative performance. “The universe is not amenable to screening like equities, as a lot of companies are private, so the numbers are not easy to come by,” says Hopper.
For investors, this means that while global high-yield can certainly offer opportunities, what a manager can and should offer will be different from what the benchmark indices are presenting and that can be seen in the huge dispersion in performance.