Last year was good for European high yield – not just in terms of investment returns, but issuance volumes last year were at record levels, passing those achieved in the now notorious Year 2000 at the height of the telecom bubble.
Although the period between the spring of 2000 through to the end of 2002 was a challenging time for participants in high yield it is with admirable stoicism that those players look back and consider the pain suffered may have been worth it in the longer term. Europe’s high yield market is now far more robust and certainly much healthier.
“There were two significant outcomes of the – temporary – demise of Europe’s high yield market,” says Mikael Lundstrom, head of fixed income and credit at Evli Investment Management. “Firstly, the blow-up saw the disappearance of the bulk of the lowest quality issuers, those huge telecoms issues which completely dominated the market in the late 1990s. This meant the market was left with healthier companies from more stable industries. Secondly, the liquidity squeeze which was hurting many former investment grade companies, was eased as they were able to issue longer dated debt to refinance their shorter debt.”
The jumbo telecom issues may have sunk with little trace but far from disappearing during 2002, Europe’s high yield market started to fill up again, with ‘fallen angels’ – issuers downgraded from investment grade (BBB- and higher) to speculative grade BB+ and lower.
Guillaume Bucaille, head of credit at Swiss group Pictet Asset Management, refers to this as ‘Stage Three of the development of Europe’s high yield market’. “Stage One was those early days of the market dominated by the telecom and cable issuers. Stage Two, the arrival of ‘fallen angels’ (into the high yield domain) automatically had a big effect on the investment universe, altering its profile dramatically. What we then saw through 2003 was the recovery of many of these ‘fallen angels’ as companies rallied and repaired their balance sheets. We talk to the managements of companies in which we invest and many of the ‘fallen angels’ state quite openly that one of their first priorities is to get their credit ratings back to investment grade status, rather than returning cash to their shareholders.”
Threadneedle Investment’s Barrie Whitman says that “2004 was similar to 2003 in that investors did get paid to take risk, with the lowest rated sectors putting in the best returns.” Asked whether this good news can continue through 2005, managers like Whitman are on the whole cautiously positive. Says Whitman: “2005 could track 2004 in term of improving/strong fundamentals supporting the market, but we do not see much return potential. Credit fundamentals have improved, earnings’ growth has continued, default rates have also come down and ratings statistics are very positive. However, it is more difficult to see the potential for further spread tightening, but then one might have said the same this time a year ago. Where 2004 was a year where we got coupon/yield plus capital, 2005 may be more a year where we have to accept just the yield.” Towards end of 2004, Whitman was actively starting to cutt back on credit risk.
Evli Investment’s Lundstrom agrees with this more cautious approach, adding: “Our main scenario is that overall in 2005, high yield will perform better than government and investment grade markets. Stable economies are good news for high yield. Companies can improve their cash flows and continue to pay down debt. The market does not want to see huge investment, funded by issuing bonds, we prefer them to stay where they are and carry on paying their debts. That said, we do not envisage spreads compressing further from today’s historically tight levels.”
Although managers seem generally bearish on interest rates, high yield managers can afford to be more sanguine than their investment grade peers. Compared to other fixed income securities high yield are least affected by movements in interest rates. The inverse relationship between a bond’s coupon and its duration, which describes its sensitivity to interest rate changes, means the higher the coupon on a bond, the shorter its duration.
However, there is increasing nervousness about how much good news spread products and especially high yield bonds have already priced in. Default rates are currently at record low levels. At the end of December last year, Standard and Poor’s global
12-month rolling speculative grade default rate was 1.77%, a fraction of its long-term (1981-2003) average of 5.27%, though it is still higher than the record low of 1.3% posted in the second quarter of 1997. S&P also highlights the narrowing of speculative-grade spreads, from 452 bps on 31 December 2003 to 336bps at the end of 2004.
As well as acknowledging that the opportunities are less attractive, some managers are expressing concern that issuer quality is declining and leverage increasing. Whitman states: “In strong market conditions there is a propensity to see issuer quality decline. The private equity houses have lots of cash just now and are in aggressive purchasing mode. These leverage buy out deals (LBOs) funded through the high yield markets tend to be lower quality, B-type rated. Disintermediation, that is switching corporate financing out of the banks and into bonds, tends to involve better quality names.”
But Pictet’s Bucaille, like other high yield managers, is careful not to state that high yield bonds are over-valued. “High yield is fully pricing in record low default rates and strong credit fundamentals. This is a fact, so we would not yet describe them as ‘expensive’. He explains: “The simple maths behind high yield makes them still interesting. The two main issues for high yield investing are the default rate and the recovery rate (this is the average proportion of money eventually returned to the high yield investor in the event of default). The average pick-up in high yield is currently around 300 bps, the default rate is 2% and the recovery rate is averaging 40/50% - it is hard not to see high yield as fairly priced, even if we add a 1% premium to compensate for the limited liquidity of this market.”
Nevertheless, Bucaille advises caution in 2005. “This year is not going to be dull. A lot of money has been piling in to CCC-rated paper because that’s where the yields are highest. I agree that there are many interesting stories in these lowest rated bonds. For example, there may be dynamic management actively cost cutting and successfully improving the balance sheet. Investors do not just look at the ‘snapshot’ of a credit rating.”
What Bucaille is most concerned about is that to sustain the rosy scenario, investors have to be sure that default rates will continue to fall, especially for CCC issuers and that is where Bucaille is not convinced.
“There are two things which worry us almost equally right now,” he says. “On the one hand, the default rate may turn out to be higher than expected, which could happen if interest rates rise further than expected.”
On the other hand, there could be a general shift out of high yield and in to equities.