Dramatic repricing has opened up opportunities in high-yield, finds Lynn Strongin Dodds
It is no surprise that the high yield market is in a state of flux. A looming euro-zone crisis coupled with a stagnant economy in the developed world has made investors extremely nervous. Ever-widening spreads means that there are opportunities to be plucked but a careful selection of short-dated credits in non-cyclical sectors is advised.
“Although spreads have the scope to go much wider in the short term it is always difficult to call the bottom,” says Jamie Hamilton, senior credit fund manager at M&G Investments. “If you wait you may miss your chance. The one lesson learned from last time is that markets can spike up again very quickly. I do not see investors piling in but pension funds with a longer-term time horizon should start to take advantage of the better quality credits.”
This is in sharp contrast to the first half of the year when investors, as well as companies, were piling into the markets and analysts were forecasting record levels of issuance. But the proverbial music stopped this summer with the prospect of Greece defaulting, the political wrangling over a resolution, and fears of contagion and double-dip recession. US high-yield issuance plunged 72% to $25.1bn (€18.4bn) in the third quarter - only $1bn came to market after Standard & Poor’s cut the US credit rating in August, compared with a healthy $18bn crop in July.
In Europe, in the first six months of 2011 there was a bountiful €38bn of issuance, approaching 2010’s record of €51bn. There had been high hopes that this less mature market was finally coming into its own but predictions are being revised while investors retreat to the traditional safe havens of cash, gold and investment grade bonds, almost $15bn pulling out of high yield in August to erase all the year’s earlier inflows, according to EPFR Global. Withdrawals continued through September.
“The elephant in the room of course is what will happen to Greece and the effect it will have on the euro-zone,” says Andrew Wilmont, head of European high yield at AXA Investment Managers. “High yield has been impacted but so have equities and other risky asset classes. Economic indicators are also declining and although no one is saying we are back in recession, this is a red flag. It is not unlike Lehman - where we are not sure what will happen - and this is why there has been a sell-off.”
Steve Roth, fund manager at GLG Partners adds: “We are once again in an unprecedented environment with the possibility of a major sovereign default back on the table and the prospect of a recession. As a result, it is difficult to price any risk asset. There is no doubt that high yield is cheap but it depends on your view as to the type of downward spiral we are in. We believe that there is good value at the quality end of the spectrum.”
Spreads have widened to about 800 basis points in the US and around 1,000 in Europe, with both markets pricing in 8-10% default rates. According to Ben Bennett, credit strategist at Legal & General, this still falls well short of the post Lehman reactions.
“Pre-crisis, the spread on the BarCap Global High Yield index dropped as low as 2.2% in May 2007 but then, after Lehman, the index peaked at a spread of 18%,” he recalls. “We then dipped back down to 4.4% at the start of this year. However, although spreads have widened substantially, we are only half-way to post-Lehman wides and corporates are in much better shape than in past recovery periods.”
One reason is that companies did not have time to embark on widescale capital expenditure programmes. Just as they were replenishing their cash stockpiles, news about Greece and stagnating growth hit the markets. As Ty Anderson, global chief investment officer high yield strategies at DB Advisors, says: “We did not have the expansionary phase that typically follows a recession. This time around we are coming off a retrenchment and the deals that have come to the market this year have been for refinancing and cleaning up their balance sheet. This is the case in both the US and Europe but the spreads have widened the closer you are to Greece, Spain, Portugal and Italy. We have a bottom-up approach and focus on individual credits because we believe that even in the toughest sectors there will be sound companies.”
Fears of high default rates are also thought to be exaggerated. “From a valuation standpoint, high yield spreads at 800-plus in the US look compelling, given the fundamental outlook for the market constituents,” notes Jeremy Hughes, high yield portfolio manager at Aviva Investors in North America. “Due to the tremendous amount of refinancing that has occurred over the last two years, the ‘wall of maturities’ that many feared in 2012 and 2013 has been pushed back substantially. Additionally, with interest rates at historical lows, issuers were able to refinance with even lower interest burdens than they had in the past. The combination of these two factors will lead to default rates remaining low for the next few years. In fact, excess spreads suggest that investors are getting compensated for an environment of 7-8% defaults not the sub 2% that are expected for the next few years.”
As with many fund managers, Hughes is focusing on the higher and quality end of the spectrum - BB and B issuers - not only because they will continue to generate significant cash flow to pay down debt, but because they are also in a strong position to weather a drawn-out slow growth period.
“The same cannot be said for CCC issuers,” says Hughes. “They are typically over-leveraged and their survival is predicated on either growing into their capital structure or an open new issue market where they can buy themselves more time by pushing off maturities. This segment of the market is most vulnerable to a prolonged period of below-trend economic growth, which is why CCC annual default rates have averaged nearly 25% historically.”
Michael Lillard, CIO at Pramerica, also talks up the ‘crossover’ space. “The best opportunities we see in high-yield are, ironically, the lowest-yielding securities,” he says. As dedicated high-yield investors reach for yield, they tend to sell two-year bonds for 10-years, and strong BBs for single-Bs. “We love to look for things like that, which become difficult for other investors to own. Money market and investment grade accounts can’t buy very high quality two-year BBs because it’s classified as high-yield, and the high-yield guys don’t want it. As a result, right now, BB spreads are very wide relative to BBBs. But CCCs are relatively tight relative to BBs. So BBs really do stand out as a cheap part of the market - and we don’t think the default rate for BBs is going to pick up severely, thanks to the conservative way the companies are being managed.”
Omar Saeed, head of high yield at Swisscanto, believes that investors in European high yield can reap 12-14% returns over the next 12 months on the back of strong corporate fundamentals. “We are positioning ourselves for a bounce but the biggest risk is the fear factor, which can drive the markets further down. Investors need certainty and, at the moment, it is still unclear how politicians are going to solve the European debt crisis.”
Overall the story looks compelling: double-digit returns might be possible from exposures and cash flows that still offer some shelter should the storm become even more violent in the months ahead.