Credit: Far from junk
High yield was a screaming buy back in March 2009. Joseph Mariathasan finds that healthy fundamentals provide good support for latecomers to come in when the broader markets get jittery
The roller coaster ride of the high yield market during and after the credit crunch has produced some spectacular losses and wins. What has become evident more recently is that the rapid changes of sentiment between market panic and euphoria have been the driving forces behind market movements, not changes in fundamentals. But perhaps it is time now for a more sober assessment of the asset class and its role within investment portfolios.
The global recession following the excesses of previous years, particularly in private equity, has certainly had an impact on high yield default rates. Compared with average historical default rates of 4-5% per year, in 2009 there were record defaults at 13% in the US and 10% in Europe.
Tatjana Greil-Castro, a managing director in Muzinich & Co's London office, argues that this cleansing has placed the market in a much better position. "It has cleared out companies with business models that did not have the right capital structure, or were too optimistic about their equity value in the case of leveraged companies bought by private equity firms who paid too much," she says. The clearout means that future default rates are expected to be much lower - Greil-Castro expects no more than 2-4% over the next year. With high yield spreads over 8% (for BB/B ex-financials) at end of May, that still represents a high pick-up over government bonds.
Klaus Blaabjerg, lead portfolio manager for Sparinvest's global high yield strategy also has strong views that default rates over the next year will be significantly lower, drawing on his firm's own forecasting model based on four key US economic figures. In the last months of 2009 there was a steep drop in the number of corporate defaults, which corresponded closely with companies' ability to refinance existing debt in a very liquid credit market. This is expected to continue.
Sparinvest's own analysis suggests that default rates would be 2.5% in an optimistic scenario and 6.3% in a pessimistic one, with an expected rate of 4.4%. May's 200 basis point widening of spreads appears to have been driven by market jitters over the confluence of the crisis in the euro-zone, rising tensions on the Korean peninsular, oil belching into the Gulf of Mexico and the prospect of punitive financial regulation coming down the pipeline, suggesting that spring's fair value might have turned into summer's cheapness.
US issuance surged through 2009; $182bn (€148.1bn) came to market. While European issuers have lagged, there now seems to be some convergence. Private equity is no longer raising finance for new leveraged deals, so the predominant activity in the marketplace is the refinancing of existing debt, says Greil-Castro. "As long as companies have the cash flow to pay interest, they should be relatively immune to the economic environment around them," she says. Some companies coming to market are very defensive - for example, cable operators that have already spent a lot of money on infrastructure and are now able to reap the benefits - while others have already undertaken much cost cutting and the resultant earnings rebound is enabling them to extend the debt maturities on their balance sheet. "There is now very little to refinance in Europe in 2011 and 2012. Companies are now refinancing themselves to beyond 2012," notes Greil-Castro.
There is also some issuance by companies refinancing bank debt in the high yield marketplace, with banks reducing their lending and demanding higher margins and tighter spreads as they shrink their balance sheets. "In 2005, 2006 and 2007, high yield issuance driven by private equity leverage buyouts had very loose covenants and the equity portion of a deal was typically between 5% to 15%," says Darrin Smith, a portfolio manager at Principal Global Investors. "Now private equity deals are few and far between, and they have to put up 50% in equity." What has changed is the strength of covenants; in 2009, covenants were very strong and while there was some loosening in early 2010, the widening of spreads in May is likely to encourage a return to stronger covenants.
For European institutional investors, adopting a global strategy to investment in high yield is sensible. As Blaabjerg points out, it means managers can buy assets where they are cheapest and not be forced into chasing European LBO deals. Moreover, the European marketplace is very young compared with the US, with a predominance of debt from unlisted companies. This creates problems since information is much more readily available from publicly listed companies.
"To get information from a private company, you need to be connected to it, and may still find a time delay," says Blaabjerg. "With publicly-listed companies, we are fighting on the same battlefield with their high yield debt." With just a 35% exposure to the US, Sparinvest has half the benchmark weighting, but it sees value in small-caps because it believes there is a significant size effect in spreads as investors are compensated for taking on the liquidity risk of smaller companies.
In contrast, the strategy is heavily driven by the oil and gas sector in Europe, which offers debt backed by hard assets in terms of drilling rigs. "We like the mortgages on modern drilling rigs. Unlike sub-prime mortgages in the US housing marketplace, here, if the location is found to be no longer attractive, the rig can be moved."
Generating a higher yield than investment grade bonds, while offering a more defensive strategy than equities are clearly attributes that are driving demand for high yield. One alternative with similar characteristics is leveraged loans. M&G is very active in this sector with around £8bn under management, according to fixed income division managing director Simon Pilcher. "With prospective returns of Euribor plus 450-500bps for B and BB credits, we see them as a superior asset class to high yield," he says.
Garland Hansmann, a portfolio manager at Intermediate Capital Managers, while enthusiastic for the asset class, is more circumspect. "Valuations of senior loans relative to high yield bonds are about at their long-term average, maybe a bit in favour of high yield," he says. "Both European high yield bonds and senior loans show good value compared to many other asset classes and compared to their long-term average. Loans are, however, floating rate and so have zero duration." Having no exposure to rising interest rates can be attractive from an absolute return viewpoint, and leveraged loans also have the advantages that they are senior to high yield in the capital structure and have much stronger covenants (see page 53 for more on this in our interview with Babson Capital).
High yield looks attractive for three fundamental reasons according to Greil-Castro: first, the expected low default rates going forward; second the growing primary issuance and third, the attractive yields being paid which, at the end of May, more than compensated for expected defaults. The biggest risk for investors might not be that of actual defaults, but of spreads widening due to market panic. For long-term investors, such movements may well be regarded as opportunities.