If there is one realm in which the theory ‘beggars can’t be choosers’ is surely disproved, it is that of the financial markets. Wounded by two to three years of weak global equity markets, investors are being thrown ever more choices as they forge ahead on their quest for positive returns. One beneficiary of the recent open-mindedness of investors is the European high yield market. Given expectations for equity returns, and government bonds yields of next to nothing, the European high yield market, strutting yields of 10-11%, is turning a few heads.
The asset class’ rather brief and chequered history has done little to promote the European high yield market. The 1998-2001 telecom bubble, and its resulting burst claimed the European high yield market as one of its worst victims. Young and immature, the market got caught holding 70% of the volume coming from start-up telecom companies, and the lack of diversification meant returns were less than stellar. But the recent phenomenon of the ‘fallen angel’ may just be about to change all that.
Fallen angels - companies which have lost their investment grade status - is relatively new concept in Europe. As credit quality deteriorated during 2001 and 2002, companies that embarked on acquisitions during the boom years were left with high levels of debt and lower than expected cash flows, and the response from the ratings agencies was an increase in the number of downgrades, explains Dresdner Kleinwort Wasserstein. 2002 saw a record number of fallen angels land in the high yield sector in both the US and Western Europe.
The result has been a profound one for the market. With the increasing number of companies and new sectors falling into the sub-investment grade zone, lack of diversification no longer holds up as a case against high yield. Investors are also gaining increasing exposure to companies that are larger than the traditional high yield issuer, and the credit cycle is not showing signs of bottoming out in the near future.
Whether these fallen angels offer value differs from case to case, and whether they will fall further is also open to debate – pessimists would need only to hold up Worldcom as example. But with sufficient due diligence it is possible to separate the wheat from the chaff to a greater extent, and investors would do well to not to punish the said corporates so readily. To cite the poetic Brooks Brady, associate director of Standard & Poor’s Risk Solutions: “Unlike the devil who fell from heaven to rise no more, corporate fallen angels have not committed the unpardonable sin, and may rise again to investment grade.”
Furthermore, as Brian Bassett, managing director of European High Yield Capital Markets at Deutsche Bank, explains: “Many of those having fallen into the high yield space are well-known names. And just because these companies are now rated below triple B minus, does it really make sense to say that each of those credits should now be avoided?” Paper from issuers such as Crown Cork and Seal is performing well – the euro paper traded down in the low 30s 18 months ago, but is now trading in the mid-90s. Xerox and ABB are also companies which have seen performance pick up over time.
On a long-term horizon fallen angels could add significant value to a portfolio, and Standard & Poor’s aptly describes the new asset class as “short-term risk with long-term potential”. But this does not mean to say that traditional high yield bond issuers should be ignored either. Although historically, fallen angels have been more likely to be upgraded than issuers that were originally sub-investment grade, Bassett believes that the traditional high yield market also contains value. After the fall-out of the telecoms bubble’s start-up companies, “what we are left with in the European high yield market is a core group of businesses which generate steady cash flow and have been around for a while.” Although issuance from these borrowers has been scant, activity is likely to pick up as European corporates become increasingly forced to turn to the capital markets for their funding needs.
High yield bonds could also be about to get lucky in terms of timing. Laurence Mutkin, head of fixed income strategy at Threadneedle Asset Management believes that if the situation in the Gulf is resolved, investors’ risk aversion diminishes and the economic outlook improves, high yield will be the bond asset class to perform. “High yield is not a market to invest in without the resources necessary to conduct a rigourous in-depth analysis at individual issuer level,” says Laurence Mutkin, head of fixed income strategy at Threadneedle. “That said, in the current environment investors with an allocation to the high yield market will see considerable benefits.”
So there you have it – investors can be choosers, and may end up being lucky beggars.