High yield is priced so keenly it would take a euro-zone break-up to really threaten investors, finds Anthony Harrington
In times of severe economic difficulty investors look for safe havens in which to wait out the storm. In one of the oddest twists for many years, by Christmas 2011, high yield corporate debt, supposedly one of the riskier asset classes, looked to many to be the safest bet around - with the added attraction of providing potentially double-digit returns on capital.
Omar Saeed, head of high yield at Swisscanto Asset Management, points out that gold got crushed in the 2008 crash and is plunging once again as investors dash for dollar assets. Against gold’s dismal story, secured high yield corporate bonds are paying an average coupon of 9%. The market is demanding a premium of 150 basis points on top of those already generous coupons from new issuers, and there are also plenty of bonds going at attractive discounts to par in the secondary markets, offering the prospect of capital gains on a pull back to par as maturity approaches. Buying US corporate bonds kills two birds with one stone, providing dollar protection and holding out the promise of double-digit positive returns instead of the negative real returns offered by short-term Treasuries.
“With new issuance increasingly secured against the company’s assets, investors have the comfort of knowing that they should get around 70% of their capital back, even in the event of a default,” Saeed says. “If you have held the bond for a few years and pocketed the coupons before it defaults, you lose nothing.”
While Treasury yields plummet even as the US credit rating is cut, markets by contrast currently price in around twice the rate of defaults on high-yield debt that most managers anticipate through 2015. Of course, if the euro-zone breaks apart suddenly and catastrophically, the default rate will soar and high-yield investors will take losses - just like everybody else.
“The consequences of a disruption on this scale would be huge,” says Baillie Gifford’s Robert Baltzer. “Which jurisdiction the debt would end up in is bound to have some impact on default rates and the broader economic disruption would really shake the tree.” Companies that are already somewhat leveraged would be likely to tip over the edge in that environment.
Under these circumstances, it is no surprise to see investors favour US over European bonds. Steve Logan, head of high yield at Scottish Widows Investment Partnership, says he has been giving a lot of cash from coupon receipts and bond redemptions in European funds to his US colleagues to invest in SWIP’s US high-yield fund. He points out that while high-yield managers have deep experience at judging where credit spreads should be at any part of the economic cycle, “none of us are experienced at analysing politicians - so that challenges the whole market”. That said, SWIP still has $25bn in sterling and euro-denominated high-yield issuance and there is no chance of finding a buyer for any significant chunk of that book - even if SWIP was minded to shed it.
“What are we to do? If we use a credit derivative from a bank to hedge out the volatility, there is always the chance that in a worst-case scenario where we need the hedge, the underwriting bank will go bust on us.” There might be an argument, he says, given the seriousness of the European situation, for getting out of everything and just holding the money in cash, but right now a migration on that scale simply isn’t possible.
Besides, most high yield managers seem to think that the EU has done enough, for the moment, to hold the currency union together and Colleen Denzler, head of high yield at Janus Capital, shares the widespread view that, short of an outright euro break-up, the rate of default in high yield is unlikely to go up to any marked degree. “High yield is one of the few spaces globally right now that offers both great returns and strong fundamentals,” she says. “Companies have built up their cash and reduced their cost structures since the crash of 2008. Their margins are good and they have a lot of cash on their books.” A severe and prolonged recession in Europe in 2012 would undoubtedly erode the safety margin that many companies now enjoy. “But we put a severe recession at only a 10% probability,” she says.
Through the summer of 2011 there was €45bn of new high-yield issuance and the amount coming to market since 2009 has been massive. Companies are clearly looking to the high-yield space for funding as banks have cut back on their lending lines. At the same time, maturities have been extending outwards for about the last three years. While no more than 5% of the market is 10-year, the fact that this is happening at all is significant, says Andrew Wilmot, head of European high yield at AXA Investment Managers. The extension of maturation dates is being driven by the combination of corporate treasurers wanting to lock in debt at 9-10% for as long as they can, fearing future rate rises, and yield-starved institutional investors wanting to secure the coupon income for longer durations.
“Pension funds, historically, have had a very high exposure to government bonds and equities,” says Wilmot. “However, with extremely low yields on core sovereign debt and equities doing almost nothing for a decade, funds have been shifting their focus to high yield.”
Anthony Robertson, head of high yield at Bluebay Asset Management, sees a good deal of institutional money rotating out of equities and into high yield. “The probability range of outcomes for high yield is much more compelling than equities under any of the worst-case or even the high-probability macro scenarios,” he says. “We see this move to bonds from equities continuing to dominate through 2012.”
Robert Macquardt, CEO and founder of the fund of hedge funds Signet Capital, agrees that opportunities really mushroom in difficult times, particularly with banks being forced to shed high yield at a discount into an environment where there are few credit experts in a position to buy. “Proprietary trading desks at banks are a thing of the past and this is the first time that European high yield has gone a bit pear shaped,” he says. “It is attracting attention from many of the biggest US hedge funds and some of the European ones as well.”
But he also warns that this is a tough market for long-only investors like pension funds, since there is too much mark-to-market downside risk. This is quintessentially a market for hedge funds which can take long/short positions, he argues - whether that be long the bond and short the equity of the same company, or long a German bank bond and short a Spanish bank bond, for example.
“What hedge funds are typically doing is looking for an event or special situation to unlock value in a bond or a company’s capital structure. So we do a tremendous amount of forensic balance sheet work to really understand the company, and the potential for future events,” he says.
Is the company likely to swap the debt forward? Is it going to be pushed to do a rights issue? Will it go into bankruptcy? How close is the debt to maturity? The great thing about bonds, he says, is that there are these intrinsic events built into a bond that create opportunities for investors. The pull-back to par as the bond approaches maturity creates capital growth potential which helps to offset risk.
But, as we have seen, many long-only managers insist that the worst-case risk is already priced into these bonds - and among the income-generating investments, that puts high-yield into class of its own.