HIGH YIELD MARKETS

What have Dell, Peugeot, ArcelorMittal and Heinz all got in common? Yes, they are all household names. And yes they all have also issued high-yield bonds. In the minds of many investors, junk bonds, as they were once called, represent the smallest, riskiest part of the corporate bond spectrum. Reality demonstrates that the rapidly-expanding high-yield market now encompasses thousands of companies across all industrial sectors.

Europe plays catch-up with us

The high-yield market in the US has attracted investors for decades and now represents more than USD 1,437 Bn (as at end Oct.’14), while Europe is progressively maturing with a total of EUR 291 Bn (as at end Oct.’14). The trend in Europe has dramatically accelerated, bolstered by rapid disintermediation as banks are now reluctant loan originators, and by the ever growing search for yield by investors in a low rates environment. As a consequence, the European market is growing at a much faster rate than the US market, and has expanded three-fold over the last 5 years.

Although the European high yield market becomes more mature as the years go by, the US market still remains more liquid. Moreover, US high yield market flows are driven by investors’ expected returns on equities.

Sources: BAML Indexes (G2D0, G6D0,GA05, GA10,HEC 0,HUC0,HEC 5,H- 4NF Index), Bloomberg, as of 31 Oct. 2014 (left), Credit Suisse, JP Morgan, Lipper, Moody’s and BOAML Indexes / Data as of Q3 2014 (right)

Not as risky as you think

While some investors equate high yield with high risk, this is not supported by the data. As the diagram shows, high-yield bonds exhibit considerably less volatility than 10-year government bonds and similar volatility to investment grade bonds. At the same time, high yield delivers returns of around 9% a year, significantly higher than other bond classes.

Although equity markets have delivered better performance over a five-year period, equity investors have had to endure five times the volatility of high-yield bonds.

In terms of valuation, after a strong rally post-crisis with spreads tightening by 250 bps since 2011, the global high-yield markets look today fairly valued. The average yield is 380 bps with an accompanying standard default rate of 2.5%. In addition, the carry offered both in Europe and the US is attractive in the current low interest rate environment.

Structurally, High Yield bonds tend to have a lower duration than the safer Investment Grade bonds. As a consequence, any potential hike in the Fed rate will probably impact High Yield bonds, but to a lesser extent, as HY bond returns are less correlated to rates than IG bonds, and more correlated to the equity markets. Moreover, any Fed hike in 2015 will be triggered by the current US recovery: as a sound economic environment is positive for credit fundamentals, we expect the ongoing US growth to drive low default rates and higher profits. We thus forecast a tightening of US credit spreads in the medium term that will offset the negative impact of US rates.

 

 Sources: Credit Suisse, JP Morgan , Lipper and BOAML Indexes (ER 00, C0A0, HEC 5 and H4NF), (data as of Nov. 19, 2014)

Time to be selective

To sustain the level of returns of recent years, bond picking is likely to become the main driver of performance, as rising dispersion within high yield markets is providing today a wealth of opportunities.

There was a significant spike in dispersion in the second half of 2014, partly as a result of poorer-quality issuers entering the market. In a low-growth environment, issuers with high leverage are sometimes unable to meet their debt repayments, and smaller companies struggle to maintain their pricing power. In a downturn, default rates might increase among these types of companies.

This provides a nice set of opportunities for a bondpicking- focused portfolio manager, in terms of relative value, arbitraging different issuers, different issues or cash bonds versus derivatives.

• In Europe, we can expect a slightly lower default rate thanks to the exceptional liquidity conditions provided by the ECB. However, forecast anaemic growth will pressure retail-oriented and building sectors, for example.
• In the US, where there is less support from the central bank, growth is much higher. We therefore foresee retail, healthcare and services as behaving well. On the contrary, if the oil price keeps well below USD 70 / barrel (the average breakeven price in shale oil extraction), we foresee ratings pressure on the energy sector (around 12% of the US High Yield market) and the basic materials sector.

Last, but not least, the size of issues, the size of companies, the number of marketmakers and the availability of credit default swaps on underlying issuers are all key to liquidity.

A growing and more diversified high-yield market, coupled with expected interest rate volatility, is likely to provide a more colourful palette for alpha-seeking investors. To achieve successful high yield bond management, the skillsets of bondpicking and deep fundamental knowledge are today preferable to a standard beta approach. Our current return expectation on the US and European high yield markets stands at 4% for 2015. Through our active management and alpha generation, we expect to achieve a performance of 5-6%.

 

Sources: Credit Suisse, JP Morgan, Lipper – Flow data as of 30 October 2014 (left), Candriam, European index BAML €,£ BB -B (H4PC) / Adjusted dispersion of average spreads of the index, calculated as Dispersion = √ VAR (Spreads) / Average spreads index (right)

Alpha is generated by multiple drivers

Alpha comes in many shapes and sizes, and the sources change over time. Candriam has identified five different sources of alpha.

1. Bondpicking based on each company profile We favour higher-growth companies with euro-denominated debt: strong, dynamic franchises – often found in the US – with euro exposure, give us the best of both worlds: US growth (for spreads) and the stable European environment (for rates). Niche companies which have high market shares are also attractive, as well as lowcyclical businesses, such as retirement home operators. These types of companies have low correlation to economic growth and are likely to be durable in the case of an economic downturn.
2. Mergers and acquisitions (M&A) With low interest rates constraining organic growth, companies are looking increasingly for M&A, which impacts the debt structure and attractiveness of both the acquiring and target companies. We try to avoid bidding companies, whose balance sheets could be depleted by their M&A offer. The flip side is that highyield issuers which become acquisition targets may increase in value through upgrading. As an example, we will very actively monitor the US energy sector, which is likely to undergo an M&A consolidation, with the same attractive opportunities we saw between 2009 and 2011 in the shale gas/oil sector before the boom initiated in 2012.
3. Debt tenders & calls Corporates are increasingly seeking to refinance their short-term debt with longer-term debt at once-in-alifetime low interest rates. And when the short-dated bonds are recalled, investors receive their capital back earlier, providing significant potential value in short duration issues.
4. IPOs offer alpha. As equity multiples recover from their lows of 2008-09, initial public offerings (IPOs) are more in evidence. Many companies financed by leveraged buyouts are seeking a return to the markets, triggering provisions that enable high-yield investors to be paid out by the proceeds of equity offerings.
5. US versus Europe Asset allocation between US and European high-yield markets is another source of potential alpha. The US market is deeper and offers longer-term maturities of 10 years, which are as yet unknown in the European high-yield market. Purchasing longer-term maturities can increase potential portfolio returns if – as is the case in the US – long-term revenues and earnings growth are likely to be high. In addition, the maturity of the US market provides greater visibility. By contrast, in the European market, we focus on mid to intermediate maturities.

A unique investment approach to benefit from the dispersion in High Yield markets

It is interesting to note the different approaches of US and European investors to high yield. For US investors, high-yield is often seen as a safe way to get equity-like exposure to markets. Thus, they tend to re-allocate from high yield to stocks in bullish equity markets. On the opposite side of the Atlantic, fixed income-focused European investors see high-yield bonds as a way to take more risk when markets are trending to the upside.

Whatever your investor philosophy, high yield bonds can play a significant role in all global portfolios as a way to improve risk-adjusted returns. For European investors in particular, the prospect of beating returns from government and investment grade bonds with controlled volatility represents a compelling argument, and a call to pick the highest-skilled high-yield-bond fund manager.