 |
| Table: High yield bond funds (CLICK TO VIEW) |
US high yield corporate bonds including CCC-rated bonds made total returns of about 12 per cent in the first three quarters of the year, while European high yield made even more with the broad market, including CCCs, returning 20 per cent and BBs and Bs returning 19 per cent.
While this severely curtails scope for further strong outperformance, rising risk appetite continues to drive unprecedented demand for corporate bonds, particularly high yield, as investors turn away from government bonds that are paying less than 1 per cent for investments of five years.
High yield also compares well with equity in the current climate. “Euro high yield is a risk asset that in the long run offers an average return of close to 8 per cent per annum, with a significant volatility (7-9 per cent) for a fixed income security, but approximately half the volatility of equity (15 per cent plus),” says Olivier Monnoyeur, portfolio manager at BNP Paribas. His own conservative BNPP Bond Euro High Yield C fund excludes both CCCs and subordinated debt and is measured against a benchmark yielding 6 per cent compared with 2.3 per cent for investment grade and government bonds in safe countries paying 1.5-2 per cent on a 10 year basis.
“If you bear in mind the time horizon for most high yield bonds is five years, they compare well with the payout on five year Germany bonds at 52 cents,” says Mr Monnoyeur.
Corporates have been taking advantage of the increase in risk appetite to refinance their debt, with new dollar-denominated high yield issuance of $261bn (€200bn) for the first three quarters of the year surpassing last year’s full-year total of $246bn and September’s $45bn issuance is one of the highest on record.
LOOKING FORWARD
“The first nine months of the year have produced a period of steady positive returns even though there have been moments of potential world events that could rile the market,” says David Bowen, investment fund manager at corporate credit specialists Muzinich.
“The market is up partly because central bankers are flooding the market with liquidity to encourage people to continue buying risk assets, but there will be headwinds. As we move through the year the focus will shift to the US election and the aftermath – post election, a lame duck Congress may not take action on a number of fiscal issues,” he says.
“Then there is always ongoing risk around Greece and Spain, and it’s fair to say we live in a truly unpredictable world – China, Iran and Israel could all kick off. You could say we are due for something to give the market a pause. But then, you could have said that in any of the last three months, so we are a bit cautious, but that does not mean that the market can’t continue respectably for the rest of the year.”
A finely balanced economy will be a prerequisite for that to happen. If the economy becomes overheated then government bonds could squeeze yields, particularly at the lower risk end of the market where there is more interest rate risk, and the technicals would worsen as investors switched to equities. At the other end of the spectrum, if the economy slows then default rates could pick up, which would particularly impact the end that carries most credit risk.
There is also speculation that a big upturn in equity markets could reverse the huge inflows into high yield exchange traded funds (ETFs) and de-stabilise the market. This may be overhyped however as these ETFs did not suffer outflows during the volatility in April and May, and ETFs comprise only $30bn of the $1.1tn US high yield market.
Within Europe, peripheral corporate bonds continued to outperform their peers in core markets, with non-financials outperforming by almost 4 percentage points since the ECB implemented its monetary policy at the end of 2011. However credit ratings are under pressure, causing spread compression to stall in the autumn.
Opinion on whether further compression in peripheral Europe is possible in the coming months divides the market, and a marked shift in the landscape has driven managers to examine a wider range of indicators such as country, sector, rating, cashflow and sensitivity, whereas rating used to be the predominant factor.
“Peripheral credits are the most interesting part of the market and where we still see room for upside,” says Raffaella Tommaselli, co-fund manager of Eurizon Capital’s high yield funds. “Clearly we could still experience volatility but the ‘ECB PUT’ has given a floor to the market. Besides that, the inflows in the European high yield market have been very strong for most of the year and many investors missed the rally and have a lot of cash to put to work. This liquidity buffer of investors will probably continue to support the market and prevent any technical meltdown.”
