High yield bonds are once again worthy of their name, yielding 10 per cent compared with under 7 per cent earlier in the year.
Many advisers are currently recommending overweight positions in high yield bonds on the basis they are priced for Armageddon default risk. Credit spreads are 900 basis points, which implies a default rate of 8-10 per cent, while the consensus is defaults are likely to remain quite low. The latest three-month default rate was 1.8 per cent on a global basis and 2.1 per cent for the US, according to Moody’s. Its projected default rate for the next 12 months is 1.9 per cent globally and 2.2 per cent in the US, more or less unchanged from recent experience. With gilts and Treasuries yielding under 1 per cent, in theory there is enough extra yield to compensate a cataclysmic default experience.
One indicator is the ratio of ratings downgrades to upgrades, and while this had been steadily improving since 2008, it tipped the other way in August and September, suggesting a worsening scenario.
Most commentators are not perturbed, however. For example, James McDonald, chief investment strategist at Northern Trust, is predicting an average annual default 2.4 per cent for the next five years – half the long-term average of 4.8 per cent – and lower rates in the initial few years owing to low refinancing requirements and healthier balance sheets.
There is particular confidence around the strength of corporate earnings. “From a fixed-income perspective, high yield corporate earnings generally have been reasonable so far this year,” says Russ Covode, portfolio manager at Neuberger Berman.
“Most companies will do well even in a slower-growth environment,” he explains. “That’s because most companies don’t need to grow into their capital structures in order to survive. Leverage levels and balance sheet liquidity right now are reasonable.”
Over the summer, high yield bonds suffered nearly as much as stocks, with which they share many characteristics. Both were hit by the general risk aversion, but European bonds came off much the worst.
“US high yield is currently 865 bspts over Treasuries, having widened from 525 bspts three months ago,” says Colleen Denzler, head of fixed income strategy at Janus Capital. “European high yield is 1049 bspts above European Treasuries as sentiment is more negative and investors are waiting to see how events in Greece and Italy pan out.”
EUROPEAN OPPORTUNITIES
Many fund managers are consequently focusing on Europe, believing investors have been over-cautious and that the region offers better opportunities. Robeco, for example, is overweight Europe because of the huge valuation differences.
“The northern European economic outlook is not much different to the US but the uncertainty around it confers a huge premium,” explains Sander Bus, Robeco’s head of credit investments. “Spreads on US high yield have widened 40 per cent year to date but spreads on European high yield have widened by 80 per cent year to date,” he adds.
“Core Europe is probably stronger than the US so we prefer to invest in companies in the region, although Europe is a much smaller region and weighted at just 15 per cent of the benchmark,” says Roeland Moraal, fund manager of CGF Robeco European High Yield Bonds, who is double the benchmark at 30 per cent.
“European HY as such is largely a North-West (core) European asset class anyway, with much less exposure to peripheral Europe,” adds Mr Moraal. “We like the economic performance of core Europe including the UK, and we like it better than the US. Our overweight is therefore based in core Europe – Germany, Holland, France and also the UK – on firstly the better economic performance of this region, and secondly the much more attractive valuation compared to US high yield.”
CLEARER OUTLOOK
Others prefer the clearer visibility in the US market. “It is possible to get a better handle on where the US is going and the US would be less impacted by another negative event,” says Darren Ruane, senior bond strategist at Investec Wealth & Investments.
“Economic data in the US over the summer got worse, but there is an upside to this, as high yield does better than equities in a low growth environment,” he explains. “In a high growth environment, the temptation is to use spare cash for M&A and share buybacks.”
Mr Ruane also anticipates improved US data in the second half of the year, pointing out that the Japanese tsunami interrupted the supply chain and the oil price rose in the spring because of the Arab uprising, and both factors are unlikely to recur.
Managers are looking for good quality, defensive companies that do not appear to need economic growth to survive, typically food, beverage and packaging companies which are linked to stable non-cyclical markets, with highly visible earnings and the ability to pass on raw materials price increases. Ms Denzler at Janus Capital points out, for example, that while the supermarket sector is up 8.63 per cent year to date, home construction is flat at 0.37 per cent, according to Barclays US bond indices, so there is a wide differential in performance between sectors.
