Investors chase high yield across Europe

European investors who pumped billions into high-yield bonds in first half of 2011 could see asset class faced with rising default rates.

In the first half of 2011, high-yield bonds attracted significant attention from institutional and retail holders alike. According to Lipper, €2.7bn made its way into high-yield bond funds across Europe in May alone as investors chased the higher coupons on offer. However, the sector now faces two major headwinds: performance has been relatively weak compared to other fixed income asset classes and the declining economic climate is likely to raise the default rate, which typically signals deteriorating performance.

At the start of the year, high-yield bonds were seen as the one fixed income asset class still offering some value, However, following the recent sell-off, which sparked a flight to safety, high yield investors have been caught out. Over the past six months, the high yield sector has dipped 2.2%, while the UK Gilt sector has risen 11.5% and the Sterling Corporate Bond sector 5.6%.

For those who have been invested for the longer term, the picture is more positive, with three-year numbers ahead of other fixed income asset classes. Those funds that have performed best during this time have tended to be those where managers have made maximum use of the flexibility available to them. The sector only requires 50% of the fund to be held in high-yield bonds, and those that kept the weighting low through the lean years, topping up their funds with higher grade bonds, performed well.

Recently, picking the right market themes has been more important. Over one year the difference between the top and bottom performing funds in the sector is 9.1% and overall allocation to high yield is similar for both sides.

Adam Cordery, manager of the Schroder Monthly High Income fund, said: “It has been a tale of two sectors. There have been the traditional industrial sectors, then there has been the financial sector. The financial sector has changed due to the aggressive downgrading of collapsing banks. A number of the agencies have reviewed the way they rate the banks and, as a result, many have fallen into high yield. The dynamics of the two sectors have been quite different.

He added industrials had done well, seeing huge interest from investors hunting for income, but this is now changing. Yields are low and the quality of new issuance is quite poor.

Cordery said: “Financials have been a mixed bag and their performance has tended to correlate with the highs and lows of the eurozone. The banks are correlated with the potential for contagion.”

Investors said issuance shifted into lower quality credits as risk appetite increased. Kieran Roane, manager of the Investec Monthly High Income fund said as the market has opened up, issuers have taken the opportunity to bring new deals to the market. He added: “A year ago, the markets were a little tender. People were still risk averse and the issuers tended to be at the higher-rated end of high yield.

They were well-secured and similar to the bank loans they were replacing. As markets continued to rally, lower-rated companies with higher leverage began to issue debt. Companies that were not able to issue debt a year ago have come to market.”

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