Managers upbeat on spread tightening for high yield paper
European high yield bonds are offering attractive potential returns for the concomitant risks, as managers say there is scope for spreads at least to halve, while rates of default among low quality issuers are expected to remain below the long-term average of 4.7%.
But some allocators are not yet convinced, saying demand on primary high yield markets has slowed and retail investors are offloading record amounts of high yield fixed income funds “adding to the selling pressure”.
However Chris Brils (pictured), manager of F&C’s European High Yield fund, is more upbeat.
He said it is not likely that spreads on European and US low grade paper – currently at 750 basis points over – will move towards 2,000 basis points over high grade, as they did in 2008, when leveraged forced sellers and illiquidity were a “lethal combination”.
F&C’s base case scenario now is for high yield spreads to tighten to below 500 basis points, although Brils warns volatility will occur because of uncertainty about economic policy in the US and Europe.
Investors will be used to volatility, coming out of what Brils said was a month with “the highest market volatility across asset classes since late 2008”.
But he added: “From the current phase of the credit cycle and assuming an extended recession can be avoided, there appears to be good value in high yield at the moment. Income is rewarding and in our base scenario, where defaults rise moderately, there is scope for spreads to tighten again.”
Brils pointed towards recent “encouraging” earnings statements from high yield issuers, and safer leverage ratios than during the 2008 crisis.
He said default rates among high yield companies had dropped to around 2%. He expects further falls in the near-term, but a “moderate” rise over the next few years, to around 3% to 4%. The historical average is 4.7%.
“Low default levels are also underpinned by the fact that most high yield issuers since the reopening of the new issue market have smartly refinanced most debt to at least 2014,” he said.
“Defaults are expected to impact mostly the lower quality side of the high yield spectrum, companies with triple-C ratings and lower, where leverage is typically four to five turns and higher.”
He said the recent downgrade of US debt by Standard & Poor’s, and escalation of the eurozone’s crisis to affect Italian debt had “roiled the credit markets on both sides of the Atlantic”.
The subsequent sell-off in the high yield market was exacerbated by the fact large investors were selling at what is typically a nadir in market liquidity each year – creating “a mini-2008 environment for high yield,” Brils said.
But he said recent UK PMI and US ISM data were steady or positive. “From these, it looks like the recession risk has abated somewhat. The more likely scenario is an extended period of low growth.”
He described this as “a Goldilocks scenario for high yield bonds, a conducive environment in which central bank rates will remain muted for some time to come, and where earnings are sufficiently large to allow for further improvement in credit metrics.”
The bifurcation of advanced and developing worlds was painted starkly by material released around the same time this week by ING Investment Management.
Its note looked to local currency bonds in Asia, predicting upgrades in ratings in the region “in contrast to the industrialised countries”.
Joel Kim, ING IM’s head of Asian debt, said after the long-term ratings for the US and “a row of European countries” were cut recently, ING IM believes that global investors are casting their eyes to Asia.
S&P upgraded of China this year to AA, and Hong Kong to AAA – higher than the US – while Indonesia is just one rung below investment grade, and Fitch raised the Philippines one grade to BB+.
In Asia, therefore, spreads have narrowed, not widened recently.
Kim said: “In light of the solid and improving outlook for Asia ratings should improve further, from which spreads should sink further. The fact the region is being regarded as a safe harbour has led to further offshore allocations in Asian debt.”
He said more upgrades would be justified: “We believe that Asian countries could receive higher ratings due to their economies’ strength. The solid financial situation has strengthened the international community’s trust in Asia.”
But not all allocators are convinced now is the time to buy further high yield paper.
Rothschild Wealth Management & Trust said: “We remain cautious on the prospects for high yield bonds, which remain very sensitive to the broader economic outlook.
“After a sustained strong run, US high yield debt has fallen sharply. Average yields soared from fairly low levels of around 7% in July to 8.6% at the end of August.
“Demand for new bonds has ebbed and retail investors have been withdrawing record amounts from high yield bond funds, adding to the selling pressure.”