Debt markets: High-yield credit awaits the great rotation

On January 17, Irish glass and metal packaging group Ardagh sold a $1.6 billion-equivalent high-yield bond deal that was both the largest high-yield trade in Europe for two years and a record tight coupon for the frequent issuer at 4.875% for the dollar piece and 5% for euros. The deal was lead managed by Citi and will fund the $1.7 billion acquisition of Saint Gobain’s US glass-bottling unit, Verallia.

The transaction is a clear illustration of the robust demand for credit that remains even after the stellar year the asset class enjoyed in 2012. On January 23 the spread of the Markit iTraxx Europe Crossover index was at 423 basis points, a tightening of 35.74bp on the month.

"The performance of the market so far this year is indicative of the amount of money that is still out there," says Alex Veroude, head of credit at Insight Investment. "High yield at just below 6% is at a low level. But the return outlook is very different in different parts of the market. To make more from high yield, investors will have to either accept a reduction in credit quality, reduce liquidity or increase their use of leverage. Reducing liquidity is the best thing to do, which is why the liquidity premium in some parts of the credit market is now 400bp to 500bp."

Persistent speculation as to whether there is a bubble in credit has now given way to persistent speculation as to the possibility that there will be a rotation from the asset class back to equities as returns are persistently squeezed. "In better economic conditions we will start to see money flow out of bonds and into equities: timing that right will be a big opportunity," says the European financing head at one US bank. "But this doesn’t mean that we are in a credit bubble."

David Newman, head of global high yield at London-based asset manager Rogge Global Partners, disagrees. "Is there a bubble in high yield? There are certainly some signs of a bubble," he says, warning that: "You don’t want to be the guy chasing that last stupid deal but there are still some pockets of value." But he argues that there are good reasons to be in the asset class and that they will persist. "When interest rates are low for long, high yield gives the best yield and when you have rising rates high yield gives the best insulation to fixed income." Nevertheless he does expect some flows out of the asset class this year. "The earnings yield of the S&P500 is now higher than the Barclays Index. There is going to be a stage where retail investors feel they should be paid more and that they should be buying equities." He warns, however, that the trade might not be as obvious as it seems. "The average rating of the S&P500 is triple-B while blue-chip equity is equivalent to double-B plus. It is a common perception that blue-chip equity is safer than high yield, but it isn’t. Double-B high yield with guaranteed payment gives a better return than blue-chip equities."

Any retail exit from the asset class could, however, be offset by fixed-income investors looking to protect themselves against rate rises. "There is a decent chance that rates will rise and that people will leave high yield this year," Newman contends. "But others may be forced into it – a global government bond manager is facing negative returns. A 5% to 10% allocation to high yield expands the efficient frontier of a fixed-income portfolio. Most US funds have this, but in Europe the allocation is still tactical."

Many other credit specialists feel that the chance of any rise in interest rates this year remains remote. "The likelihood of a normalization of interest rates is not high," says Andrew Wickham, head of UK and global fixed income at Insight Investment. "The peripheral European market has got itself into a positive feedback loop, partly due to rhetoric and partly due to Mario Draghi’s OMT."

Thus, despite the historically low yields on offer, inflows to credit will likely continue. "Even if inflation starts to come through I can’t see central banks becoming more hawkish as the impact on asset prices would be systemic," says one banker. "Central banks are tied down by their own strings – they are stuck in a web of their own making." Robert McAdie, global head of fixed-income strategy and credit research at BNP Paribas argues that while these conditions remain there is a compelling reason to stick with high yield. "High yield is the right investment while central banks continue to flood the system with liquidity. But it is the wrong investment when the delta in terms of earnings capability of the sector starts to be impinged. We are starting to see this in the SME sector and in examples such as HMV."

So the great rotation might not be upon credit markets, but it could be coming. "I wouldn’t buy European equities, but I would buy small-cap US equities," says McAdie. "It doesn’t point to me that there will be a massive switch from high yield to equities, but the trend is there."