Last year was straightforward for investors in high-yield credit – buy the whole market and watch the money roll in. With spreads now hovering near record lows, the next year promises to be tougher and analysts say only those who make the right choices will prosper. And many market participants are beginning to whisper the fateful refrain: “Bubble trouble.” According to some market benchmarks, total returns on high-yield bonds were around 24.15%, compared with a loss of 1.62% in 2011. The iTraxx Crossover index started 2012 at 750 basis points and closed at 480bp, despite a weak economic backdrop and the eurozone sovereign debt crisis.
The exceptional performance was due to a number of factors, including low default rates, liquidity support from the central bank and a wall of money chasing yield amid historically meagre returns on government bonds.
As G7 central banks’ liquidity adventure reaches new highs, the first month of 2013 saw levels of primary market enthusiasm undiminished, with issuance substantially higher year-on-year in Europe and the US. US issuers sold $33.24 billion of bonds in January, while 23 European borrowers raised €7.13 billion in the fourth most active month since 2005. Globally, some $51.4 billion of high-yield bonds were sold, more than twice as much as in the same period in 2012.
Investor demand, meanwhile, showed no signs of abating, and analysts reported inflows up to the final week of January into high-yield bond funds and ETFs. Some say January was the biggest month of high-yield inflows on record, and sales desks reported overwhelming demand for new issues. Last month’s pricing of the Virgin Media bond to back its acquisition by Liberty Global was brought forward a day driven by exceptional orders for the £2.3 billion-equivalent offering.
However, few believe the market will repeat its incredible performance of last year, and there might be more serious concerns hovering at the margins, such as price indiscipline and herd mentality.
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| Jochen Felsenheimer, managing director at XAIA Investment |
“People are buying in without any sort of credit analysis and companies are finding it incredibly easy to tap the market to get funding irrespective of their business prospects,” says Jochen Felsenheimer, managing director at XAIA Investment in Munich. “Normally, these companies would not be able to borrow so what we are seeing is misallocation of capital on a grand scale.” While European companies have embarked on a borrowing spree, the economic outlook remains highly uncertain, and fears are rising that the positive impact of the European Central Bank’s (ECB) promise to backstop the peripheral eurozone sovereign bonds will not translate into growth. At the same time, the ultra-low interest rates resulting from the ECB’s actions are showing signs of rising.
“The ECB has the capacity to contain the sovereign crisis but that does not mean it is resolved, and there is no guarantee of jobs and growth,” says David Watts, a credit strategist at CreditSights. “There are concerns about Cyprus, the Italian political situation and the deficit in Spain, and operationally for companies it’s likely to be very difficult.”
Europe in January saw its first default of the year after Italian yellow pages publisher Seat Pagine Gialle’s missed payments on its bonds, and the rating downgrade-to-upgrade ratio rose sharply in recent months, hitting seven times in December, according to Moody’s Investors Service, compared with an average of 2.2 times across the whole of last year. In January, there were zero European ratings upgrades, Moody’s says.
Government bond yields have risen, meanwhile, with the Germany 10-year Bund hitting 1.71% in late January, compared with 1.32% at the beginning of the year.
Default rates remain low, hovering at around 3% for the whole of last year, compared with 12% in 2007, but the percentage of companies rated B3 negative or lower has risen sharply from around 10% at the end of 2011 to around 17% in recent weeks.
“Defaults are still low, which is positive for high-yield credit, but the number of companies in stress is rising and if we see a change in policy or some other negative macro event then many of these stressed companies will default,” says Chetan Modi, managing director European high-yield at Moody’s. “We continue to see weak operational performance in Europe, which is driving downgrades, and it’s worth remembering that when defaults occur they tend to do so in clusters.”
For investment managers, the challenge of the coming months is to avoid the companies likely to become victims of the low-growth environment and to focus on those with better credit profiles.
“[Credit differentiation] will become key in generating returns,” says David Fancourt, a high-yield bond fund manager at M&G Investments in London. “We have become more choosy in terms of new issues, are going for security in terms of credit selection and are choosing shorter-dated bonds, which will be less impacted if there is a sell off.”
Corporate leverage and default rates are still relatively low and growth could yet pick up in Europe, but the longer the technicals remain positive, the greater the risk of localized bubbles forming in the market.