"It is probably fair to say that everything is a rate product," mused Gary Jenkins, director of independent credit firm Swordfish Research, in May. He includes in that definition high-yield bonds, where the biggest short-term risk to performance is now a sharply growing economic environment rather than a deteriorating one. "Who would have thought that possible a couple of years back?" Jenkins asks.
The atmosphere in the credit markets is one of almost eerie calm. Paul Abberley, interim CEO of Aviva Investors in London, describes quantitative easing as "the equivalent of injecting morphine into the market, making it very relaxed". The problem weighing on everyone’s mind is what happens when the injections stop. "Hanging over the market is the day of reckoning when central banks have to taper, stop and eventually unwind their unconventional policies," says Derek Hynes, lead portfolio manager at ECM in London. "The global economy remains too fragile to even consider such an exit now. The central banks have well and truly boxed themselves in."
While they remain so the markets are, in the words of most asset managers Euromoney spoke to last month, rigged. Managing money under such conditions is a fiendishly difficult task.
"The probability of systemic failure has receded, which has encouraged people to reach for yield," says Francis Scotland, director of global macro research at investment manager Brandywine Global, a subsidiary of Legg Mason. "There is a rotation out along the risk spectrum and it is the Fed’s strategy to chase investors out along the curve.
"The danger for bond investors with this strategy is that it has helped create one of the biggest pricing anomalies in the world, which is the negative level of real yields in traditional safe-haven sovereign bond markets. The drivers of this anomaly have been a pessimistic view of the future, investors’ desire for safety and quantitative easing. The great irony is that the asset class viewed as the safest may turn out to be the riskiest when bond yields begin to rise as perceptions of systemic risk recede and growth expectations improve."
The natural response of the rational investor is to pile into the highest-yielding asset class that they can – hence the boom in high-yield and riskier bonds such as hybrids.
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| Richard Ryan, manager of the M&G Alpha Opportunities Fund at M&G Investments |
"Investors want to capture spread without interest rate volatility so they tend to buy the riskiest piece of credit that they can and then hold on," says Richard Ryan, manager of the M&G Alpha Opportunities Fund at M&G Investments in London. "However, they are confusing yield and return. The yield is not the return – the capital price movement can be so large that it wipes out the yield." This is something that many investors are acutely conscious of. "We are growing increasingly concerned with the growing gap between fundamentals and valuations," says Hynes. "Easy money and excessive liquidity are creating very strong technicals; abundant money is chasing too few assets in a low-yield environment."
According to Ryan, this has resulted in yields reaching levels that make taking on more risky instruments – as many are doing – a bad idea.
"If high yield trades above 800bp then as an investor you should just close your eyes, write the cheque and buy it – at every point in history you will have made money," he points out. "But doing that with an all-in yield of 5% is a very different proposition. At 400bp there is a roughly 50/50 chance that you will make money. You are taking a gamble on a market that on an all-in basis is the most expensive that it has ever been."
There are signs that others are coming to the same conclusion: according to Bank of America Merrill Lynch, during the week of May 17 US high-yield funds posted their second-highest outflow of the year – $400 million, along with $520 million outflows from high-yield ETFs.
"High yield is very cyclical," says Ryan. "If you decompose returns you see that the spread for credit risk in Europe is about 400bp today versus the long-term average of 520bp. This reach for yield does not deliver the same level of performance as a more muted strategy would. Investment grade outperforms high yield in terms of prospective returns in almost every scenario," he claims.
Long-term average
That 400bp level of compensation may be well below the long-term average, but for many investors it still makes a lot of sense, given the rigged risk environment that QE has created. "The European high-yield market is pricing in a 26% default rate over the next five years," says Chris Higham, high-yield bond fund manager at Aviva Investors. "Global high-yield default rates have been 2% for the past two years so the market is pricing in a level way in excess of what we are seeing. There is still an awful lot of compensation for credit risk in corporates," he reckons.
