Confidence high yield bonds can stay afloat in market turmoil

The market has reached a crossroads, with opinion fairly evenly divided on whether poor economic data, particularly from China and the US, marks the beginning of bear markets globally. Every piece of news is being scrutinised for clues as to when the US Federal Reserve may implement an interest rate rise. For bond markets, this uncertainty is a huge pressure, causing prices to fall up to 30 points in the last three months as the market reacts strongly to any negative event.

“Recent figures for US non-farm payrolls  were disappointing, so the market is wondering whether now is the start of the end or whether we will see a stabilisation in growth  and an improvement in China, emerging markets and the commodity markets,” says Alexis Renault, head of high yield at  Oddo Meriten AM. 

The market is split 50/50 and does not know where it is going, he explains. “You could argue that spreads of 560 basis points  are the market’s long-term average, but is it too wide? For it to tighten, we will need to see some good figures coming out of China.” 

As an example, Mr Renault points to the car market, where growth in demand has slowed but a lot of capacity is coming on, and price pressures will impact German manufacturers with high exposure to China such as Volkswagen.

The Fed was on the brink of raising rates in September but held off, saying it was waiting for evidence that China’s slowdown had not derailed US growth and that inflation would gradually move back toward its 2 per cent annual target. Fed chair Janet Yellen has since said that a rate hike is still likely this year, but poor US jobs data and other disappointments could easily push this back.

The prospect of a rate rise usually suggests poor performance for the high yield sector. “While simple maths tells you, all else being equal, yields going up should equate to bond prices moving down, there are more subtleties at play that I believe would actually create a positive backdrop for high yield, particularly if we see the gradual increase in rates that most market participants are expecting,” says Jeff Mueller, portfolio manager and global high yield analyst at Eaton Vance. 

High yield is a relatively low duration asset class, and therefore the direct mathematical impact is lower than in other markets, he explains. “While global investment grade and emerging market indices have durations of 6.2 and 4.7 years respectively, global high yield’s duration is only 4.1 years, which, in a rising yield environment, will help to shield bond prices on a relative basis compared to these other asset classes.”

Another reason for optimism is that spreads on developed markets high yield have widened this year by roughly 150 basis points, wider than average, despite moderate growth and a low default environment. This suggests there is scope for spread tightening. 

“Markets are discounting a default rate of 30 per cent over the next few years, so a very high, and probably overestimated, level of uncertainty is already priced in,” says Bernard Lalière, head of high yield strategies at Petercam Institutional Asset Management. 

“There is no wall of maturities; most high yield companies are well funded for the next few years and I see no reason for a 5-10 per cent default rate next year.” 

The current level of high yield has its origins in uncertainty in the financial markets and the lake of liquidity around the asset class, and this is keeping credit spreads at this level, he adds.

Falling oil prices have wrought havoc on the high yield sector this year. Until June, when oil was priced at $100 per barrel (Ä88), there had been significant new bond issuance for shale gas players, mainly for sucking shale oil out of relatively expensive terrain.  Typically they required oil prices of around $70 per barrel to break even. But a supply/demand imbalance and geopolitical noise pushed the oil price down in June and into the fourth quarter, forcing the shale players to cut costs to make themselves profitable at $60-65 per barrel. 

Glencore’s sharp falls,  the default of Samson Oil & Gas, an Australian-based company holding extensive acreage in the US, and the cessation of Liberty’s discussions with Vodafone, all  shocked the market. 

However, only 13 per cent of US high yield is in the energy sector, and exploration and oil services companies are only about 8 per cent of that, so even wholesale failure could only take the global default rate to 3 per cent, not a lot more than before the oil crisis when the default rate was 2.1 per cent. 

“That is reflected in the spreads in the energy sector – even over this quarter since 30th June energy spreads have widened by 240 basis points,” says David Newman, head of global high yield at Rogge Global Partners. 

But the impact on the European high yield index has only been 36 basis points and the widening of  the US high yield index ex-energy  has only been 24 basis points, as measured by the The BofA Merrill Lynch US High Yield BB-B ex-energy (H4XC), he says.

“So while we have seen wider spreads in energy, the market has been good at differentiating where the risk of default lies. The rest of the pie is relatively stable.”

For the most part, oil companies are able to buy time, either by selling assets or by merging with a stronger entity, and this increase in M&A could produce some bargains. A 35 per cent  drop in the service cost of completing wells is also allowing the oil services sector to remain profitable.

“Only one commodity is showing demand growth year over year and that is oil,” says Scott Roberts, co-head of high yield investments at Invesco. 

The supply side problem is being addressed and demand is growing – we consume 94.5m barrels a day, which compares with 50m a day in 1970, he says, adding that 2008 was the only year global demand declined. 

“While we do see oil prices rising in the coming months, it likely won’t be $100 per barrel but it can easily be better than $65 per barrel, and even at $50 per barrel some of these companies can make money.”

To put the sector’s risks into perspective, US oil production from high yield companies is only a relatively small part of the market. High yield companies produce just 1.3-1.4m barrels of the 9.3m barrels a day produced in the US.

US-centred growth such as home construction and building products, which has helped sustain the US economy, is unlikely to be jeopardised by a Fed rate rise.  Most US citizens will have a 30-year mortgage so if the average house costs $250,000-$400,000, a 25 basis point hike would translate to only $50 a month in additional payments.

“The bigger concern is whether US GDP will slow,” adds Mr Roberts. “The sum of macro fears may impact the US as markets are getting more linked. For example, chemical companies have recently been warning about a slowdown of demand in Asia. I sense that risk is changing for the worse.”

There is also some nervousness about the Fed’s views on overborrowed businesses and its plans to penalise banks that lend to companies with more than six times leverage. This will typically be  the mega leveraged buyouts of the 2006 era such as First Data and Visa. Ratings agency Moody’s came out saying that this will include any refinancing, which has resulted in a widening of CCC paper where the risk of refinance is rising. 

Around $9-12bn of high yield is traded daily and most managers report that they have not had an issue with trading liquidity. However, investors have recently been drawn to the concept of bond funds that invest in high yield credit default swap (CDS) indices, such as the Ubam Global High Yield Solution fund that uses high yield crossover indices – the Markit CDX High Yield index for the US and Markit iTraxx Xover index for Europe. 

“When you buy a bond, you get a package of credit spreads and exposure to interest rates, but with a CDS there is only exposure to credit,” says Olivier Debat, senior investment specialist, global and absolute return fixed income, UBP. 

“The beauty of the concept is that you don’t have to bother about liquidity, nor about interest rate exposure so you don’t for instance have to worry about what the Fed will do next,” he says. “And as the fund is invested only in US and European names, investors are not getting any exposure to emerging markets which is helpful if they wish to be precise about their emerging market exposure.”  It has also meant they have avoided big downgrades such as Gazprom. “Whether you like emerging markets or not, there is no overlap. It’s clean.”  

Maturing sector

The high yield bond sector, particularly outside the US, is often considered to be a small market that deserves only a tactical, rather than strategic, allocation of capital.

In the seven years since the global financial crisis, there has been a 60 per cent increase in the number of high yield issuers, as well as a near-tripling in the global market value size, including year-on-year growth every single year. At the same time, default rates have plummeted to all-time lows, with global default rates now running at less than 2 per cent.  This growth and diversification should provide investors with an opportunity to invest in a market that continues to mature, and perhaps warrant a more strategic allocation.

Coutts believes high yield bonds offer a better source of risk adjusted income than the higher quality areas of government bonds and investment grade. “We invest across mainstream global high yield and special situations, including financial hybrids and individual securities,” says Niamh Wylie, portfolio manager at Coutts. 

“Earlier this year we bought the Algebris Financial Credit fund which invests in CoCo and hybrid securities of globally systemically important financials. This fund has held up well over the summer due to stronger bank balance sheets, improving profitability, asset quality and regulatory change.”

Coutts recently allocated to Union Bancaire Privée’s Global High Yield Solution, a strategy based upon five year credit default swap (CDS) indices across the US and Europe. 

“The yield reflects the liquidity gain from utilising the credit derivatives,” she explains. “We also hold the iTraxx Crossover, an index of the average CDS spread of Europe’s 75 largest high yield issuers.”

View from Morningstar: Fundamentals remain sound

During the first nine months of 2015, the eurozone high yield market suffered from an increase in risk aversion owing to concerns about the Chinese economic slowdown and declining commodity prices. 

The Morningstar EUR High Yield Bond category is thus down -0.17 per cent year-to-date (in euros). Though only a few issuers in the euro high yield space operate in the commodity space or are directly exposed to emerging markets, the asset class was broadly sold off as investors retreated to safer-haven assets. 

Nevertheless, the fundamentals of the asset class appear to remain sound. Over the last 12 months, the average default rate among European high yield issuers remained stable at 2 per cent, a figure well below the long-term historical average. Many fund managers thus remain confident in high yield issuers’ financial health and some have taken advantage of the market turmoil to add to their top convictions at attractive prices.

In this context, Candriam Bonds Euro High Yield, rated Bronze by Morningstar analysts, delivered 0.88 per cent year-to-date (in euros), landing in the top quartile of its category. Veteran manager Philippe Noyard, who has been at the helm since 1999, has maintained an underweight to commodity-related sectors such as basic materials and chemicals, preferring more resilient sectors such as consumer goods (with issuers such as French frozen foods group Picard), telecoms (Altice, Telefonica) and healthcare. 

This caution paid off in this year’s rocky markets, but the fund has also built an attractive track record over the long term. Over 10 years to the end of September 2015, its annualised return of 5.6 per cent has outpaced the category’s 5 per cent, without excessive risk. 

HSBC GIF Euro High Yield Bond, rated Silver by Morningstar analysts, has fared less well year-to-date with a loss of -1.80 per cent, which lands behind 80 per cent of its category peers. Manager Philippe Igigabel prefers issuers that he believes are relatively insensitive to the economic environment, either because of their business model or the soundness of their fundamentals. For the past five years, he has thus maintained a significant overweight in subordinate financial debt as he was convinced by banks’ and insurers’ efforts to clean up their balance sheets after the credit crisis of 2008. 

Mr Igigabel has also increased exposure to the junior debt of non-financial issuers (‘hybrid’ bonds) which made up 24 per cent of assets in September 2015, compared to 14 per cent a year before. This positioning has held the fund back this year as market volatility took its toll on many hybrid bonds during the sell-off  –EDF and Volkswagen were among the worst performers in the second quarter of 2015. 

Nevertheless, the manager remains comfortable with this positioning, and took advantage of the market dip to increase his exposure to certain hybrids. Such moves are a testament to the contrarian flavour of the approach, which in spite of short-term weakness, has worked very well for investors over the long term. Over 10 years to the end of September 2015, the fund’s 6.5 per cent annualised return outpaces 84 per cent of competitor funds, with a lower level of risk.

Mara Dobrescu, manager research analyst, Morningstar