Investors flock back into high yield

Improving corporate fundamentals have seen investors return to high yield. But sovereign risk could easily limit sentiment, writes Paul Burgin.

In the dark days of the banking crisis, investors could not exit high yield bonds fast enough as downgrades forced sellers to market. They found few buyers when they got there.

Bond prices fell hard, no more so than in the high yield sector. From Summer 2007 to the end of last year, the IMA Sterling High Yield sector lost around 30% of its value.

When the dust cleared, investors soon realised their fears had been overplayed. The sector recovered sharply.

Parmeshwar Chadha, co-manager of the Newton Global High Yield Bond fund, says: “In late 2008 and into early 2009, all high yield fell to low values, way below what fundamentals suggested they should be.”

High yield bonds could be picked up for a mere 15 cents on the dollar, or even lower. Chadha says one of his holdings, chemical firm Ineos, dipped to just five cents, creating a massive buying opportunity.

Sentiment has recovered remarkably. Ineos now trades around the 85 cents mark.

General corporate fundamentals are improving at a pace. Two years ago, companies panicked in the eyes of the storm, cutting costs and restructuring their businesses aggressively. “As soon as there is a pick-up in economic growth and there are signs that this is happening, the top line feeds straight through to the bottom line,” Chadha says.

Confidence returns

As company revenues and profits rise, so they are more able to service their debt. In the high yield space, issuers and bond buyers are far more confident these days interest payments will be met and maturing loans repaid on time.

Default rates have dropped dramatically. Predictions of 25% default rates proved wide of the mark. Chadha believes the rigid quant based systems used by bond rating agencies simply could not cope with the special nature of the crisis that pushed bond spreads to unprecedented levels.

Defaults eventually peaked at around 12% in Europe. Chadha says: “The breakdown in world trade simply did not happen. Scary stories may have sold newspapers but they did not hold true in the longer term.”

With the implosion of world commerce averted, investors are flocking back, pushing up capital values and causing spreads to tighten. Chadha’s own fund rose in value by 70% over the year to end March according to Lipper data.

The amount of retail and institutional money coming in, or at least waiting in the wings, is also a signal to issuers to get busy. In Europe, the bank deleveraging trend is set to continue which should ensure a good supply of new issues. Old bank deals are being turned into debt issues, with often higher securitisation levels than in the past. High yield may remain tagged as high yield, but some new issues look far safer than perhaps they once might have been.

“They are giving the same security package to investors that they used to give to the banks. Recovery rates on secured bonds are much better than on senior or other debt, all of which is good for investors in the long run,” says Chadha. Institutional recovery rates on asset-heavy companies can hit 85% to 90%, he says.

Corporates are also spreading maturities from three to four years on bank loans to a wider five or seven years in the high yield market. They are prepared to pay an additional premium to mix their maturities should the liquidity window shut again. Chadha says bank-debt issues of Libor +350 basis points are more likely to be fixed 7% or 7½% bond issues with added scheduling flexibility today.

If that all sounds too good to be true, it is. James Gledhill, fixed income manager at Henderson, says there is another force at work in the high yield arena. Default rates may have fallen to 2% in the last quarter and just 0.09% now, but investors still have plenty to be jittery about.

Sovereign debt

Sovereign debt is the big issue. Despite last month’s rescue package, Greece could still default in the future. That would hit local banks, the main holders of Greek debt, and also many European banks.

If they find themselves holding worthless debt, the banking system could shut down again as each institution worries about its counterparties’ exposure. If they do that, corporates faces yet another liquidity freeze.

If history repeats itself, investors will withdraw from risky high yield markets and corporates will be unable to refinance, no matter how sweet the deal.

Gledhill says Greece will have to inflict some pain on sovereign investors. “They will default to some extent. It may be ‘voluntary’ exchanges into longer dated debt to avoid triggering credit default swaps, but they will have to do something.”

For the time being, Greece has simply bought itself time. But there is a silver lining to the crisis. Other European periphery nations are being forced to act too. Gledhill says: “It has put a rocket up everyone else. Politicians do not want to admit problems, but they are having to be more aggressive.”

Not surprisingly, Gledhill remains cautious. He has virtually no exposure to the PIIGS (Portugal, Ireland, Italy, Greece and Spain) aside from Santander, one of Europe’s strongest banks and heavily dependent on the UK and Latin America for its profits.

Gledhill is adapting his high yield portfolio to the double-edged environment. He is currently heavily weighted to high yield as defaults fall and earnings rise, but shifting to the middle ground.

Investment grade was attractive 18 months ago but now has little upside. Top end high yield is being sucked into the general investment grade universe as buyers reach down the spectrum. The riskiest low grade still has potential to upset, forcing him to the mid range where fundamentals have recovered faster than sentiment.

Thematic opportunities remain few and far between. He would like to move further into cyclicals such as semi-conductor, steel and chemical issues. But these were early risers with little immediate potential.

Gledhill also notes investors should not expect the capital gains they have experienced of late. “There may be a few per cent in capital gains, but we are coming into the territory where the main gain will be income,” he adds.

Q&A: KAM TUGNAIT, GARTMORE HIGH YIELD BOND FUND

Kam Tugnait, co-manager of the Gartmore High Yield Bond fund, says investors cannot expect the bumper income cheques of the last year or so. They may even shrink a little further.

Q. What happened to investors’ monthly income cheques in the crisis?
A. When Lehman’s collapsed, spreads and yields rose to unprecedented levels. Yields hit 20 odd percent. Investors would have seen their income rise to 10% or more on their investments, but you have to remember that they only went up because capital values went down.

Q. And what sort of levels are they at now?
A. There was a compression in yield and spreads in 2009. But even as we entered 2010, they were still at the 650 to 750 basis point level. Now the yield for investors is around 7½% to 8%, with spreads in the 500 to 600 points range depending on the index you are looking at and geography.

Q. And what can income seekers expect for the rest of the year?
A. We are not going to get the returns we saw in 2009, and 2008 was a once in a lifetime event. We will see some spread compression to the year end, perhaps falling another 50 basis points on the conservative side.

But we are at least in a more normal situation. Income should be stable and should even start increasing when we get interest rate rises. It is worth remembering yields are relatively low at the moment because of those low interest rates. That should start changing in the next 12 to 18 months.

ADVISER VIEWS: TIM COCKERILL, ASHCOURT ROWAN

Advisers like:

• Small range of funds but plenty of choice
• Mixture of investment grades to suit needs
• Good yields at present compared with other assets

Advisers dislike:

• Bond ratings are not gospel, often lagging reality
• Portfolios need careful comparison
• Some yields are not accurate of true returns

The Sterling High Yield sector may be small but it still offers investors plenty of choice. With the accent on income, investors have to accept an added level of riskiness in their portfolios.

“We use Henderson Extra High Yield run by James Gledhill. The fund has done phenomenally well recently but you cannot ignore what has happened in the past. The phrase ‘Extra High Yield’ tells us we are looking at funds with low credit ratings by most people’s standards,” says Tim Cockerill of Ashcourt Rowan.

He is keeping a sharp eye on the fund’s portfolio. It currently offers around 7% and its wide range of over 130 holdings should minimise any fallout from defaults.

Whilst High Yield has acted more like equities in the recent past, Cockerill warns that investors should not expect more of the same this year. “With a fair wind, investors should see around 2% to 3% growth in the next 12 months,” he says.

At the other end of the yield spectrum, Cockerill also likes the M&G High Yield Corporate Bond fund run by Jim Leaviss. It is also diversified but has a lower distribution yield of 5.4% according to the fund’s last factsheet.

“This includes a lot more investment grade and far less risk,” says Cockerill.

To assess the funds, investors should start by looking at the distribution yield which includes an element of amortisation. Given recent events, this could easily affect a fund’s ranking. “If a bond has been bought below par, then amortised it is reflected in the yield. But it is not necessarily what the client is going to receive,” warns Cockerill.

He says the running yield and gross redemption yields are a better indication of true income returns.