The key to unlocking value in high yield bonds

The market value of the US and European high yield markets has doubled and tripled respectively over the last decade. This is partly because, since the global financial crisis, fewer corporates have been able to receive financing from banks and have turned to non-bank alternatives (such as bonds) instead.

While we believe a nuanced approach to investing in high yield bonds can be beneficial we also view it as a specialist investment area and demanding substantial skill and resource.

Understanding a company’s business profile is one way of mitigating some of the risks associated with investing in the asset class – but to do so requires extensive SWOT analysis and competitor reviews. Free cash flow is one way of determining the issuer’s financial viability. Most companies, both IG and HY do not generate sufficient cash to repay bond debt. HY companies have a greater emphasis on generating free cash flow and this provides a path to refinancing and overall credit quality improvement. The ability for the company to call (redeem early) or not call its bond can also directly impact its value.

At the same time, the terms and conditions regarding a high yield bond can be complicated and term sheets are frequently several hundreds of pages long. They include details regarding structural protections such as seniority (the bond’s priority in the capital structure), security against company assets and debt covenants. The latter can help ensure a bond’s credit quality is not compromised by company management.

A company’s liquidity is another crucial determinant of its ability to repay. When investment grade companies have no cash available to repay the bond’s principal, they can usually draw on a revolving credit facility. However, high yield companies will not typically have a facility that is large enough. Furthermore, for high yield companies the facility is typically secured against inventories, further blocking available sources of liquidity.

Uli Gerhard – Insight, a BNY Mellon company

The market value of the US and European high yield markets has doubled and tripled respectively over the last decade. This is partly because, since the global financial crisis, fewer corporates have been able to receive financing from banks and have turned to non-bank alternatives (such as bonds) instead. While we believe a nuanced approach to investing in high yield … read more

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The global uncertainty principle and why investors should care…

The basic assumption by markets at the moment is that President Trump and the Republican administration will engage in fiscal stimulus. The question to ask is whether that fiscal stimulus is successful or whether it will end in failure. If it is successful then perhaps it will lead to US dollar strength and growth both in the US and the rest of the world and perhaps even a normalisation of the US Treasury curve. If it doesn’t succeed, as many people expect, then likely there will be a reversal of market expectations, an increase in policy uncertainty and perhaps a lower growth profile than currently priced in. These two routes have very different outcomes for the prospects of emerging market fixed income and equity markets.

There are some variables around this. First, think about President Trump and his tweets: they generate a significant amount of headline risk as we have seen already in the early weeks of his administration. That in turn creates uncertainty and perhaps a higher risk premium for some of the emerging markets such as China and Mexico and even for developed markets like Europe. It is too early to tell the result of this rhetoric but there is definitely a whiff of protectionism in the air.

The other variable is whether the Republicans in control of Congress have a high enough tolerance to increase the deficit in order to engage in this type of fiscal stimulus, which is not particularly clear to us at this point. Putting all this together, we believe the level of uncertainty in markets is going to fluctuate a lot over the next few months.

Colm McDonagh – Insight, a BNY Mellon company

The basic assumption by markets at the moment is that President Trump and the Republican administration will engage in fiscal stimulus. The question to ask is whether that fiscal stimulus is successful or whether it will end in failure. If it is successful then perhaps it will lead to US dollar strength and growth both in the US and the … read more

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Beware the bond market mirror

Last year, we saw government bonds rally and then fall, while high-yield bonds struggled and then rallied. It looks like this year we could see a similar pattern but in reverse.

The stronger economic growth momentum and rising inflation statistics are the driving force for higher government bond yields. In addition, a number of President Trump’s pledges such as pro-business policies and infrastructure spending could be positive for the economy, leading to higher growth and inflation – a bearish environment for bonds.

However, his more controversial campaign promises, including protectionist trade policies and an immigration clampdown, could lead to a flight to safety – a boost for bonds perceived as ‘safe-havens’. We are concerned that risk markets are currently complacent about this uncertainty, with investors seemingly buying into the good news rather than taking account of any potential problems.

Paul Brain – Newton, a BNY Mellon company

Last year, we saw government bonds rally and then fall, while high-yield bonds struggled and then rallied. It looks like this year we could see a similar pattern but in reverse. The stronger economic growth momentum and rising inflation statistics are the driving force for higher government bond yields. In addition, a number of President Trump’s pledges such as pro-business … read more

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Supersized EM sovereign debt

The market for issuance of EM debt in 2017 will be cautious in our view. If you drew up a winners and losers list from likely Trump foreign policy, Saudi Arabia would likely be on the losers list. For the moment, the Saudis are able to spend money they already have to plug any gaps and won’t want to issue into weak demand.

Issuers will be in a wait-and-see mode and probably only the very desperate will issue early in 2017. Should things prove to be not as bad as anticipated then there may be a rush for issuance later in the year.

From what we can estimate from economic policy it will likely be inflationary, we can see this from the sell-off in US Treasuries. That is only going to push yields higher in EM debt, thus increasing the cost of borrowing and issuance.

 Carl Shepherd – Newton, a BNY Mellon company

To read more about expectations for 2017 read our market outlook

The market for issuance of EM debt in 2017 will be cautious in our view. If you drew up a winners and losers list from likely Trump foreign policy, Saudi Arabia would likely be on the losers list. For the moment, the Saudis are able to spend money they already have to plug any gaps and won’t want to issue … read more

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Are you aware of this correlations shocker?

Since 2008 there has been a succession of ‘risk-on, risk-off’ (RoRo) periods: when risk is ‘on’, bond investors have seen fit to buy emerging markets and high-yield corporates; when risk is ‘off’, they have run for the proverbial hills with their pockets full of government bonds.

In ‘normal’ markets, government bonds and risk assets are negatively correlated, making them happy bedfellows in a portfolio.

During periods that central bank action (or investor expectations of action) was the dominant factor, correlations are much lower, so owning government bonds or risk assets wouldn’t always have compensated investors for losses in the other.

The latest period is the most extreme: since the UK’s EU referendum, prices of bonds and equities have been moving in the same direction – a positive correlation.

It seems that RoRo has been replaced by QEoQEo (or ‘quantitative easing on, quantitative easing off’) as the new way for markets to behave, with investors fixated upon the monetary easing activities of central bankers.

For a longer article on this topic, head to Newton’s blog.

Jon Day – Newton, a BNY Mellon company

Since 2008 there has been a succession of ‘risk-on, risk-off’ (RoRo) periods: when risk is ‘on’, bond investors have seen fit to buy emerging markets and high-yield corporates; when risk is ‘off’, they have run for the proverbial hills with their pockets full of government bonds. In ‘normal’ markets, government bonds and risk assets are negatively correlated, making them happy … read more

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Argentinian sovereign debt: oversubscribed and overrated?

We feel the market’s response to the Argentinian sovereign debt offer has perhaps been somewhat overenthusiastic. While we applaud the achievements made thus far, Argentina remains a B- rated country and therefore heavily sub-investment grade. At the same time, there remains a lot to be done and [the country] must continue with a package of severe fiscal consolidation.

This will take place against a backdrop of weak global growth, and with Argentina’s largest trading partner Brazil in the middle of its own crisis. In addition, around two thirds of Argentinian debt is denominated in US dollars; therefore any further weakening of the Argentinian peso will impact the ability to service its current debt and the new issuance.

Although macro headwinds have turned to tailwinds for the time being, the growth backdrop for many emerging markets remains challenging, and it keeps us mindful that the improvement in fundamentals has not been commensurate with the extent of the rally that we’ve seen in recent weeks. We’ll be looking for potential softness in the market – perhaps from congestion related to the extensive issuance that we’re expecting imminently; perhaps from the UK/European Union referendum (which poses considerable risk for the EU convergence story in central Europe); or perhaps a refocussing on the possibility of a June Fed rate hike – before adding further exposure from here.

Carl Shepherd – Newton, a BNY Mellon company

We feel the market’s response to the Argentinian sovereign debt offer has perhaps been somewhat overenthusiastic. While we applaud the achievements made thus far, Argentina remains a B- rated country and therefore heavily sub-investment grade. At the same time, there remains a lot to be done and [the country] must continue with a package of severe fiscal consolidation. This will … read more

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No siesta in sight for global bond markets

In recent weeks we’ve had yet another bond market tantrum; these seem to be becoming a regular occurrence these days. Just over the last month we’ve seen volatility in yields for both Bunds and US Treasuries.

May and June tends to be a period when risk assets are a lot more volatile, and, because we’ve seen significant pick-up in volatility in both currencies and in the core bond markets, we wouldn’t be surprised to see some volatility coming through in risk assets as well. So we think it’s a prudent idea to reduce some exposure high-yield markets, which have held up very well during this volatility and have placed it back into the core bond markets.

Paul Brain – Newton, A BNY Mellon company 

In recent weeks we’ve had yet another bond market tantrum; these seem to be becoming a regular occurrence these days. Just over the last month we’ve seen volatility in yields for both Bunds and US Treasuries. May and June tends to be a period when risk assets are a lot more volatile, and, because we’ve seen significant pick-up in volatility … read more

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High yield debt: a blockage in the system?

One consequence of the widely discussed hunt for yield has been enduringly strong flows into high yield assets. What is perhaps less known is how much those markets have grown over the long term. Net annual flows into the asset class have been positive in 17 of the past 23 years, for example. Net outflows have only occurred in six of those 23 years.

Meanwhile, retail ownership in the asset class has also skyrocketed. According to Morgan Stanley data, about 20% of US high yield is now owned by mutual funds or ETFs. That compares with 5% in 1993. More of the market than ever before is now owned by retail investors.

Accompanying this overall growth in the levels of debt has been a decline in the ability of the market to cope with inflows and outflows, as increased regulation, such as Basel III, has stymied the ability of banks to take on inventory.

As the market has grown, the amount of dealer capital available to trade fixed income has fallen. The liquidity of bond markets versus equities has always been low but now it is even more so. The trend is reflected in the frequency of bond trades versus that of equities. In January 2015, for example, the percentage of NYSE stocks with zero trades was 0.1%. For bonds, that figure was 53%. The percentage of equities with more than 25 trades a day was 99.7%. For bonds, that figure was just 0.4%.

Raman Srivastava – Standish, a BNY Mellon company

One consequence of the widely discussed hunt for yield has been enduringly strong flows into high yield assets. What is perhaps less known is how much those markets have grown over the long term. Net annual flows into the asset class have been positive in 17 of the past 23 years, for example. Net outflows have only occurred in six … read more

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Europe’s incredible declining yields

With yields grinding ever lower, income-seeking investors have begun to head in some novel directions.

For income-oriented investors, the combination of ECB quantitative easing, negative yields and negative interest rates is a real problem. Increasingly they are reallocating their funds into investment grade or high-yield bonds, but also into other interest-bearing asset classes. Given the small size of the market for higher yielding assets, even only a minor reallocation of money will support spread tightening and, we believe, lead to attractive total returns over the course of the year.

Part of the reallocation has already taken place on the back of stabilizing growth indicators in Europe and sound credit fundamentals. Up to the end of February, according to JP Morgan data, mutual funds saw strong inflows, reversing most of the outflows from the second half of 2014. The same data suggests high-yield debt now accounts for some 8% of mutual fund assets.

Henning Lenz – Meriten, a BNY Mellon company

For income-oriented investors, the combination of ECB quantitative easing, negative yields and negative interest rates is a real problem. Increasingly they are reallocating their funds into investment grade or high-yield bonds, but also into other interest-bearing asset classes. Given the small size of the market for higher yielding assets, even only a minor reallocation of money will support spread tightening … read more

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Will investors continue to buy bonds at any price?

The notion of value is often discussed by fund managers but rarely followed. Despite low valuations investors will still buy assets, especially if they are being driven by new information. Take the yields on European government debt. The assumption peddled by euro officials and supported by declining inflation expectations (principally the oil price) is that you need to buy bonds at whatever level they are on offer. Value doesn’t come into it. This is also having an effect on the surrounding markets.

One market that hasn’t really joined in the move to extreme values has been the US. Strong growth and a hawkish Federal Reserve has kept yields relatively high. For the US to join the party the market needs the news that US rates will not be going up in 2015. This would put the nail in the coffin of one if the big consensus trades of 2014 – being short the front end of the US curve and there would be a big squeeze.

Paul Brain, Newton

 

 

The notion of value is often discussed by fund managers but rarely followed. Despite low valuations investors will still buy assets, especially if they are being driven by new information. Take the yields on European government debt. The assumption peddled by euro officials and supported by declining inflation expectations (principally the oil price) is that you need to buy bonds … read more

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