Caveat emptor – new deals in the high yield market

Posted on 4 April 2013 by James Tomlins

The volume of new bond deals in the European high yield market has been very strong this year. One (unscientific) measure of this has been the growing pile of bond prospectuses on the desk; already the 2013 pile is more than halfway up the 2012 pile after just three months.

A marginally more robust measure is the data below published by Morgan Stanley. The year to date number of €25.2 bn is running well ahead of last year as more and more companies take advantage of lower yields and looser financing conditions in the wider credit markets to term out their debt and reduce interest costs.

Whilst this is generally good for the long term development of the high yield market in terms of depth and diversification, at this point in the cycle there are a few factors that are beginning to cause us to pause for thought.

In brief they are:

Capital structure – in recent months we have seen the re-appearance of more equity like instruments being issued. This can take the form of deeply subordinated debt, or bonds that pay interest in the form of more bonds rather than cash (aka payment in kind notes). These instruments are typically used to fund dividends to the owners of businesses and can expose bond investors to equity like downside.
Covenants – less of an issue for the bond market, but several leveraged loans in recent months have been issued on so called “cov-lite” terms (i.e. with significantly looser legal restrictions)
Quality of issuer – looser conditions in the credit markets make it easier for riskier issuers to refinance their debt. In early 2012, the market was largely closed to cyclical or more challenged southern European issuers. This is no longer the case.
Pricing – all the factors above are acceptable as long as buyers of the bonds are being compensated for the inherent risks. However, given that these deals are being priced in a market with an average yield of 5.6%*, the general prospects for attractive returns are more limited.

We believe that on a case by case basis there are still some attractive opportunities. Nevertheless this is very much a seller’s market. The terms are arguably more attractive for the issuers of bonds rather than the buyers. Accordingly, when looking at new deals, now is the time for a healthy dose of cautious discrimination – caveat emptor.

*B of A Merrill Lynch Euro High Yield Index yield to maturity 02/04/13

The Real Income Enigma

Posted on 12 March 2013 by James Tomlins

“The question isn’t at what age I want to retire, it’s at what income.”

George Foreman

The carry trade, the grab for yield – call it what you will, but this has been a persistent fact of life in today’s investment climate, especially as larger cohorts of the developed world join the ranks of the retired. As Mr Foreman points out above, the financial aspect of retirement isn’t really dominated by how much capital you might have, but how much income can be generated from your savings and various entitlements. Furthermore, safeguarding this income from the rapacious grasp of inflation is crucial. Real income is the goal.

While there is plenty of demand for real income, the supply of assets that can provide this is now dwindling. The chart below is a very simple one (and arguably too simplistic), but it paints a stark picture for income hungry investors. On the left hand side is the nominal income yield from various asset classes (dividend yield in the case of equities, yield to maturity for fixed income). The right hand side merely takes away the last inflation number to give you a snapshot of real income yields. This does not take into account the possibility of earnings and dividend growth from the equity markets (an important aspect) or indeed any changes in the inflation rate. For any income orientated investor, this essentially gives you the menu of options for generating inflation beating income in the here and now.

One thing that should come as no surprise is that cash and government bonds offer negative real returns on a buy and hold basis, but what is less obvious perhaps is that the number of asset classes that offer a positive real return has shrunk dramatically. Indeed, only high yield bonds offer a significant pick up above and beyond the inflation rate. (This pick up is there in part to compensate investors for the risk of default, volatility and lack of liquidity). Whilst we do not expect dramatic capital gains from high yield in the near future, absent a major negative shock for risk appetite, this context provides very powerful structural and technical support for the asset class. Investors, particularly those seeking income, ignore this at their peril.

High yield – it’s pickin’ time

Posted on 29 January 2013 by James Tomlins

It’s fair to say that we have been toning down our view on the high yield market of late. We could well see returns in the high single digits for 2013, but the potential for more substantial capital gains is less apparent in today’s context.

This does, however, ignore quite a powerful feature of the current high yield environment – the scope for exploiting opportunities and pricing dislocations within the market itself. To use a more technical term, spread dispersion within the market is very elevated. What do we mean by this?

Here is a snapshot of the European high yield market back in 2007 with credit rating plotted against credit spread. As credit risk increased, you got paid incrementally more credit risk premium. This produced a gentle upward sloping curve. The market was fairly efficient and the level of spread dispersion within a credit rating category was fairly limited.

Compare this to a snapshot of today’s market below: not only is the average risk premium significantly higher than in 2007, but more importantly, there is a much higher range of spreads within each rating category.

How can this obvious dislocation be exploited? If you can correctly assess credit risk independent of the ratings agencies, then you can start to pick and chose the bonds that are mispriced. Furthermore the reward for getting this “stock selection” correct can be meaningful. If for example you purchase Bond X at a credit spread of 750bps and sell Bond Y at 250bps, this is a 500bps difference. Let’s say that this difference moves to zero over time with both Bond X and Bond Y converging to a credit spread of 500bps, with a duration of 5 years. This is a relative price performance of 25% (a capital gain of 12.5% for Bond X, and avoiding a 12.5% capital loss for Bond Y).

If an active manager can realise even a small element of these sorts of opportunities across a portfolio, then the additional returns can be meaningful. It’s (stock) pickin’ time.

Five guidelines for European high yield peripheral investing

Posted on 2 January 2013 by James Tomlins

“The Chinese use two brush strokes to write the word ‘crisis’. One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger – but recognise the opportunity.”

John F Kennedy

2012 was a very good year for the European high yield market, total return coming in at 27.2% . Whilst we do not expect to see the same magnitude of performance in 2013, there are still some interesting pockets of value in the market. One of these is the “peripheral” region of Europe. In line with JFK’s sentiment above, we think it’s very important to engage pragmatically with Spanish, Italian, Greek, Irish and Portuguese companies. There is little doubt that the “periphery” is a major source of risk in these uncertain and austerity-bound times, but is also a good source of opportunity. So how can investors navigate these dangerous waters? When it comes to trying to pick out the better opportunities within the periphery, we think the following guidelines can be useful:

Right company, wrong postcode – It’s often easy in the first instance to dismiss a company due to the location of its business. This is why it’s so important to look at the underlying fundamentals of a business, no matter where it happens to be based. The market can often apply an unfairly harsh peripheral risk premium to some very high quality businesses.
Example – Guala Closures SpA is a specialty packaging business based mainly in Italy. We view Guala as a high quality business that has a strong competitive position in a fast growing, niche area of the packaging world, namely tamper-proof spirit bottle closures that help drink manufacturers defend their product against counterfeiters.
International earnings – Looking at where a company’s underlying cash flow and earnings actually originate is important. This is something that helps to mitigate the downside of weak domestic earnings. Also, if international operations become the dominant source of earnings and cash flow over time, the market will start to reduce the peripheral risk premium to the benefit of bond holders.
Example – Fage Dairy Industry SA is a Greek yoghurt manufacturer with significant domestic operations. However, over the past few years, the business has made major investments in the fast growing US market with a plant based in upstate New York. The US business now accounts for the majority of the group’s cash flow.
Recession resilient balance sheet – If a company does have significant exposure to an austerity hit economy, it’s important to discriminate in favour of those who can survive a weak economic environment. Going into a recession with a relatively healthy balance sheet means a business has the ability to endure a few setbacks and thus greatly increases the chances of survival in the medium term. If and when a weak domestic economy stabilises and returns to growth, then these businesses will also be the first to benefit.
Example – Bormioli Rocco is an Italian glass packaging and tableware business. The company has had some poor operating results in recent quarters. This has resulted in the Net Debt to EBITDA increasing from around 2.5x to around 3.5x over the space of a year, a negative move but from a low starting point and in our view still manageable.
Hard currency bonds – This is arguably less relevant in the post Draghi “whatever it takes” world, but if we ever return to an environment when any country’s membership of the Eurozone is in doubt, then the currency of a company’s liabilities will also become a factor in limiting your downside risk. If, for instance, the markets begin to entertain the possibility of a euro bond issued under domestic law being re-denominated into a weaker currency, then the price of these instruments would be much more vulnerable than a foreign currency bond (USD or GBP) governed by US or UK law.

Example – Ono, a Spanish cable business, issues both EUR and USD debt. Everything else being equal, USD denominated bonds issued under US law would be the favoured holdings should Spain’s membership of the Eurozone ever be called into doubt.
Value, Value, Value – there is no point in exposing yourself to risk unless you are being compensated for it. There must be a risk premium attractive enough in the first instance to engage with these bonds and issuers. Not only can you capture a favourable yield, but if this risk premium dissipates, bondholders can benefit from additional returns. The table below illustrates the pick up in yield relative to the broader European and US markets for some of the bonds issued by the aforementioned companies. Above everything else, the value argument remains the definitive starting point for looking at potential opportunities.

	Bond	Yield
Guala Closures	EUR 9.375% 2018	7.5%
Fage Dairy Industry	USD 9.875% 2020	8.0%
Bormioli Rocco	EUR 10.000% 2018	8.6%
Ono	USD 8.875% 2018	8.3%

European Currency High Yield*	-	5.3%
US High Yield*	-	6.0%

*Bank of America Merrill Lynch European Currency High Yield Index and US High Yield Index

Source: Bloomberg / M&G as of 27/12/12
Full disclosure: M&G has an interest in the bonds issued by the companies mentioned

European High Yield – stay in the game, but don’t bet the ranch.

Posted on 25 September 2012 by James Tomlins

We mentioned late last year that the high yield market had crossed into cheap territory as credit spreads went over 1,000bps. Historically this has proven to be a relatively robust signal to take a constructive view on the market, and it proved so once again. To use a poker analogy, it was like being dealt a full house – the odds were sufficiently in your favour that, even if you didn’t know exactly what would happen, it was worth making a reasonably big bet.

In what’s been a fairly rocky ride, the European high yield market has seen a total return of 20.1%* so far this year, which compares to a 15.8% rise in the S&P 500, a 10.4% for the Euro Stoxx 50 and 4.8% for the FTSE 100. In all honesty, this has been a stronger result than we anticipated, fuelled mainly by the actions of the ECB (most of this year’s returns coming in Q1 on the back of the LTRO programme) Mr Draghi’s commitment to “do what it takes” and other central bank injections of liquidity in what has been an otherwise lacklustre year for economic growth.

So far so good, but the real question is where to now for high yield? Can we see another few months of double digit returns?

To try and answer this, first let’s consider a few of the key valuation signals. In terms of all-in yields, the high yield market is not too far away from multi year lows. The European market is currently yielding around 7.3% to maturity** compared to a 10 year low of 5.3% in February 2005. There is some scope for yields to fall further on this basis, but the scale of the move will not be enough to generate the sort of capital gains we have seen in the last few months.

This means that anyone who buys high yield assets at this point in the cycle looking for large capital gains will probably be disappointed. To generate a further capital return of around 16%, for example, yields would have to fall to around 2% on average. Does this then mean high yield is a screaming sell ? No, not really. To think that high yield is a sell you have to be fearful of either a big rise in underlying government bonds yields, a major re-pricing of credit spreads or both.

In the case of government bond yields, we could well see a rise from current levels, however, the extent of the rise, in my view, will be limited. I don’t think we will see 10 year yields north of 5% for Treasuries, Bunds and Gilts anytime soon as governments and policy makers have made it very clear that they will continue to intervene in the markets to keep long term interest rates lower for longer. Nominal growth and the labour markets are the primary concern, not the risk of higher inflation. This means the potential move up in sovereign yields is likely to be limited and hence capital losses for high yield bonds due to this move will be relatively benign. To put this in context, the modified duration of the European high yield market is currently 3.1 years**, hence if government bond yields rose by 1% across the board, the capital loss would be around 3% all other things being equal. When you add back a credit spread of 6.7%, assuming that you are not hit by a wave of defaults (always a big ‘if’ admittedly), then the total return from high yield would still be positive.

The more important driver of returns for the asset class will be any move in credit spreads and what default rates are likely to be. In contrast to all-in yields in the previous chart, we can see from the chart below, that credit spreads are still a long way off their lows. The incremental yield over government bonds was at 7.4% at the end of August, compared to 1.9% in May 2007. As such, there seems to be plenty of scope for spreads to go tighter, with the potential for some capital gains as they do so.

Does this mean high yield is a screaming buy? Again, no. We have to look at credit spreads in the context of the economic reality for companies in Europe. Much of Europe remains in the grip of low or no growth and credit remains scarce. As such the price of credit (the spread) should reflect that reality. At the end of the day, investors should demand a credit spread that adequately compensates them for the illiquidity inherent in the asset class and a modest rise in default rates. With this in mind, spreads are extremely unlikely to go anywhere near the 2007 level of 1.9% any time soon. There is also the ever present threat of a macro-economic or political curve ball that prompts a general shift in risk appetite and push spreads wider. Nevertheless, when we look at fundamentals and consider the medium term valuation case I think high yield spreads are closer to “fair value” right now.

This leads us to the rather unsatisfying conclusion that whilst the high yield market may not generate big capital returns, there is a case for remaining invested. What I would say though, is that a more defensive approach within high yield portfolios is probably merited in the current environment. The risk/reward trade off between a more aggressive position and a less aggressive position has shifted in favour of the latter. In essence, this means dialling down the “beta” for want of a better phrase.

To revert to the poker analogy, betting on the high yield market right now is like playing a hand with two pairs – you might make money so it’s worth staying in, but it doesn’t feel like the time to go all in and bet the ranch.

*Merrill Lynch Euro High Yield Index total return from 31st Dec 2011 to 21st Sep 2012. Equity market returns year to date as of 21st Sep 2012. Source: Bloomberg, Bank of America Merrill Lynch

** Merrill Lynch Euro High Yield Index as of 21st Sep 2012, Source: Bloomberg, Bank of America Merrill Lynch

The quiet de-coupling of high yield from equity markets continues

Posted on 24 July 2012 by James Tomlins

High yield and equities have historically been seen as highly correlated in terms of their returns, and before 2008, this was true. However, what we have witnessed in the post-Lehman environment is a structural shift that requires a more nuanced appreciation of the relationship between fixed income and equities. This is something we looked at in a more in depth piece we published earlier this year.

This point has been reinforced by the surprisingly divergent performance of the European high yield market and the European equity markets so far this year.

The chart below shows that European high yield performance has been strong, returning a little over 12% year to date. This contrasts sharply with lacklustre equity returns. The MSCI Europe ex UK index is down 1.3% at the time of writing whereas the more concentrated DJ Euro Stoxx 50 is showing a negative 8.4% return.

Accordingly, whilst high yield returns will always be sensitive to the economic cycle and market sentiment, in a world of zero interest rates, financial repression, deleveraging and slow growth, we continue to believe that the relationship between equities and high yield bonds has shifted in a subtle but meaningful way.

US – a video from Chicago. Research trip on the US High Yield market

Posted on 2 July 2012 by James Tomlins

I recently returned from Chicago after a research trip. We put together a short video to share a few of our findings with the wider world. The mood of most economists, investors and indeed the man on the street was noticeably more upbeat than in Europe. With positive GDP growth, a housing market showing the first signs of stabilisation, if not growth, and – in our opinion – a banking system that is in better shape than its European equivalent, the US continues to provide a more benign context for High Yield investors. Indeed, whenever we encountered concerns and pessimism it was firmly focused on this part of the world. Consequently, we continue to find some interesting themes and opportunities in the US, both from a top down perspective and also for individual issuers and bonds.

High Yield Default Rates Finally Starting to Rise

Posted on 30 May 2012 by James Tomlins

Default rates for high yield bonds have started to rise from a low level over the past few months. The trailing last 12 month default rate for Global High Yield was 2.7% in April, having bottomed out at 1.8% in October 2011 according to data from Bank of America Merrill Lynch. This in itself is not unexpected as default rates were running at historically low levels, helped by very loose monetary policy, markets that were willing to refinance many companies and some positive underlying earnings growth.

How far default rates will rise from henceforth is the real question. Some of the elements that helped keep default rates low over the past 2 years are unsustainable or unrepeatable. For instance the huge fiscal easing from many of the G8 economies that spurred a lot of the bounce back in 2009 is not an option available to many governments today. Likewise, underlying earnings growth in today’s world of austerity and uncertainty is much harder to come by. Finally, whilst the credit markets are willing to finance good businesses with sensible balance sheets, it’s far more discriminating when it comes to businesses that are struggling to grow or have too much debt.

The bottom line is that we think the next few years will be a tough environment for highly leveraged issuers and that in the absence of a dramatic pick up in growth or a very dramatic policy response (full Eurozone QE and Eurobonds anyone?), bearing in mind the huge range of potential outcomes in the European economy, our best guess is that default rates in the European high yield market will average 6% per annum for the next five years.

One area of the market which could see a marked impact is the short dated or short duration high yield strategy. This type of strategy has performed very well in the past few years in terms of providing reasonable returns but with much lower volatility than conventional high yield strategies. The benefit of a low default rate over the past 2 years has been a key element of this performance. However, as the number of defaults starts to increase, this following wind will disappear and the scope to deliver similar levels of risk adjusted returns becomes much harder. At the end of the day, your downside risk in a default is the same if you hold a 2 year bond or a 10 year bond.

The good news is that valuations in the broader high yield markets already compensate you for a default rate of a little over 8% p.a. over the next 5 years, so there is already a lot of bad news in todays’ prices. There are also many ways to mitigate the risks of default when taking on high yield risk (active stock selection, sticking to defensive industries and focusing on regions that have healthier economies for instance). Nevertheless, as default rates start to rise, we think investors need to tread with a degree of caution.

High Yield in the Post Lehman Era

Posted on 29 March 2012 by James Tomlins

We recently published an in-depth note on the high yield market which you can access here. In it we consider some of the issues facing investors in the era of negative real interest rates and financial repression and how high yield as an asset class fits into the current paradigm.

Our main conclusions are:

Low interest rates and ageing demographics are enticing investors to high income generating assets.
High yield fixed interest assets are set to benefit from these structural shifts in investor behaviour.
The low duration, high income nature of the asset class is attractive in a world of ultra-low interest rates.
There are genuine opportunities in today’s high yield market due to the wide dispersion of credit spreads. Fundamental credit research is vital.
There is a structural shift to high yield occurring in fixed income markets right now.

We also looked at the high yield market in terms of current valuations and potential returns after a period of strong relative performance over the past few years (see chart below).

4 Housing Markets, One Country

Posted on 16 February 2012 by James Tomlins

The Eurozone has become a very extreme example of the dangers inherent of creating a single currency area populated with a myriad of different countries and regions. There is little doubt that the right monetary policy for Germany is not necessarily the correct one for Portugal given the underlying structural differences and lack of fiscal coordination.

However, closer to home, there could be an argument that the same (albeit in a less extreme form) is true of the UK. Looking through the prism of the UK housing market over the past 30 years, it’s possible to argue that there are 4 distinct regional markets within the UK. The UK is not an optimal currency area.

Using historical regional data from the Halifax house price index (see the chart below), there have been some very large and identifiable variations between different regions within the UK. Prices within Greater London have fared the best over the period, showing a strong bounce back from recent lows. Northern Ireland has suffered from an extreme boom and bust whereas the Scottish market has been the relative underperformer over the same period. In contrast, the other regions of the UK have, by and large, moved in lock step with each other.

Given the fact that Bank Rate is the same in Chelsea & Kensington as it is in Dundee, the potential to exacerbate structural imbalances between regions due to a common monetary policy is clear to see. Indeed there is a sense that as central London market prices rise to new highs in absolute and relative terms, we are witnessing a new liquidity fuelled bubble divorced from the economic fundamentals of the rest of the UK.

However, there are mitigating factors: existing within a single sovereign political entity, fiscal transfers and labour force mobility should all help redress these imbalances over time. The fact the London and the South East contribute a greater proportion in tax revenue is a case in point. However, due to the foibles of negative equity, labour mobility has been greatly constrained in recent years. Differences in regional unemployment bear witness to this fact. For example, the latest ONS data states that the unemployment rate in the North East is 12.0% compared to 6.4% in the South East.

Are we therefore condemned to a future of further economic stresses and strains within the UK? Maybe not. If the Scottish do eventually decide to leave the United Kingdom with their own central bank and currency, maybe the Northern Irish and Londoners should be given the same option too?

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