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Sprouting out: green bonds come of age

Green bonds are instruments in which proceeds are exclusively applied towards new and existing green projects – defined as activities that promote climate or other environmental sustainability purposes. They enable capital raising and investment in projects with environmental benefits. The International Capital Market Association (ICMA) set out some guidelines for issuing of green bonds in January 2014.

Originally dominated by supranational issuers (for example, European Investment Bank, World Bank and the European Bank for Construction and Redevelopment), financials and corporate issuers are increasingly tapping into this new source of funding.

Green corporate bonds, being a nascent asset class, are a place for many firsts. In October 2012, industrial gases company Air Liquide claimed they were the ‘first private company to issue bonds meeting the SRI investors’ criteria’. This bond predated the Green Bond Principles, and technically may not be a green bond, but is noteworthy in having been ‘mostly placed with Socially Responsible Investor (SRI) mandated issuers’. Since then, we’ve had French utility EDF in November 2013 announce ‘the issuance of the first corporate Green Bond’, although that title may just (by a couple of days) go to the Swedish property company Vasakronan. More recently we’ve had consumer goods company Unilever announce in March 2014 ‘Unilever’s green sustainability bond is the first green bond in the sterling market, and the first by a company in the FMCG sector’.

It is apparent that corporate issuers are keen to spur the development of the green bond market as an alternative funding source and, in doing so, raise awareness of the environmental issues they face. Looking at the chart below shows that corporates are now the single largest source of green bond issuance. Whilst it’s clear that issuers and investors both earn brownie (greenie?) points in terms of enhanced reputation for their involvement and support of sustainable projects, green bonds lack a binding internationally recognised definition, they merely adhere to a voluntary set of guidelines.


One of the structural features of green bonds is that they are often issued off existing Euro Medium Term Note (EMTN) programs and guaranteed by the parent company. Cash flows that service bonds come from the issuer, therefore benefiting from the overall cash flows of the corporate, not just the project that is being funded. It is not surprising, therefore, that the credit rating of these bonds is in line with other bonds issued by the same issuer. This dislocation does, however, mean that investors are not able to identify the cash flows from the underlying project.

Corporate bonds issuers often bracket their use of proceeds into ‘general corporate purposes’, which rarely tells investors much about how or where the proceeds are to be used. Is it, for example, for refinancing, M&A, capital expenditure or share buybacks? In contrast, one of the cornerstones of a green bond is that the use of proceeds is defined in the legal documentation of the security, which should bring a degree of transparency. I say degree because, in practice, once the proceeds are deployed the investor may have limited information on the progress of the project and the extent to which it is meeting environmental targets. For instance, are bond proceeds for the specified project leading to an identifiable reduction in greenhouse gases, water and waste?

There is a certain asymmetry in green credentials required between issuers and investors. For an entity to issue a green bond they have to abide by the principles as outlined by the ICMA. Alongside use of proceeds, these also include project evaluation and selection, reporting, as well as management of proceeds. The latter includes a suggestion to enhance the environmental integrity of the instrument through the use of an external auditor, an independent verifier or as some have called it, a Socially Responsible Investment (SRI) rating agency. Yet with so much stringency on the issuer side, there seems to be no limitation on which bonds funds are able to participate in owning such an issue. Whilst issuers are often citing a desire to diversify their funding sources and attract SRI and Environmental Social and Governance (ESG) conscious investors seeking sustainable (both from a cash flow and environmental perspective) fixed-income instruments, the investors themselves do not necessarily need to have such a green bill of health.

Indeed, even a bond issued in a ‘green wrapper’ may not satisfy certain SRI funds which may argue, rightly or wrongly, for example, that EDF is using cash flows generated through nuclear power activities to pay coupons on its green bond. Another angle on this would be to say that environmental projects are receiving credit enhancement through use of corporate cash flows to prop-up investment in green initiatives. Regardless, the burden remains with the investor to determine how green the bond is. The rating agencies have so far not waded into the argument by assigning a relative ranking of ‘greenness’.

Finally, looking at a few examples of corporate green bond issuers in the table below, it appears that the pricing of green bonds on the secondary market is in line with other (‘non-green’) issues, which to us makes sense given the structural and cash flow arguments mentioned.



Burrito Bonds – an example of the retail bond market

One of our local burrito vendors has been advertising a new 8% bond to its customer base. The company, Chilango, wants to raise up to £3m to fund expansion of its chain in central London. This will be done via a crowd sourced retail offering that’s already drawn some interesting coverage in the financial press. Having performed some extensive due diligence on the company’s products as a team, we can safely say they make a pretty good burrito. However, when we compare the bond to the traditional institutional high yield market, we have some concerns that investors should be aware of.

  1. Disclosure – a typical high yield bond offering memorandum (the document that sets out the rules of the issue, its risk and all the necessary historical financial disclosure) can be several hundred pages long. Producing this is a very time intensive and expensive process, but a valuable one for producing a host of useful information for potential investors. Additionally, a law firm and an accounting firm typically sign off on this document, effectively staking their reputation and incurring litigation risk based on the veracity of the information disclosed.

    In contrast, the Chilango’s document is 33 pages long, with some fairly superficial financial disclosure. The photo below illustrates this comparative informational disadvantage and the relative lack of depth in financial information compared to a recent institutional high yield bond offering from Altice.


  2. Financial Risk – there are two big potential concerns here. Firstly, the starting leverage for the bonds is potentially quite high. Using some admittedly finger in the air assumptions regarding the potential cash flow of each new outlet opened (a necessary approach given poor disclosure), leverage could be around 6.0x Net Debt/EBITDA in 2015. This is certainly at the riskier end of the high yield spectrum. The second major concern is that we don’t know for certain how much debt the company will raise. Chilango state that they target at least £1m in this issue, but are willing to raise up to £3m, leverage is likely to be north of 10x (again this is a best guess). All this means the bonds would in our opinion get at best a CCC rating, right at the riskiest end of the credit rating spectrum for sub-investment grade bonds.Slide2
  3. Security – Chilango state very clearly that these bonds will be unsecured instruments. This means that in the event of a default, the creditors will rank behind any secured creditors. There appears to be limited existing secured creditors, but we see nothing in the documentation to prevent a layer of new secured debt being raised ahead of these notes (something that is a common covenant in institutional bonds deals). Consequently, it’s prudent to assume that in a default situation the recovery value of the bonds is likely to be significantly below face value. This equity-like downside means investors should demand an equity-like return in our view.
  4. Call Protection – these bonds are redeemable at the option of the issuer at any time. Consequently, investor returns could be materially curtailed due to the lack of call protection. Call protection is the premium over face value the investors get when the issuing company redeems the debt early (their call option). Thus some of the benefit also accrues to the bondholder. Take the following return profile:
    8% Bond, Callable at Par
    Years Outstanding Total Return
    1 8%
    2 17%
    3 26%
    4 36%

    If the plan to open new branches goes well, the bond investor should be happy right? Wrong. If this happens, the company may well look like a less risky prospect and will be able to raise debt finance more cheaply. Let’s say a bank offers them a loan at 5%, they could then redeem the 8% bond early, diminishing the total return to bondholders (as per above), and save £90,000 a year on interest costs per year (assuming they issued £3m bonds). Again, call protection is a common feature of the institutional high yield market which protects investors in these situations.

  5. Liquidity – these are non-transferrable bonds. This means that a) the company does not have to file a full offering memorandum hence the lack of disclosure and b) it will not be possible to buy or sell the bonds in a secondary market. This is more akin to a bilateral loan between an individual investor and the company, with the investor in it for the long haul. Consequently, an investor will neither be able to easily manage their risk exposure nor will they be able to take profits should they so wish before the bond is redeemed.
  6. Value – we can see that there are many risks – but to be fair that is the nature of high yield investing. So the real question is, “is 8% sufficient compensation for this risk”. The good news is that this bond has a unique bonus coupon in the form of a free burrito a week for anyone prepared to invest £10,000. At current prices, this equates to 3.63% additional coupon (a steak, prawn or pork burrito with extra guacamole is £6.99), so an all-in coupon of 11.63% (8% cash + 3.63% burrito).We’d argue that a “burrito fatigue factor” should be applied, simply because you may not want a burrito every week and you will probably not be physically near a Chilango every week to cash in this extra coupon. A 75% factor feels about right, which reduces the burrito coupon to 2.72% and the all-in return to 10.72%. So is 10.72% a fair price? To get a sense of this we can look at some GBP dominated CCC rated institutional bonds in other asset light industries
    Bond Price Yield
    Phones 4 U 10% 2019 90.5 12.7%
    Towergate 10.5% 2019 98.5 10.9%
    Matalan 8.875% 2020 101.5 8.5%
    Average: 10.7%

    By coincidence, the all in coupon of 10.7% is bang in line with the average of this (very limited) group of comparable bonds. However, I’d argue that the Chilango bonds should be significantly cheaper than the bonds above due to higher leverage, no liquidity, no call protection and the lack of disclosure. What should this differential be? Again, there is no scientific answer, but our starting point would probably be in the 15-20% range, and only then with some more certainty around the potential maturity of the bond and the ability to share in the future success of the company.

So, much as though we would all enjoy the tasty weekly coupons, our view is that like many of the so-called “retail” or “mini” bond offerings, the Chilango burrito bonds stack up poorly against some of the current opportunities in the institutional high yield market.

M&G has no financial interest in seeing this issue succeed or fail, either directly or indirectly.


Sell in May and go away – does it work for European fixed income?

As is usually the case on 1 May, there was a plethora of articles and commentary on the “sell in May and go away” effect. If you are unfamiliar with this highly sophisticated trading strategy, it involves closing out any equity exposure you may have on 30 April and re-investing on 1 November. Historically, U.S. equities have underperformed in the six-month period commencing May and ending in October, compared to the six-month period from November to April. No one knows why this seasonal pattern exists, but some theories include lower trading volumes in the summer holiday months and increased investment flows when investors come back from holidays.

With this in mind, we thought it might be interesting to see if the same effect exists in European fixed income markets. In order to identify the sell in May effect, we generated total returns on a monthly basis for a portfolio of European government, investment grade and high yield bonds. We then generated a total return for a portfolio that was invested between the months of November and April and compared this with a portfolio that was invested between the months of May and October. In order to generate the maximum number of observations possible, we went back to the inception of the respective Merrill Lynch Bank of America indices. The results are below.


There appears to be a seasonal effect in European high yield markets. This is the fixed income asset class that is most correlated to equity markets, and the analysis shows that a superior return was generated by only being invested between the months of November and April (199% total return). In fact, this strategy substantially outperformed a strategy of being invested over the whole period (1997 – April 2014). If an investor chose to only invest between the months of May and October, they would have suffered a 21% loss over the past 16 years.


The natural extension of this analysis is to gauge how a trading strategy that was fully invested in European government bonds between the months of May and October and fully invested in European investment grade between November and April would have performed over the past 18 years. We can then assess how this strategy would have performed relative to portfolios that were fully invested in European government bonds, European investment grade corporate bonds and European equities only. The results show that a strategy of selling investment grade assets in May and buying government bonds has produced superior returns equal to 5.9% per annum, outperforming European equities by 56% in total or 2.5% p.a.


The above chart shows the same analysis, this time looking at how the strategy would have performed in total return terms but we have replaced European investment grade exposure with European high yield. Following this strategy would have generated an annualised return of around 10.5% or 391% over 16 and a bit years. This is far superior to the returns on offer in the European high yield and European equity markets over the same time period, which were 155% and 43% respectively.

Our analysis shows that there is a strong seasonal effect evident in European high yield markets, where returns are more volatile and there can be large upside and downside contributions due to fluctuations in the capital value of high yield bonds. However, it should be acknowledged that the results have been biased by the fact that major risk-off events (like Lehman Brothers, the Asian financial crisis and the Russian financial crisis for example) have generally occurred between the months of May and October. Nonetheless, historical total returns suggest that there is a seasonal effect in European high yield markets that investors should probably be aware of. Ignoring transaction costs or tax implications which would eat into any total returns, a strategy of selling investment grade or high yield corporate bonds in May and buying government bonds until November would have produced superior returns relative to European government bonds, investment grade corporate bonds, high yield corporate bonds and European equities.

Whilst it is always dangerous to base a trading strategy around a nursery rhyme, based on historical total returns there does appear to be a bit of sense in selling risk assets in May, retreating into government bonds which would likely benefit most in a risk-off event, and adding risk back into fixed income portfolios in November. But of course, another old saying still rings true – past performance is not a guide to future performance.


Tomlins’ guide for getting the best from High Yield in 2014

2013 was another decent year for returns in the high yield market. The US market returned 7.4%, with Europe a little way ahead at 10.3%. Bonds saw solid income returns, low default rates and a small capital gain as a tightening in credit spreads was enough to overcome weakness in the government bond markets. Once again this illustrated how high yield can be one of the few fixed income asset classes that can generate positive returns within a rising interest rate environment.

However, the dead hand of mathematics weighs heavily upon the prospects for the market in 2014. We still believe it will be a positive year for total returns, but expectations are for returns to be in the mid-single digits.

How then can we seek to potentially enhance these returns and reduce volatility in High Yield this year ? Here are five strategies that could help:

  1. “Clip the coupon and conserve your capital” – with lower return expectations, we think coupons (or rather income) will form the bulk of returns this year. On the other hand, with average bond prices above par, protecting the downside and lowering the volatility of capital returns will also be key.
  2. “Dodge duration” – one of the ways to lower the volatility of capital returns and protect portfolios from downside risk is to reduce exposure to volatility in the government bond markets, i.e. reduce the exposure to interest rate duration.
  3. “Financials are your friend” – recently we’ve been much more positive on the scope of financial high yield to enhance returns, especially in Europe. There are still many fundamental issues to be resolved, but the relative valuations and excess yields on offer to gain exposure to a sector that is essentially de-leveraging and de-risking are attractive in our view.
  4. “Learn to love liquidity” – if we do see opportunities to put capital to work at a later stage of the year, it’s important to have the liquidity on hand to take advantage. This may take the form of wider volatility and a sell off or indeed a rush of new issues hitting the market at the same time.
  5. “Don’t burn and certainly don’t churn” – keeping unnecessary transaction costs to a minimum will have a proportionally high impact when returns are expect to be more muted. Trading to try and capture a 10-15% upside is very different from trying to capture an additional 1-2% return when transaction cost can be anything for 50 – 100bps.

Technical support for Euro IG; around 4% of the market set to mature this month

Benjamin Franklin said that death and taxes were the only inevitabilities in life. I’d like to add the discussion of the January effect to his list. Every year I receive at least one piece of commentary telling me that January is always a good month for risk assets (we’re far from innocent ourselves – see here).

Basing investment decisions purely on seasonal anomalies isn’t a particularly reliable investment process and the sensible investor should take other, more robust information into account when making changes to their portfolio.

The improving economic outlook for Europe and the general lack of pessimism should help the European credit market rally this month. So too should the fact that about €64bn worth of investment grade bonds are set to have matured by the end of the month. I think it rather unlikely that we’ll see enough supply to offset the bonds that are maturing. J.P. Morgan recently publishing a research piece pointing out that gross European investment grade issuance has only ever been higher than €64bn a month on four occasions in the past, and all were prior to 2008.

2014-01 matt blog

J.P. Morgan also point out that January has been on average the month when most issuance takes place throughout the year. The primary market has been true to form since 2014 began but it will need to maintain the pace of the roughly €16bn that was issued in the first week of the year to give investors with maturing bonds somewhere to put their cash.

If net issuance turns out to be negative in January it will be a key technical support that could see Euro investment grade spreads continue to tighten further. It will also give us all another nice data point to talk about come next January.


The year of the Snake – 2013 returns in fixed income markets

2013 has offered another injection of both adrenaline and performance to fixed income investors. A rapid sell-off shook emerging markets just before the summer while the Fed was conducting a “tapering yes/tapering no” ballet that lasted for more than six months. European peripheral countries finally came out of recession, although unemployment levels remain alarmingly high. In parallel, global high yield markets delivered further stellar performance, while Japan started to feel the effects of the unprecedented monetary and fiscal revolution driven by Shinzō Abe.

However, a common theme clearly emerged: the developed economies appear to be finally growing at a reasonable pace. Markets largely normalised as volatility and correlations returned to pre-crisis levels. While central bank intervention (set to continue for some time) has been the mantra in a liquidity driven environment, the world is transitioning back towards a growth based model. The US is well positioned to lead the pack, although high debt levels in Europe may continue to leave governments with limited room to support the recovery via fiscal stimulus. However, the good news here comes from a healing and deleveraging banking system, as well as rock solid support and a clear accommodative stance by the ECB and its leader Super Mario Draghi.

In this context, many fixed income asset classes offered satisfactory returns. Which assets have been top performers? The results are surprising. Who would have said, back in January 2013, that – together with a new Pope from Argentina, China landing on the moon and an economic bailout in Cyprus – Spanish “Bonos”  would have offered total returns in excess of 11% YTD, for example? Let’s take a closer look at government bonds, corporate bonds and major currencies compared to the US dollar (all total return YTD figures are measured from 31 December 2012 to 17 December 2013 in local currency).

Government bonds

Risk-free government bonds have been negatively affected by expectations over rising rates and tapering uncertainty. The UK gilts index – with an average duration of over 9 years – has been the most negatively hit, followed by US Treasuries (5+ years duration) and finally by less volatile German bunds (6+ years). It was a different story for some countries in the European periphery, where Greek government bonds offered tremendous total returns above 50%, followed by Spanish and Italian sovereign debt. Following the May debacle, emerging market government bonds in hard currency (measured by the commonly used JPM EMBI Index) took a significant hit and offered a negative return below 6%, despite a decent rebound after the summer, while the local currency index (JPM GBI-EM) looks set to end the year broadly flat (while once translated in USD, it is negative by around 8%)

Following 2012’s fall from grace for linkers, due to both falling inflation expectations and very low inflation in Europe and US, 2013 has continued to see the US, European and EM markets negatively affected while the UK market is about to close in a marginally positive territory thanks partly to the decision to maintain the link to RPI earlier this year (here’s a blog from Ben on the topic).

Looking back: government bonds

Corporate bonds

A great degree of value over the past year was to be found in corporate bonds. Companies are benefitting from the broad-based economic recovery around the developed world and from the subsequent increase in consumer demand (higher consumption = higher corporate revenues) and public investments. A conservative management of financial resources and balance sheets by bond issuers on average (especially in Europe), improving economic prospects, forward guidance on interest rates and a low inflation environment have all supported the ride of corporate bonds. Names active in the high yield space – especially in the US and Europe – have been amongst the standout performers within credit. Financials have also had a very strong run, especially in the subordinate space, helped by a healthy investor demand for higher yielding and more cyclical paper, as well as a general financial deleveraging process that is going in the right direction to restructure their balance sheets.

Performance highlights include European high yield (+9.9%), European subordinated financials and US high yield banking (+7.1% and +8.9% respectively) and an overall good showing from BBB non-financial corporates in Europe (+4.4%, to compare against -0.8% in the US). Emerging market corporate debt was in negative territory overall (-1.0%), while the high yield portion was marginally positive (+1.1%).

Looking back: corporate bonds


The most noticeable development amongst major currencies has been a general lack of excitement around the US dollar from global investors, probably due to the ongoing tapering tantrum together with fears around the US fiscal cliff and the recent government shutdown. The USD index (DXY in Bloomberg) has generated a rather lacklustre  performance of +0.4% YTD. We need to make a clear distinction between two separate trends this year: the index generated positive returns for around 6% between January and early July, while it lost ground in the second part of the year (around -5.6%) due to uncertainties around the US government shutdown and Fed’s decision to maintain loose monetary policy. However, today the US economy is growing, its current account deficit is decreasing, the nation is moving towards energy independence, and Fed policy is now clearer following its tapering announcement on 18 December: we strongly believe that US dollar is good value and is set for a strong rebound.

Amongst G10 currencies, the Euro and GBP have gained significant value over the USD in recent months. Thanks to surprisingly strong economic developments in both the UK and the Eurozone, sterling and the euro have been amongst the best performing global currencies between March and December. Stay tuned on the British pound, because the UK’s 5.1% current account deficit in Q3 is the 3rd is the worst in UK history (and worse than Indonesia, India and Brazil). This suggests that there is no sign of the UK economy rebalancing and the UK’s economic recovery in its current form is nowhere near as sustainable as the US recovery.

The Japanese Yen has lost significant value (-15.4%) versus the US dollar due to the fresh efforts of the Bank of Japan to create inflation (and nominal growth) in the country. Some emerging market currencies offered strong performance, including the Argentine peso, Chinese Renminbi, Hungarian Forint, Polish Zloty, and Mexican peso, but the majority of EMFX has underperformed the US dollar, notably the Brazilian real, Indonesian Rupiah or South African rand, with the latter being the only currency to return less than the Yen at the time of writing.

Looking back: major currencies performance vs. USD

In conclusion, who would have expected such an interesting ride for fixed income asset classes this year? What is going to happen in 2014? Will next year be a negative or positive one for financial markets, and fixed income specifically? Read our latest Panoramic here and continue to stay tuned to this blog, explore recent posts (here from Ben, here from Mike and here from myself) and read more in the upcoming weeks.

Before saying goodbye, let me ask you something related to the Chinese calendar. The Year of the Snake, which began  on 10 February 2013, will be over at the end of January 2014. In the Chinese zodiac, the snake carries the meanings of cattiness and mystery, as well as acumen, divination and new beginnings. Do you see any fit with 2013? The new year of the Horse will start on 31 January 2014. The horse is considered energetic, bright, warm-hearted, intelligent and able. Any hint? Good luck and happy 2014!


A Fed taper is on the table

The FOMC took markets and economists by surprise in September this year when the committee members decided to hold off from tapering and maintain its bond-buying programme at $85bn per month. Three months down the road and the consensus for the December meeting outcome is that the Fed will not reduce the pace of MBS or treasury purchases. Consensus has been wrong before; will it be wrong again tomorrow? We think it will be a closer call than many expect.

In our opinion, there are several good reasons for the Fed to taper very slowly. Firstly, inflation is a non-issue, below target and close to lows not seen for decades. Secondly, the 30 year mortgage rate has risen from 3.5% in May to around 4.5% today, impacting US housing affordability and already tightening policy for the Fed. Thirdly, there is continued concern that 2014 may bring a return of the political brinkmanship that characterised late September, with the US Treasury signalling that the debt limit will have to be raised by February or early March to avoid default. Ultimately, the Fed is nowhere near hiking the FOMC funds rate.

There is no doubt after the September decision that tapering is truly data dependent and in this sense, macro matters. Fortunately, Ben Bernanke has told us what economic variables he and the FOMC will be looking at a press conference in June. The Fed wants to see a broad based improvement in three economic variables – employment, growth and inflation – before reducing the scale of bond buying.

The table below shows that the data has improved across the board. Annualised GDP is stronger, the unemployment rate is lower and the CPI is only 1.2%. Other key leading economic indicators like the ISM and consumer confidence are higher while markets are in a remarkably similar place to where they were three months ago with the 10 year yield at 2.86%.

US macroeconomic indicators chart

After the surprise of September’s announcement, we believe that every FOMC meeting from here on out is “live” – that is, there is a good chance that the Fed may act to reduce its bond-buying programme in some way until it reaches balance sheet neutrality. A reduction in bond purchases is not a tightening of policy, we view it as a positive sign that policymakers believe that the US economy is finally healing after the destruction of the financial crisis. As I wrote in September, interest rate policy is set to remain very accommodative for a long time, even after balance sheet neutrality has been achieved.

Given the positive developments in the US economy over the past three months, the December FOMC announcement could announce a) a small reduction in bond buying and b) an adjustment of the unemployment rate threshold or a lower bound on inflation. Whatever the case, quantitative easing is getting closer to making its swansong.


Jim Leaviss’ outlook for 2014. The taper debate (watch the data), inflation (where is it?), and it’s a knockout. Merry Christmas!

With many expecting a ‘great rotation’ out of fixed interest assets in 2013, bond investors will, in the main, have experienced a better year than some had predicted 12 months ago. It might not always have felt like it at the time – indeed, over the summer when markets were sent into a spin by the prospect of the US Federal Reserve (the Fed) cutting its supply of liquidity earlier than expected, it almost certainly did not. But riskier assets, notably high yield corporate bonds, have continued to perform strongly, while investment grade corporate bonds are on track to deliver another year of positive returns, in spite of the volatility.

Meanwhile, the macroeconomic backdrop has generally improved over the past year, with the economic recovery gaining significant momentum in the US and, more recently, the UK. However, the picture in Europe remains mixed, while our concerns over the emerging markets are mounting. However, despite their disparate prospects, all countries – and all bond markets – are united by at least one common dependency: the Fed.

So what does 2014 have in store for global bond markets? In our latest Panoramic outlook, Jim outlines his macroeconomic and market forecasts for the year ahead. And for those of you who have been wondering, the annual M&G Bond Vigilantes Christmas quiz will be posted later this week.



A vintage year for high yield issuance?

Much like fine wines, we believe that the year in which a bond is issued is an important factor in shaping its inherent character. The right climate in the markets, like the right weather conditions in the Gironde, can influence the nature of a security for better or for worse. 2013 is already a record year for the new high yield issuance in Europe (see the chart below). But will 2013 be one of the great vintages, or will investors just end up with a bad taste in their mouth and a nasty hangover?

Record HY issuance already in 2013

First of all, let us consider the conditions in which the current crop of deals has been grown. By and large, it’s been fairly benign this year. With a brief hiccup in the summer, the market has enjoyed promises of excess liquidity from all the major central banks, the Eurozone has shown the first green shoots of stabilisation and default rates have remained low.  Happy days then? For issuers and their investment bank advisers, yes, but for investors looking for future returns this is not the case.  The perfect conditions for investors to invest capital is when the storm clouds are on the horizon, there is the sniff of panic in the air and only the juiciest of yields from the highest quality issuers can tempt people to part with their cash. In these times, the power rests with the buyers and the risk premiums extracted can be very attractive.

In contrast, we can see from the chart below that in today’s sunny climes a) the quality of issuance has been deteriorating (measured by credit rating and leverage) b) structural features such as weaker legal covenants*, optional coupons and subordination are becoming more common and c) given the market has been strong, the coupons and hence future returns investors can expect has greatly diminished. Valuation, as always, is at the heart of it all.

Debt/EBITDA of first-time rated HY companies continues to rise

Take for instance, the respective returns experienced by two bonds issued by German healthcare provider Fresenius (one issued in 2009, the other issued in 2013). The USD 9% 2015 bond issued in the vintage year of 2009 performed admirably over the first nine months of its life. In contrast, the EUR 2.875% 2020 bond issued in January 2013 has been far less fruitful for investors. Products of the same vineyard, but with some very different results.

Same vineyard, very different results

Of course we are not comparing like for like; 2013 is not 2009, but it illustrates the importance of market conditions and your starting point for valuations when it comes to assessing prospective returns.

There is a silver lining, however. The wave of new issuance is good for the long term development of the European high yield market. More bonds and issuers means more depth and more diversification. There is also greater scope for differentiation between different fund managers as the investment universe grows. The stock selection decision is becoming ever more important.

Nevertheless, whereas the quantity of the 2013 vintage is beyond dispute, we believe its quality is somewhat dubious. The 2013 crop is arguably more Blue Nun than grand Bordeaux.

*One new development has been the introduction of “portability”. A standard high yield covenant obliges the issuer to buy back all bonds at 101% of face value in the event the business is sold. This protects bondholders from an adverse outcome in the case of unexpected M&A. Exceptions to this are now being introduced into the legal language governing the bonds allowing issuers to be bought or sold without the obligation to redeem their bonds – allowing a so called “portable capital structure”. We do not like this dilution of bondholder rights.


Panoramic: The Power of Duration

The early summer surge in bond yields will have focused the minds of many investors on the allocation of assets in their portfolios, particularly their fixed income holdings.

The largest risk to a domestic currency fixed income portfolio is duration. When investors discuss duration they are more often than not referring to a bond or portfolio’s sensitivity to changes in interest rates. Corporate bonds however also carry credit spread duration – the sensitivity of prices to moves in credit spreads (the market price of default risk).

Exposure to interest rate risk and credit risk should be considered independently within a portfolio. Clearly the desirable proportion of each depends heavily on the economic environment and future expectations of moves in interest rates.

I believe that the US economy and, to a lesser extent, the UK economy are improving and at some point interest rates will begin to move closer to their (significantly higher) long-term averages. We may still be a way off from central banks tightening monetary policy, but they will when they believe their economies are healthy enough to withstand it. Since a healthier economy increases the probability of tightening sooner, and is positive for the corporate sector, one should endeavour to gain exposure to credit risk premiums while limiting exposure to higher future interest rates.

In the latest version of our Panoramic series I examine the US bond market sell-off of 1994 to see what we can learn from the historical experience. Additionally, I analyse the power of duration and its importance to fixed income investors during a bond market sell-off.

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