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jamestomlins_100

5 Signs That the Bond Markets (rightly or wrongly) think the Eurozone Crisis is Over

Regardless of your opinion on the merit of the ECB’s policy, there is little doubt that the efficacy of Mario Draghi’s various statements and comments over the past 2 years has been radical.  Indeed there are several signs in the bond markets that investors believe  the crisis is over. Here are some examples:

1)      Spanish 10 yr yields have fallen to 3.2%, this is lower than at any time since 2006, well before the crisis hit, having peaked at around 6.9% in 2012. This is an impressive recovery, almost as impressive as …

Spanish 10 Year Government Bond Yields

2)      The fall in Italian 10 year bond yields, which have hit new 10 year lows of 3.15%, lower than any time since 2000. The peak was 7.1% in December 2011. To put this in context, US 10 year yields were at 3% as recently as January this year.

Italian 10 Year Government Bond Yields

3)      Last month, Bank of Ireland issued €750m of covered bonds (bonds backed by a collateral pool of mortgages), maturing in 2019 with a coupon of 1.75%. These bonds now trade above par, with a yield to maturity of 1.5%. The market is not pricing in any material risk premium relating to the Irish housing market.

4)      There is no longer any risk premium within the high yield market for peripheral European risk. The chart below (published by Bank of America Merrill Lynch) shows that investors in non-investment grade corporates no longer discriminates between “core” and “peripheral” credits when it comes to credit spreads.

Core vs. peripheral high yield bond spreads

5)      Probably the biggest sign of all, is that today Greece is re-entering the international bonds markets. The country is expected to issue €3bn 5 year notes with a yield to maturity of 4.95%.

matt_russell_100

The power of duration: a contemporary example

In last year’s Panoramic: The Power of Duration, I used the experience of the US bond market in 1994 to examine the impact that duration can have in a time of sharply rising yields. By way of a quick refresher: in 1994, an improving economy spurred the Fed to increase interest rates multiple times, leading to a period that came to be known as the great bond massacre.

I frequently use this example to demonstrate the importance of managing interest rate risk in fixed income markets today. In an investment grade corporate bond fund with no currency positions, yield movements (and hence the fund’s duration) will overshadow moves in credit spreads. In other words you can be the best stock picker in the world but if you get your duration call wrong, all that good work will be undone.

We now have a contemporary example of the effects of higher yields on different fixed income asset classes. In May last year Ben Bernanke, then Chairman of the Fed, gave a speech in which he mentioned that the Bank’s Board of Governors may begin to think about reducing the level of assets it was purchasing each month through its QE programme. From this point until the end of 2013, 10 year US Treasuries and 10 year gilts both sold off by around 100bps.

US UK and German 10 year yields

How did this 1% rise in yields affect fixed income investments? Well, as the chart below shows, it really depended on the inherent duration of each asset class. Using indices as a proxy for the various asset classes, we can see that those with higher durations (represented by the orange bars) performed poorly relative to their short duration corporate counterparts, which actually delivered a positive return (represented by the green bars).

The importance of duration

While this is true for both the US dollar and sterling markets, longer dated European indices didn’t perform as poorly over the period. There’s a simple reason for this – bunds have been decoupling from gilts and Treasuries, due to the increasing likelihood that the eurozone may be looking at its own form of monetary stimulus in the months to come.  As a result, the yield on the 10-year bund rose by only 0.5% in the second half of 2013.

Whatever your view on if, when, and how sharply monetary policy will be tightened, fixed income investors should always be mindful of their exposure to duration at both a bond and fund level.

Claudia_Calich_100

The emerging markets rebalancing act

Over the past year, investors’ perception towards emerging market bonds changed from viewing the glass as being half full to half empty. The pricing-in of US ‘tapering’ and higher US Treasury yields largely drove this shift in sentiment due to concerns over sudden stops of capital flows and currency volatility. For sure, emerging market economies will need to adjust to lower capital flows, with this adjustment taking place on various fronts over several years.

Some emerging market countries are more advanced than others in the rebalancing process, while others may not need it at all. Also relevantly, the amount of rebalancing required should be assessed on a case-by-case basis, as the economic and political costs must be weighed against the potential benefits. Generally, the necessary actions include reducing external vulnerabilities such as large current account deficits (especially those financed by volatile capital flows), addressing hefty fiscal deficits and banking sector fragilities, or balancing the real economy between investment and credit and consumption.

In our latest issue of our Panoramic Outlook series, we examine the main channels of transmission, policy responses and asset price movements, as well as highlight the risks and opportunities we see in the asset class. Our focus in this analysis is on hard currency and local currency sovereign debt.

  

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Stand up for your rights! Covenant erosion in high yield bond documentation

2013 saw a record year for new issue volumes in the European high yield market. A total of $106bn equivalent was raised by non-investment grade companies according to data from Moodys. Whilst this is beneficial for the long term diversification and growth of the market, there have been some negative trends. Given the intense demand for new issues, companies and their advisors have been able to perpetuate the erosion various bondholder rights to their own advantage. What form has this erosion taken and why are they potentially so costly for bondholders? Here we highlight some of the specific changes that have crept into bond documentation over the past 2 years and some examples that demonstrate the potential economic impact for investors.

1) Shorter call periods – high yield bonds often contain embedded call options which enable the issuer to repay the bonds at a certain price at a certain point in the future. The benefit for the issuer is that if their business performs well and becomes less financially risky, they can call their bonds early and re-finance at a cheaper rate. The quid pro quo for bond holders is that the call price is typically several percentage points above par, hence they share in some of the upside. However, the length of time until the next call is important too. The longer the period, the higher the potential capital return for any bond holder as the risk premium (credit spread falls). The shorter the call period, the less likely the issuer will be locked into paying a high coupon. Take for example the situation below: reducing the call period has an associated cost to the investor of 2.6% of capital appreciation.

Shorter call periods

2) 10% call per year at 103 – Similar to the example above, the ability to call a bond prior to maturity has the impact of reducing potential upside to investors. One innovation that favours issuers has been the introduction of a call of 10% of the issue size every year within the so called “non call” period, usually at a preset price of 103% of par. So assuming a 3 year “non call” period, almost 1/3rd of an issuers bond can be retired at a relatively limited premium to par. Take for example the counterfactual scenario below. Here we see the inclusion of this extra call provision has reduced the potential return to bondholders by 3.3% over the holding period.

10% call per year at 103

3) Portability – One of the most powerful bondholder protections is the so called “put on change of control”. This gives the bondholder the right but not the obligation to sell their bonds back to the issuer at 101% of face value in the event the company changes ownership. Crucially, this protects investors from the potential re-pricing downside of the issuer being purchased by a more leveraged or riskier entity. For the owners of companies, this has been a troublesome restriction as the need to refinance a complete capital structure can be a major impediment to any M&A transaction. However, a recent innovation has been to introduce a “portability” clause into the change of control language. This typically states that subject to a leverage test and time restriction, the put on change of control does not apply (and hence the bonds in issue become “portable”, travelling with the company to any new owner removing the need to potentially re-finance the debt). With much of the market trading well above 101% of par, the value of the put on change of control is somewhat diminished so some investors have not seen this as an egregious erosion of rights. The owners of the issuers on the other hand enjoy a much higher degree of flexibility when it comes to buying and selling companies. There are costs to bondholders, however. In particular, as and when bonds trade below face value, this option can have significant value. In the example below we see that the inclusion of portability has an associated cost of 2.4%

Portability

 

4) Conditional Restricted Payment Basket – Another protection for high yield bondholders has been the restrictions on dividends. This prevents owners of businesses from stripping out large amounts of cash leaving behind a more leveraged and riskier balance sheet. If a company was performing very well and the owners wished to take out a large dividend, they would usually be forced to re-finance the debt or come to a consensual agreement with bondholders to allow them to do so. Consequently, the call protections would apply and the bondholders would be able to share in some of the success of the issuer’s business. However, another recent innovation has been the loosening of this “restricted payments” provision to allow a limitless upstreaming of dividend cash out of the business subject to a leverage test. This limits the ability of owners to load up the balance sheet with debt at will, but without the need to re-finance the bonds bondholders loose some of their bargaining power and once more are likely to lose out in certain situations. In this example, we see an impact of 1.0%

Conditional Restricted Payment Basket

What can investors do to cope with these unwelcome changes? Some sort of collective resistance would probably be the most effective tool – bondholders need to be prepared to stand up for their rights – but this is difficult to maintain in the face of inflows into the asset class and the need to invest cash. Until the market becomes weaker and negotiating power swings back toward the buyers of debt rather than the issuers, the most pragmatic course of action is for investors to asses any change on a case by case basis, then factor these in to their return requirements. This way investors can at least demand the appropriate risk premium for these changes and if they deem the risk premium insufficient they can simply elect to abstain. In the meantime, the old adage holds as true as ever – caveat emptor.

richard_woolnough_100

The UK electoral cycle is alive and kicking

Yesterday’s UK Budget had one major surprise, the relaxation of rules regarding drawing down your pension. This means that from April 2015 you can draw down your pension pot in one go, to do with it as you wish. This policy move chimes with the coalition’s beliefs that one should take responsibility over one’s own finances. However, like all political decisions there may well be an ulterior motive behind the timing of this decision.

We talked previously about why a dovish central banker appointment at the Bank of England was politically expedient two years ahead of the May 2015 election. The current government had its last opportunity yesterday to add a last feel-good give away Budget to enhance the economy and its own electoral prospects. At first glance, what has it achieved with its surprise change in pension policy?

It has potentially released a huge wave of spending commencing April 2015. This will obviously make people feel wealthy as the cash literally becomes theirs as opposed to being locked away for a rainy day. The economic effect looks as though it would be too late to boost the economy ahead of the 2015 general election. However it is highly likely that the forthcoming pension pot release will be taken into account. Holidays would be booked ahead of the windfall, cars could be purchased, redecorating done, and Christmas presents bought as the promise of money tomorrow means you can run down saving and consume today. This pension release scheme will spur growth in the UK ahead of the election.

The particular neat trick of this policy change is that it is a giveaway Budget measure at no cost. This is because it is not the government giving away money, but it is simply giving people access to their own money. Fiscal stimulus at no cost, combined with low rates and a strong government sponsored housing market means the UK will continue to have a relatively strong economy.

Wolfgang Bauer

Seeking relative value in USD, EUR and GBP corporate bonds

In terms of investment grade credit, it has been a common theme for global fixed income investors to think of EUR denominated credit as relatively expensive versus USD credit. Conversely, many see GBP corporate bonds as relatively cheap. But can it really be as simple and clear-cut as this? To answer this question, I have compared monthly asset swap (ASW) spreads of IG credit, issued in these three currencies, both on an absolute spread and a relative spread differential (EUR vs. USD and GBP vs. USD) basis.

At first, I looked at the three BoAML corporate master indices for publicly issued IG debt, denominated in USD, EUR and GBP. As shown below, until the onset of the financial crisis in the middle of 2007, USD IG credit was trading at spread levels of around 50 bps, which is almost exactly in line with GBP and on average only 15 bps wider than EUR IG credit. During the financial crisis, USD spreads widened more dramatically than EUR and GBP spreads. At peak levels in November 2008, when USD spreads reached 485 bps, EUR and GBP credit spreads were significantly tighter (by 215 bps and 123 bps, respectively). Subsequently, GBP IG spreads surpassed USD spreads again in May 2009 and have been wider ever since.

Slide1

In contrast, EUR IG credit spreads have been consistently tighter than USD spreads. Even at the height of the Eurozone crisis in late 2011, the EUR vs. USD credit spread differential was negative, if only marginally. Over the past three years, USD IG credit has been trading on average at a spread level of 166 bps, i.e., nearly 30 bps wider than EUR IG credit (137 bps average spread) and c. 50 bps tighter than GBP IG credit (215 bps average spread). Hence, when only looking at an IG corporate master index level, it is justified to say that subsequent to the financial crisis EUR credit has been looking relatively expensive and GBP credit relatively cheap compared to USD credit.

Taking only headline master index spreads into consideration is an overly simplistic approach. A direct comparison between the USD, EUR and GBP corporate master indices is distorted by two main factors: index duration and credit rating composition. As shown below, there are substantial differences in terms of effective index duration between the three master indices. Over the past ten years, the effective duration of the USD master index has been on average 6.2, whereas the EUR and the GBP indices exhibited values of 4.4 and 7.3, respectively. Currently, index duration differentials account for -2.1 (EUR vs. USD) and 1.4 (GBP vs. USD).

Slide2

These significant deviations in duration, and thus sensitivity of bond prices towards changes in interest rate, render a like-for-like index comparison problematic. The same applies to differences in credit rating composition. Take, for example, the rating structures of the USD and the EUR master indices in March 2010. Whereas the USD index hardly contained any AAA (below 1%) and only c. 18% AA rated bonds, the EUR index comprised nearly 6% AAA and c. 26% AA bonds. In contrast, the ratio of BBB bonds was significantly higher in the USD index (almost 40%) than in the EUR index (c. 22%). The credit quality on that date was distinctly higher for the EUR index than for the USD index, and directly comparing both indices would therefore be a bit like comparing apples to… well, not necessarily oranges but maybe overripe apples, for lack of a more imaginative metaphor.

Duration and credit rating biases can be removed from the analysis – or at least materially reduced – by using bond indices with narrow maturity and credit rating bands. As an example, I plotted relative spread differentials (i.e., EUR vs. USD and GBP vs. USD) for the past 10 years, based on the respective BoAML 5-10 year BBB corporate indices. To add another layer of complexity, this time I did not use headline corporate index level spreads but differentiated between financials and industrials instead. As only relative spread differences are shown, positive values indicate relatively cheap credit versus USD credit and, conversely, negative values signal relatively expensive credit.

Slide3

Until October 2010, the graphs follow a very similar path, EUR and GBP credit spreads trade fairly in line with USD spreads up to the financial crisis, when USD spreads widen more strongly than both EUR and GBP spreads, pushing spread differentials temporarily into deeply negative territory (below -220 bps in the case of financials). Then things got more interesting as spread differentials seem to decouple to a certain extent from October 2010 onwards. At this level of granularity it becomes clear that it is an inaccurate generalisation to refer to EUR credit as expensive and GBP credit as cheap versus USD credit.

In terms of 5-10 year BBB credit, EUR financials have in fact been trading consistently wider than USD financials, although the spread difference has been falling considerably from its peak Eurozone crisis level of 201 bps in November 2011 to currently only 10 bps. EUR industrials have been looking more expensive than USD industrials since early 2007 (c. 35 bps tighter on average over the past 3 years). The trajectory of GBP financials spread differentials has been broadly following the EUR financials’ humped pattern since late 2010, rising steeply to a maximum value of 259 bps in May 2012 and subsequently falling to current values at around 115 bps. GBP industrials have been looking moderately cheap compared to USD industrials since late 2010 (c. 37 bps wider on average over the past 3 years), but the spread differential has recently vanished. Hence, regarding 5-10 year BBB credit, currently only GBP financials are looking cheap and EUR industrials expensive versus the respective USD credit categories, whereas GBP industrials and EUR financials are trading in-line with USD credit.

To sum things up, when comparing USD, EUR and GBP IG credit, headline spreads are merely broad-brush indicators. To get a greater understanding of true relative value, it is worth analysing more granular data subsets to understand the underlying dynamics and the evolution of relative credit spread differences.

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The M&G Central Bank Credibility Survey – the Carney impact?

Whilst YouGov is surveying consumers around the UK, Europe and Asia for the M&G YouGov Inflation Expectations Survey, we thought it would be useful for them also ask some questions about how people perceive both their central bank’s ability to hit the inflation target, and the likely effectiveness of government fiscal policy.  You probably won’t be surprised to hear that Europeans generally don’t think highly of the ECB or their politicians (although France is striking in its low levels of confidence in both, reflecting a degree of economic stagnation there, even as other areas of the Eurozone see signs of recovery).  But it’s the UK that’s seen the biggest improvement in sentiment towards its central bank, the Bank of England.

Mark Carney was announced as the 120th Governor of the Bank of England at the end of November 2012, at the start of our first survey quarter.  At the time, only 28% of the 2000+ people surveyed who had a view (stripping out “don’t knows”) were confident that the “central bank is currently pursuing the correct policies in order to meet its target of price stability (i.e. inflation around 2%) over the medium term (i.e. the next 3-5 years)”.  Our latest survey shows that in every quarter since then – and Mark Carney arrived at his desk on 1 July 2013 – this percentage has increased.  The latest quarter shows the biggest increase yet, with 55% of respondents confident that the Bank is following the right policies to achieve medium term price stability.

The M&G Central Bank Credibility Survey

And this is against a backdrop of a fair few raspberries about the Bank’s forward guidance regime (gilt yields tended to rise, and the pound strengthened every time Carney did some more communicating).  So why the almost doubling in the confidence in the Bank of England amongst the UK population?  Well, it’s the economy.  The UK has been one of the developed world’s fastest growing economies over the past year, with GDP growth at 2.7% year on year, after a couple of years where it felt as if it would be stuck at or below 1% forever.  Crucially when it comes to thinking about credibility, for the very first time since the depths of the financial crisis in 2009, CPI inflation is back below the Bank of England’s 2% inflation target.  At one point in 2011 CPI was running at over 5% year on year. And whilst real wages are still falling, nominal wages have started to perk up in the past few months, so the hit to workers’ pay is lessening.

Goldilocks? CPI falling, wages rising in the UK

Our survey isn’t the only measure that shows that the Bank of England’s credibility is strong and improving.  Central banks like to use index linked bonds to derive a market participant view of whether inflation expectations are anchored.  Remembering that UK index linked gilts are priced from RPI rather than CPI, and that estimates are that the long term “wedge” between the two measures is somewhere around 1.1% over the medium term (it could be higher in a rate rising environment as RPI contains a big chunk of mortgage interest payments).  The current 5 year 5 year forward breakeven inflation rate – the market’s price for average inflation over the five years from 2019 to 2024, i.e. taking out the current cycle and looking at a medium term expectation for inflation – stands at 3.35%, down from 3.65% at the end of November last year.  If you subtract the wedge you end up with a market CPI inflation forecast of 2.25% over the medium term.  This is a little above target, but given the Bank’s history in recent years of large upside misses, could reflect improving credibility.  It should be said however that this measure has generally been pretty stable (5 year average of 3.5%) so it doesn’t feel as if there is a significant signal on King Bank versus Carney Bank credibility here.

UK 5 year 5 year forward breakeven inflation rate

You can see the full M&G YouGov Inflation Expectations Survey here, and the M&G Central Bank Credibility Survey is within that report on page 6.

anthony_doyle_100

France and Ireland – a look at the economic scorecard before the big game this weekend

The 6 Nations Rugby Championship comes to a conclusion this weekend, with three teams still in the running to win. The key game to watch will be France versus Ireland, as a French win would open the door for France or England to win. Of course, England will still have to beat the Azzuri in Rome. An Irish win would see the “boys in green” send record-breaking captain Brian O’Driscoll home to Dublin with the Championship trophy in his final game of rugby.

In the spirit of competition, here is a look at the economic scorecard for France and Ireland. Will it provide an indication of who will win Saturday’s match?

Round 1 – Real gross domestic product per capita

Slide1

Despite a large deceleration in output from the Irish between the years of 2007-2010, the Irish are still producing around €6,000 more per capita more than the French. IMF forecasts suggest that by 2018, Irish GDP per capita will be around €38,000 while the French equivalent is estimated to be around €30,000. The IMF forecasts suggest that the Irish workforce is expected to remain more efficient and productive than the French in coming years. For the entire Eurozone, the Irish currently rank second behind Luxembourg on this measure. The French are ranked seventh.

On this measure, it is a clear win for Ireland.

Round 2 – The unemployment rate

Slide2

Based on recent trends, the unemployment rates in France and Ireland appear to be converging. The Irish unemployment rate has fallen from a peak of 15.1% in January 2012 to sit at 11.9% only two years later. Over the same time period, the French unemployment rate has risen from 9.9 to 10.9%. The deterioration in the labour market in France reflects the general stagnation of economic growth. In recent months, the French government has been attempting to tackle the problem of the deteriorating labour market through its active employment policies such as sponsored contracts and training positions for the unemployed.

Despite the improving unemployment rate in Ireland, and worsening unemployment rate in France, round two goes to France on account of the unemployment rate being 1% lower than Ireland. Unless France can generate better growth, it may be the case that in twelve months’ time the Irish unemployment rate is actually lower than the French equivalent. For now, it’s a French win.

Round 3 – Household saving rate

Slide3

French households have consistently saved between 15-16% of their gross disposable income over the past ten years, suggesting that there is some scope for French consumers to stimulate their economy should confidence pick-up. The Irish household saving rate has been more volatile, falling and rising as one would expect given the concerns around the economic outlook for the country. More recently, Irish households have been spending more and supporting the economic recovery. This is a tough one to call, as the fall in household savings suggests stronger economic growth in Ireland in the short-term. However, because of the potential for French consumer to spend some of their savings in the future, France wins this round.

Round 4 – Percentage of the population with tertiary education

Slide4

Since 2004 there has been a substantial increase in the percentage of the population that has attained a tertiary level of education in Ireland, with an increase from 24.9 to 35.9%. France, whilst improving, has not been able to generate the same increase and in 2013 the percentage of the population that had obtained a tertiary level of education was 28.7%. Ireland ranks number one while France is at number twelve in the EU on this key measure. There is widespread recognition that tertiary education is a major driver of economic competitiveness in an increasingly knowledge-driven global economy. Ireland’s well educated workforce has certainly assisted the economy in recovering from the financial crisis. It has become increasingly difficult for industries in the west to compete with the emerging nations in terms of manufacturing products; a flexible, highly-educated and competitive labour force is vital in our globalised world.

Ireland’s workforce looks like a winger, whereas the French workforce could be compared to a prop forward. Ireland wins this round.

Looking at measures like real GDP per capita, the unemployment rate, household savings and the level of education in the workforce for Ireland and France is interesting. It shows that Ireland appears very well positioned to generate positive economic growth over the medium term. The old way of categorising European economies as “core” or “peripheral (or worse – PIIGS)” appears no longer relevant, as “peripheral” nations have taken a lot of vital steps to become more competitive through internal devaluation and lower wages. Improved export performance has been reflected in an improvement in current account balances in recent years. Today, the French economy appears cumbersome; it is hampered with a relatively inflexible and rigid labour market and is struggling to become more competitive in a globalised economy as we previously mentioned here.

Final round – the rugby statistics

Slide5

After a 2-2 economic scorecard, the final round had to focus on the rugby itself. Unfortunately for the French, the Irish rugby team appear superior in 16 out of 20 key rugby statistics including total points, metres gained and lineouts won. The French have home advantage which is a big positive; though this will be mitigated by the emotion felt by the Irish players given it is Brian O’Driscoll’s last match.

This leaves a 3-2 economic and rugby scorecard win to Ireland over France. That said, it would take a brave pundit to discount Les Bleus, who have a habit of rising for the big occasions. If you don’t believe me, just ask any New Zealander.

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Win a place in the Prudential RideLondon-Surrey 100 bike ride!

We have two exclusive places available for the Prudential RideLondon-Surrey 100 on Sunday 10 August 2014! Those of you who rode it in 2013 will know what an incredible day out it was. Starting in the Queen Elizabeth Olympic Park, this is a tough 100 mile cycle on closed roads through London and out to the famous climbs of the Surrey Alps before returning to the capital and finishing on the Mall. Later in the day you’ll be able to watch the 150 professional riders sprint in after they have ridden the same route in the Prudential RideLondon-Surrey Classic.

You can read all about the Prudential RideLondon-Surrey 100 here.

Over 80,000 people registered for places so many cyclists were unlucky in the ballot. The good news is that our parent company Prudential has kindly given us the chance for readers of the Bond Vigilantes blog to win a place. We have two packages available which include:

  • Entry to the Prudential RideLondon-Surrey 100
  • Team Prudential cycling jersey and goodie bag
  • Access to the VIP start area

Whilst it’s a fun day out, don’t underestimate the challenge of riding 100 miles. You should ideally commit to at least 10 weeks of training leading up to the event, and be confident of finishing within 8 ½ hours (by which time the pro peleton will be hammering along the course at an average of 40 kph!). But it’s only March now, so you’ve plenty of time to train. A few of us from the M&G bond team will be taking part – I’ll be heading out to the Surrey Hills this weekend. Unless it rains.

So the question. Which double Olympic cycling champion is the ambassador for Prudential RideLondon, and won the inaugural Prudential RideLondon Grand Prix in 2013?

Please click here to enter, and here for terms and conditions.

If you aren’t lucky enough to win, you can still take part by joining up with one of the charities which still have guaranteed places (see here for a list) or by entering as part of a team through your local British Cycling club. Good luck!

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High yield: bullish or blinkered?

I recently attended JP Morgan’s annual US high yield conference. It’s one of the best conferences around: well attended, and with more than 150 companies, panel discussions and specialist presentations. As such, the topics covered give a good flavour of the market’s latest thinking.

Unsurprisingly, many of the well-rehearsed arguments in favour of high yield resurfaced once again, with presentations focused on the following:

  • The structurally low default rate (see chart below), largely a function of accommodative central bank policy, limited refinancing risk and growing investor maturity, with spreads over-compensating as a result.

Slide1

  • Projections that US high yield will outperform other fixed interest asset classes in 2014, returning 5%-6% (leveraged loans likely to deliver 4.5%).
  • Room for spreads to tighten further given that they remain over 100+ bps back of the lows in 2007. Currently 378bps vs 241bps in May 2007.
  • How refinancing, rather than new borrowing, is driving the majority of issuance in the US. Refinancing accounted for 56% of issuance in 2013, though down from 60% in 2012.
  • The need for income in a low interest rate world is providing a strong technical support, evidenced by $2bn+ of mutual fund inflows into the US high yield market year to date. Significant oversubscription for the vast majority of new issues has also been a notable feature of the market for some time now.
  • The short duration nature of the asset class – particularly attractive in an environment of potentially rising rates. Modified duration for US and European high yield is 3.5 years and 3 years respectively. This compares to 6.5 and 4.5 years for the investment grade equivalents.

Now these are all relevant arguments in favour of the asset class, and indeed I believe that US high yield will likely be one of fixed income’s winners in 2014. What did surprise me, though, was the almost total absence of discussion around some of the headwinds that it faces.

For example, presentations seemed to gloss over the fact that much of the good news, from the perspective of default rates at least, has arguably already been priced in. The market is unlikely to be surprised by another year of sub-2% defaults, rather the risk lies in an outcome that sees a higher default rate than anticipated by the consensus, even if that is difficult to envisage right now.

Other challenges are presented by liquidity (while this has improved since the immediate aftermath of the credit crunch, investment banks are still reluctant to offer liquidity given the high capital charges they face and the low yields currently on offer); by the lack of leverage available to end investors compared to 2006-7, when banks had the ability, strength and desire to lend to those investors on margin; and by the increasing negative convexity the market faces at the moment.

Slide2

With US high yield paper already trading at an average price of 105 and as high as 107 in Europe (see chart above), the threat of bonds being called will act as a cap on further capital appreciation. And, of course, the flip side of these high prices is low all-in yields. With these standing around 3.8% on the European non-financial high yield index and 5.2% on the US high yield index, investors can only question how much lower they can go.

Slide3

Perhaps in this environment, with inflation ticking along comfortably below 2%, investors should accept that a nominal return of 5-6% looks decent. That said, returns this year are likely to be driven by income rather than capital appreciation, and may well look skinny versus previous years. As I said before, I’m still constructive on high yield, but after the stellar returns in the past few years, we must be careful to avoid being blinkered.

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