The high yield market is set to significantly outperform investment grade corporate bonds for the fourth consecutive year. By far the biggest driver of performance over not only this year, but the last four years, has been a plummeting default rate. Strong global economic growth has translated into profitable companies with healthy balance sheets, and as a result there have been very few companies that have missed their loan repayments. Click on the image to the left to view global high yield default rates.
The picture in Europe has been particularly rosy. Since February 2005, just three companies have defaulted, out of around 140 companies in Europe with bonds rated sub-investment grade. But before everyone rushes out to buy the lowest rated, highest yielding bonds they can find, it’s worth pointing out that all three of these defaults have taken place in the last six months. One company was Eurotunnel, which is restructuring, while the other two were manufacturers in car parts (GAL is a French company that supplies parts to Renault, while Dura is US-based and manufactures parts for GM and Ford). Auto parts companies have really felt the heat this year as a result of major production cutting by the big car manufacturers – in the US, there have been a number of defaults in the sector, including Delphi, GM’s largest supplier.
I’m not overly concerned with the recent pick up in the default rate at the moment. There are very few companies “in distress”, which is defined as a bond yielding at least 10% more than a government bond. Those that are in trouble are concentrated in the auto part sector (which I’ve avoided). The big risk to the market over the medium to long term is that the global economy slows sharply next year, as this would start putting pressure on those companies that are already highly leveraged or are struggling with high production costs.
Graph source: Moody’s Default Report, end November 2006
Elsewhere we learned that basketball is a mediocre spectator sport, and that the New York Knicks can’t buy a home win at the minute; and that the Gramercy Park Hotel’s Rose Bar is the hippest place in the universe right now – even if I did have to ask Stefan who exactly any of the celebrities were (Misha Barton?)…
Apologies for the low number of posts this week – we’ve been preparing for Friday’s (8th December) launch of the new M&G Optimal Income Fund, run by Richard Woolnough. This is our first “specialist” bond fund to utilise UCITS III wider powers, and allows the fund manager to have a lot of flexibility in managing exposures to different bond asset classes (i.e. high yield, governments, investment grade) as well as being able to use derivatives to manage both duration and credit risk. For the first time we will be able to express a negative view on a company’s bonds as well as a positive one – which given that bond fund management is a lot about identifying the downside risks to companies is a good development. Richard’s initial portfolio also contains about 10% in equities where we think that the potential returns from the shares look more attractive than those of the bonds – this might be the case if the equity yield is higher than the bond yield, or if we consider the company to be a target for an LBO through a private equity bid. This is likely to be a riskier bond fund than normal, so click through to see health warnings etc.
US investors are taking note of the weakening dollar (see Top Dollar no more? for more info on the dollar weakness). Data released by Merrill Lynch shows that so far in 2006, Americans have been net sellers of US mutual funds (fund flows were -3.9% as a percentage of total assets). Interestingly, the slack has been taken up by non-US funds, which have recorded flows of +17%. These figures demonstrate that US citizens are losing confidence in the dollar and are looking to enhance returns by purchasing non-US funds.
Any increase in pension fund liabilities means that companies will need to increase pension fund assets, and long dated bonds are the best assets to match with long term liabilities. The total supply of gilts maturing in at least 25 years is only £74bn, and this huge demand/supply imbalance should continue to support long dated bonds.
You might like to also take a look at Jim’s recent article Longevity starts to worry the actuaries.
When Harvard MBA graduates start rushing to take up jobs on Wall Street, it’s time to get out of US equities. That’s according to research from Soifer Consulting. If 30% or more of these grads take jobs in investment banking, fund management or private equity, history suggests that it’s a good long term sell signal for shares. Sell signals were generated from 2000 to 2002 and in 1987 as well. The bad news is that the 2 most recent annual statistics from Harvard Business School show that 37% of the Class of 2006 have decided to take market sensitive jobs, following the 30% of the Class of 2005 into the world of red braces, Blackberries and bonus anxiety. So we’ve now had two years in a row where the long term sell signal has been triggered. Burger flipping grads in 2007?
this size is potentially on the horizon.
If it does occur, then corporate bond holders better watch out. A leveraged buyout results in a large amount of debt placed on the victim’s balance sheet, and inevitably results in multiple credit rating downgrades. LBO targets have traditionally been BBB rated companies as they tend to be smaller companies than their higher rated contemporaries, and are therefore within range of private equity companies. A deal of $100bn would suddenly bring a significant part of the UK corporate bond market into play. Spreads may well then widen out across the board, because LBOs mean higher leverage, which in turn means greater default risk.