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Thursday 28 March 2024

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.

Globally, the high yield default rate stands close to record lows, but it’s not just the low default rate that’s impressive, it’s the fact that it has been so low for so long. The global high yield default rate has now been stuck below 2% for 13 consecutive months, breaking the record set in 1981-1982. The default rate is a trailing 12 month average, so I can say with a degree of certainty that this record will be extended unless something catastrophic and unexpected happens over the next month.

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

Stefan and I had a research trip to see our New York counterparties at the end of last week. Two key themes emerged. Firstly, when we were there a year ago, many of the Wall Street strategists were cautious on high yield and investment grade bonds. But after a year of strong returns from credit – and especially risky credit – capitulation appears to be the order of the day. Not one strategist was anything but positive on the asset class. There are a couple of reasons why – the high yield default rate continues to stay around 1%, and the demand for corporate bonds from structured credit vehicles like CDOs (and CPDOs, see our earlier post) remains incredibly high. This strikes me as a little complacent, after all since I was last in NY the US growth rate has collapsed. GDP growth was over 5% in the first quarter of 2006, but is likely to be running at around a 2% rate in Q4 – and according to some indicators like the ISM manufacturing survey, the industrial sector may well be approaching recession. This can’t be good for credit fundamentals, and we continue to think that it’s time to rotate out of riskier corporate bonds into more conservative issuers.
Secondly, the Wall Street economists on the whole think that 2007 will see a continued US slowdown rather than a recession. A couple of people we saw even thought that US rates would end the year at their current level (5.25%) or higher. There were a couple of outliers however. Both Merrill Lynch’s David Rosenberg and BNP’s Richard Iley see the US housing market weakness tipping US growth over a cliff next year. The US corporate savings rate is currently extremely high (companies are very cash rich and can’t find opportunities to invest in the US, which in itself is quite bearish – has the US economy gone “ex-growth”?) – what happens if the US consumer weakens further and starts to save rather than spend? As a result Rosenberg sees the Fed cutting to 3.75% by year end, and Iley to an even more punchy 3% – both moves implying that the US is getting a hard landing rather than the consensus soft landing.

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.

Life expectancy isn’t just increasing, the rate of change is actually accelerating, thanks to rapid medical advancements. Great news for humankind, great news for owners of long dated bonds, but a nightmare for pension funds.
Recent research from Paternoster, a company that buys up final salary pension fund schemes, has published a report estimating that if life expectancy continues to increase at its current rate, pension funds will be in deficit of £175bn. Even if the rate of change slows, pension fund liabilities will still exceed pension fund assets by around £75bn.

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?

There are rumours in the market that private equity firms are considering bidding for US DIY giant Home Depot. Home Depot’s market capitalisation is currently $78bn, so any private equity bidders would have to pay somewhere in the region of $100bn to takeover the company. To put this figure in perspective, only six companies in the FTSE 100 have a market cap of over $100bn.
A leveraged buyout (LBO) of this magnitude would send shock waves around the world. Before this year, the $25bn takeover of RJR Nabisco in 1988 was the largest the LBO the world had ever seen. But in July this year, HCA (a US health care company) was LBOd for $33bn, and last month Equity Office (owner of Worldwide Plaza in New York) was bought for $36bn. The market believes that an LBO of $100bn is unlikely, as shown by the fact the Home Depot’s share price has hardly moved, but the fact that there is speculation that such a large takeover could occur is proof that an LBO of
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.

Month: December 2006

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