Money managers are getting worried about the global credit markets.
While company fundamentals look strong for 2014, high valuations and lower-quality credits issuing in the high-yield market in particular have led to neutral and underweight positions for allocations that in recent years have delivered double-digit returns.
“While not at the lowest, spreads have widened a bit on the back of a more nervous start to the new year, but we are not a long way above the levels of the boom years of the credit cycle — from 2005 to 2007 — when lots of money was chasing credit,” said John Stopford, London-based co-head of global multiasset at Investec Asset Management. Investec's valuations put high yield about “50 basis points expensive. That doesn't sound (like) a lot, but the market is pricing in a very favorable backdrop, with equity volatility close to low single digits and default rates around 2% to 3%, which historically was only really bettered in 2005 to 2007.”
The Credit Suisse High Yield index gained 14.7% in 2012, dropping to a gain of 7.5% for the year ended Dec. 31, 2013. This year is looking equally subdued, despite growth in the U.S. and Europe, strong corporate earnings forecasts and healthy balance sheets.
“Yields for European high yield are currently around 4.5%, so on an historical basis, we are observing close to all-time lows for the asset class,” said Adeel Shafiqullah, managing director of European leveraged finance at PineBridge Investments LLC, London.
The biggest risk to global high yield is default of the companies issuing these bonds.
“According to Credit Suisse's default leverage outlook, Europe's default rate for high-yield bonds is 0% to 1% for 2014 and 2015,” said David Newman, head of high yield at Rogge Global Partners in London. “For the U.S., that is 2% to 3%. There is very little to destroy the asset class — the U.S. is pricing today at a 1.6% default rate, and the European market at 0.5%. So Europe is bang in the middle and the U.S. is below. Has the market run a bit too far? Probably, but not massively.”
Rogge manages $59 billion in investments, including $2.5 billion in high yield.
Fair, but not attractive
Investment staffers at Insight Investment Management (Global) Ltd. think high yield is trading “around fair value, but that doesn't make it particularly attractive in our eyes,” said Alex Veroude, head of credit at Insight in London. The firm has a neutral position in high yield. “We expect this to be a year where you collect coupons but do not see any further spread compression. That said, the coupon alone is 5.5%, which will be a reasonable total return in 2014.”
Insight manages £62.3 billion ($103.33 billion) in fixed-income assets.
Elsewhere, managers are neutral or hedging their bets. Ben Bennett, head of credit strategy at Legal & General Investment Management in London, said the manager's credit funds have been neutrally positioned overall, “with some funds even underweight credit as we worry about the exit of quantitative easing.” However, he said LGIM, which manages £138 billion in fixed-income, is conscious of the fact that “wobbles in 2013 turned out to be buying opportunities. I think we just want to adjust, buy some protection, but also switch out of some bonds that, if the market does turn really bad, may become illiquid.”
Investec's portfolio managers have reduced the firm's exposure to credit. “In the short-term (this reduced position) is beginning to work as a deterioration in sentiment means credit spreads begin to widen,” said Mr. Stopford. Investec uses the iTraxx Crossover index — a basket of 40 high-yield corporate bonds names — to hedge some of its bond positions.
Managers are also cautious given the volume of 2014 high-yield issuance.
Last year was the second-best on record in U.S. issuance, at $340 billion gross, according to Guggenheim Partners' High Yield and Bank Loan Outlook published in January. That trailed gross high-yield bond issuance in 2012 of $347 billion.
The start of 2014 has been somewhat slower. As of Feb. 10, U.S. high-yield bond issuance is $31.8 billion, trailing the $38.1 billion a year earlier, according to data from S&P Capital IQ LCD, New York.
Quality of new issues slipping
Issues also are sliding down the quality scale. “We have also seen an uptick in CCC-rated issuance — companies that only restructured their balance sheets a couple of years ago and are now able to access the market due to the hunger for yield,” said Mr. Shafiqullah.
The danger, said Insight's Mr. Veroude, is that persistent lack of issuance will lead to a vicious circle of defaults and further lack of issuance.
“If you look at the long-term history, when there is no issuance, default rates have tended to be high. There is a dual causation. If default rates are high there is not much interest in buying and if there is no issuance, at some point companies will run out of money and that leads to default. A lack of issuance generally indicates a market dislocation and it will lead to higher default rates in the long-term. But that is something that would need to persist for quite some time to impact the market, and is a long way from where we are now.”
A lack of quality is also a concern. “The low level of primary issuance of high yield so far this year has been disappointing — not only weaker than expectation but quality is getting weaker in terms of credit profile,” said PineBridge's Mr. Shafiqullah. “We have seen an uptick of issuance from corporates in Spain and Italy that only 18 months ago wouldn't have been considered candidates as high-yield issuers.”
However, that is somewhat cushioned thanks to ample issuance over the last few years, which has led to companies pushing out funding maturities — thereby delaying their need for market access for refunding in the near term — and so able to survive without additional liquidity for the foreseeable future.
Concern about covenants
Fraser Lundie, co-head of credit at Hermes Fund Managers in London, is also concerned about some elements of bond covenants. “In the new-issue market there is a constant battle between bankers and companies, and investors, in terms of covenants and call structures.” Mr. Lundie said companies and their banks have been shortening call periods. “The balance of power is currently with the banks and companies.
“Over 10 to 20 years, high yield has been able to achieve equity-like returns with half the volatility, which has made it such an attractive asset class and grown in its own right. That is now under threat in part because of this declining call period — that restricts the ability for these bonds to go up,” he said.
Despite concerns over call structures, tighter spreads and high valuations, institutional investors do not appear to have been deterred. According to data from eVestment LLC, quarterly flows into European high-yield fixed-income strategies have exceeded $18 billion per quarter every quarter since 2010, peaking at $70.6 billion in the quarter ended March 31, 2013. The data for U.S. high-yield fixed-income investments are even stronger, with quarterly flows ranging from a low of $229.8 billion in the first quarter of 2010 to a high of $427.4 billion in the quarter ended March 2013.
This rush to invest is a threat, said Konstantin Leidman, portfolio manager, European high yield, at Schroders PLC in London. “When interest rates are extremely low, everyone chases yields without doing the work. There used to be active market participants (such as banks) cushioning market levels by providing liquidity, but they are not there anymore.”
Nor, said Rogge's Mr. Newman, are distressed buyers likely to step in at current prices. He said Rogge's portfolio managers have discussed increasing allocations to the sector, but decided high yield is not yet cheap enough.
Managers say while institutional investors are not yet showing signs of a mass exodus from high yield, some are reviewing their reasons for allocating.
“If you are allocated to high yield because you believed you would get great income with spread compression leading to a high total return, that is a harder case to make now,” said Olivier Lebleu, head of non-U.S. distribution at Old Mutual Asset Management, based in London. “If you are allocated to high yield because it gives you high income that you need and with shorter duration bonds such as high yield, the case is still strong.” n
This article originally appeared in the February 17, 2014 print issue as, "Declining high-yield market making managers nervous".