22/05/06
High yield bonds coming into their own
As levels of issuance reach record highs, the European high yield bond market is coming into its own as an asset class and charting an increasingly different course from the investment grade bond market.
European high yield has staged an impressive recovery since the dark days of late 2002, when default rates by volume reached around 60%. In common with investment grade bonds, over the last three years high yield has benefited from a benign period for credit markets during which companies have been able to strengthen their balance sheets and refinance existing debt more cheaply. All of this has led to three years of solid performance from corporate bonds across the credit spectrum.
However, in 2006 high yield has continued to perform well while investment grade bonds have faced stronger headwinds. There are numerous reasons for this decoupling of the relationship between the two halves of the European corporate bond market.
Since the start of the year there has been a sharp increase in investor concerns over the potential for leveraged buy-outs (LBOs) to damage the interests of bondholders (eg BAA and Compass Group). Although only a relatively limited number of such transactions have actually occurred, the threat of a takeover has been sufficient to focus the attention of management teams on accelerating the return of capital to shareholders through special dividends, share buyback programmes or transactions such as Sainsbury's recent secured bond issue that release hidden value from a property portfolio. In almost all cases these shareholder-friendly actions are detrimental to the interests of bondholders. Since it remains unusual for investment grade bonds to contain covenants protecting investors against increases in levels of indebtedness, there is clearly scope for bonds to decline in value where companies are unduly generous to shareholders.
However, the situation in high yield is very different. Since high yield investors take increased financial risk (because of higher initial debt levels) in addition to business risk when they buy a bond, as a quid pro quo they receive a much more robust covenant package than investment grade bondholders. This would typically include features such as a limitation on the additional debt that the company can raise and the right to have their bonds bought back by the company at 101% of par value in the event that the company is taken over by an entity that does not meet with their approval. This effectively insulates investors from some of the more common forms of negative event risk. At the same time, however, there are numerous sets of circumstances in which high yield investors can benefit from positive event risk, such as being taken over by a more highly-rated issuer or reducing debt with the proceeds of an equity issue.
The second key differentiating factor in 2006 has been the responsiveness of the two halves of the European corporate bond market to changing interest rate expectations. Because very few high yield bonds remain outstanding until maturity without being refinanced, duration is not a particularly relevant concept to a high yield investor. Thus the sell-off in government bonds has had a far less immediate effect on high yield bonds than in investment grade, although it should be recognised that ultimately higher interest rates are likely to undermine the business prospects of companies that issue high yield and erode their ability to pay their coupons. For the moment, however, we are more focused on default rates than on 10 year government bond yields.
Bull points:
Default rates remain well below long term averages
Strong equity markets underpin positive event risk
Issuer base increasingly diversified
Bear points:
Stretched valuations
Rising government bond yields will eventually have an impact
Limited case law on insolvency and restructuring in some jurisdictions
Alasdair MacLean, Fund Manager of the Select Income Fund and Ethical Corporate Bond Fund, Standard Life Investments
First published in Investment Week on 22 May 2006
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