There is not a bubble in the high yield bond market – John Pattullo, head of retail fixed income at Henderson – is adamant about that.
The high yield bubble has been widely reported over the last couple of months, mostly in the pink pages, as fears that the price of high yield is unsupported by the underlying assets. Prices have indeed risen dramatically – and yields conversely fallen, meaning many high yield bonds are simply not living up to their moniker. Average yields on high-yield bonds peaked at more than 25% at the height of the financial crisis. In May 2014, they were back down to 4.2%.
Demand for sector has increased as investors looked to more risky fixed income to fulfil their income requirements. Assets under management in European high yield bond funds have grown from €12 billion at the beginning of 2009 to €57 billion in April 2014, according to Morningstar data. This spike demand has led some to question just how liquid the asset class is, and whether investors are paying over the odds for ‘junk bonds’ – and not being properly remunerated for default risk when it comes to the yield.
Alan Miller of SCM Private has warned a shock price correction would cause damage to pension funds and private portfolios alike, while Jeremy Roberts, head of UK Retail Sales at BlackRock revealed that half of advisers intended to decrease their clients’ holdings for high-yield bonds.
But the default risk is surprisingly low. The 10 year average default risk for high yield bonds has been less than 2%, although default risk does increase significantly with smaller businesses.
“We don’t like small business issuers,” said Pattullo. “Companies such as GHD to not appeal to us. There are more small bond deals in the high yield space than there used to be; banks do not want to refinance companies, so they go to the bond market. Defaults are higher in this space, but this is not a sign that the high yield market is overheating, it is a sign that banks are having to be more exclusive with their lending.”
What is a concern for Pattullo and his co-manager on Henderson Strategic Bond Jenna Barnard is the lack of capital growth available in the market.
“Most high yield bonds do not run to maturity anymore,” said Barnard. “A small amount go bust, but most refinance after one or two years. Companies pay a small premium to be able to so, but it means the opportunity to make capital is falling. In the past a bond from Debenhams for example would be issued £1, bought back at 116p. Now a quick refinancing offer means there is no time for capital growth – the bond is issued at £1, refinanced at £1 and you have to be happy with just getting the yield.”
Further challenges present themselves in the US, which the pair predict is entering a period of secular stagnation – low growth, low volatility and low inflation. This Japan-like state is expected to last for several years. The UK at least has the advantage of economic growth – although UK bonds face the challenge of predicting interest rate hikes.
What Next for Interest Rates?
Much of what happens in the UK bond market is influenced by the Bank of England base rate, and when Governor Mark Carney decides to start raising it from the record low floor of 0.5%.
Low inflation and falling unemployment support Carney’s plans to raise rates, but both the market and the public were shocked when last week he announced rates would be rising by the end of the year – six months earlier than expected.
Pattullo says that Carney is in danger of losing credibility in the market, thanks to his is inconsistency. Last summer Carney introduced forward guidance as a way to predict when rates would rise – but then scrapped it six months later.
“Rate rises will be low and slow,” said Barnard. “We expect a rise of around 25 basis points every three months. Carney has the flexibility to ease rates back up – there is no pressure to whack base rate back to the pre-recession peak of 5.75%.
“Despite market nerves, rising rates are not actually bad for bonds. The only reason an interest rate rise is bad news is if expectations are wrong. Having said that if rates go up slower and peak at a lower point than expected that will be good for gilts.”
Opportunities?
High profile mergers and takeovers present great opportunities in the bond sector as well as for equity investors. The more leveraged player in a deal will benefit most; a takeover reduces their debt, and as the yield falls to reflect this, prices rise. Spotting takeover targets and buying in before the deal creates capital growth in a market where it is hard to find.
One particular sector the Henderson duo like for this is telecoms. Europe has around 100 telecoms operators, while the US has half a dozen. European regulators want 4G infrastructure development and merging back offices would free up cash for providers to pay for this.
