Bond picking is the new name of the game

What have Dell, Peugeot, ArcelorMittal and Heinz all got in common? Yes, they are all household names. And yes they all have also issued high-yield bonds. In the minds of many investors, junk bonds, as they were once called, represent the smallest, riskiest part of the corporate bond spectrum. Reality demonstrates that the rapidly-expanding high-yield market now encompasses thousands of companies across all industrial sectors.
                                                         

Europe plays catch-up with us

The high-yield market in the US has attracted investors for decades and now represents more than USD 1,313 Bn (as at December 31^st, 2016), while Europe is progressively maturing with a total of EUR 301 Bn (as at December 31^st, 2016). In recent years, the trend in Europe has accelerated, bolstered by rapid disintermediation as banks are now reluctant loan originators, and by the ever growing search for yield by investors in a low rates environment. Although the European high yield market becomes more mature as the years go by, the US market has still more depth. Moreover, US high yield market flows are driven by investors’ expected returns on equities.

Not as risky as you think

While some investors equate high yield with high risk, this is not supported by the data. As the diagram shows, high-yield bonds exhibit considerably less volatility than 10-year government bonds and similar volatility to investment grade bonds. At the same time, high yield has delivered a little over 8% annualized return on a five-year period, which is significantly higher than other bond classes.

Although equity markets have delivered similar performance over a five-year period, equity investors have had to endure three times the volatility of high-yield bonds.

In terms of valuation, the global high-yield markets look today fairly valued and represent a carry opportunity. The current yield is 502 bps with an accompanying standard default rate of 3%. In addition, the carry offered both in Europe and the US is attractive in the current low interest rate environment.

Structurally, High Yield bonds tend to have a lower duration than the safer Investment Grade bonds. As a consequence, any hikes in the Fed rate would probably impact High Yield bonds, but to a lesser extent, as HY bond returns are less correlated to rates than IG bonds, and more correlated to the equity markets. Moreover, any further Fed rate hikes in 2017 will be triggered by the current US recovery post the Trump election: as a sound economic environment is positive for credit fundamentals, we expect the ongoing US growth to drive low default rates and higher profits. We thus forecast a slight tightening of US credit spreads in the medium term that will offset the negative impact of US rates.

Time to be selective

To sustain the level of returns of recent years, bond picking is likely to become the main driver of performance. In a low-growth environment, issuers with high leverage are sometimes unable to meet their debt repayments, and smaller companies struggle to maintain their pricing power. This creates dispersion around issuers’ quality and therefore opportunities for bond pickers, who can do

relative value, arbitrage different issuers, different issues or cash bonds versus derivatives.

• In Europe, we can expect a slightly lower default rate thanks to the prevailing exceptional liquidity conditions provided by the ECB. However, forecasted low growth can pressure retail-oriented, pharmaceuticals or paper and pulp sectors.
• In the US, where there will be no support from the central bank, growth is much higher. We therefore foresee telecommunications, oil and gas and services as behaving well.
• Last, but not least, the size of issues, the size of companies, the number of marketmakers and the availability of credit default swaps on underlying issuers are all key to liquidity to optimize performance.

A growing and more diversified high-yield market, coupled with expected interest rate volatility, is likely to provide a more colourful palette for alpha-seeking investors. To achieve successful high yield bond management, the skillsets of bondpicking and deep fundamental knowledge are today preferable to a standard beta approach. Our current return expectation on the US and European high yield markets for our funds stands at 3-5% for 2017, through our active management and alpha generation.

Alpha is generated by multiple drivers

Alpha comes in many shapes and sizes, and the sources change over time. Candriam has identified different sources of alpha.

• Bondpicking based on each company profile We favour higher-growth companies: strong, dynamic franchises – such as, companies based in the US benefiting from the America First policy; as well as companies in Europe investing in organic growth to generate revenues. Niche and best in class players which have high barriers to entry are also attractive, as well as low cyclical businesses, such as retirement home operators. These types of companies have low correlation to economic growth and are likely to be durable in the case of an economic downturn.
• Mergers and acquisitions (M&A) With overall contained organic growth, companies are looking increasingly for M&A, which impacts the debt structure and attractiveness of both the acquiring and target companies. We try to avoid bidding companies, whose balance sheets could be depleted by their M&A offer. The flip side is that high yield issuers which become acquisition targets may increase in value through upgrades.
• Debt tenders & calls Corporates are continuing to refinance their short-term debt with longer-term debt within a still overall low interest rate environment. And when the short-dated bonds are recalled, investors receive their capital back earlier, providing significant potential value in short duration issues.
• IPOs offer alpha. As equity multiples recover from their lows of 2008-09, initial public offerings (IPOs) are more in evidence. Many companies financed by leveraged buyouts are seeking a return to the markets, triggering provisions that enable high-yield investors to be paid out by the proceeds of equity offerings.
• US versus Europe Asset allocation between US and European high-yield markets is another source of potential alpha. The US market is deeper and offers longer-term maturities of 10 years, which are as yet unknown in the European high-yield market. Purchasing longer-term maturities can increase potential portfolio returns if – as is the case in the US – long-term revenues and earnings growth are likely to be high; but flexible interest rate hedging policies are needed. In addition, the maturity of the US market provides greater visibility. By contrast, in the European market, we focus on mid to intermediate maturities.

A unique investment approach to benefit from the dispersion in High Yield markets

It is interesting to note the different approaches of US and European investors to high yield. For US investors, high-yield is often seen as a safe way to get equity-like exposure to markets. Thus, they tend to re-allocate from high yield to stocks in bullish equity markets. On the opposite side of the Atlantic, fixed income-focused European investors see high-yield bonds as a way to take more risk when markets are trending to the upside.

Whatever your investor philosophy, high yield bonds can play a significant role in all global portfolios as a way to improve risk-adjusted returns. For European investors in particular, the prospect of beating returns from government and investment grade bonds with controlled volatility represents a compelling argument, and a call to pick the highest-skilled high-yield-bond fund manager.