High-Yield Corporates

Transcription

1 Loosening the Bonds Rethinking your Fixed Income Allocation FOR PROFESSIONAL INVESTORS ONLY by David Gibbon Fixed income investing has rarely been more demanding for investors. In response to the unique confluence of secular and cyclical challenges facing the global economy, central banks across the G7 economies have lowered official rates to 1% or below, and longerterm government yields have declined sharply. Other high-quality fixed income assets for which government bonds serve as the yield benchmark have followed suit: some investment grade corporate bonds are paying yields last seen in the mid-1960s. With high-quality yields so low, the focus on income generation has naturally led investors to other asset classes. However, there are still segments of the bond market with strong income potential for which the long-term investment case is compelling but investing in them means removing the shackles from your fixed income allocation. High-Yield Corporates One way investors are increasing the yield potential from their fixed income allocations is by adjusting the quality constraints on their corporate credit allocations to allow below-investment-grade bonds and loans. Non-financial corporate balance sheets, in contrast to those of banks, are solid at this stage of the credit cycle: leverage has been steadily reduced; debt, at 3.9x earnings, is a full multiple lower than two years ago; and liquidity is very strong, with the ratio of liquid assets to short-term liabilities at the highest levels since the 1950s 1 in The relative strength of high-yield issuers reflects a combination of expense discipline, cautious investment spending and earnings retention. It is also indicative of progress by corporates in using improved liquidity conditions and strong end-investor demand to David Gibbon is an investment strategist in BlackRock s Fixed Income Portfolio Management Group. 1 Source: Federal Reserve, Flow of Funds Report, December 2011 Currents January 2012 issue 1 Currents January 2012

2 term out short-dated debt and minimise refinancing risk (see Chart 1). These stronger credit fundamentals translate into a positive picture on defaults and ratings migration. High-yield default rates remain at historically low levels just 1.9% of the universe by volume defaulted in the 12 months ending November 2011, compared to a long-term annual average of around 4.5%. Rising credit costs and the weakening growth picture in 2012 will likely translate into higher defaults, but our current projection is only for a modest increase to 2.7% this year. The yield premium earned on highyield bonds is primarily compensation for this default risk. Broad US high-yield indices ended 2011 with a yield of 8.4%, representing a yield advantage of 700bp over government bonds. While this spread is less than half the level seen in late 2008, adjusting spreads for expected losses due to downgrade and default shows that true credit risk premia are only about 25% lower than their previous highs in this cycle, and significantly above prior cycle peaks. Another way to think about the relationship between credit spreads and defaults is to consider the cumulative default rate on a portfolio of high-yield corporate bonds that would cause a hold-to-maturity investor to lose money compared to holding a portfolio of risk-free assets. Based on today s pricing, defaults would have to exceed 44% over the next five years (assuming a 40% recovery rate) for the high yield portfolio would underperform 2. Since 1970, the highest historical level of five-year cumulative defaults for high-yield issuers was 31%, which occured in the early 2000s. For investors with a longer-term investment horizon, high-yield bonds provide more than ample compensation for default risk and 2 Using constituents and pricing for CDX-HY S17 as at 31 December 2011 Chart 1: Change in High Yield and Loan Maturity Schedule ($Bn) over the Past Three Years Source: JP Morgan Maturity year Change in maturity schedule, $bn 2 Currents January 2012

3 reflect in some part a generally lower risk appetite associated with policy risks and difficult liquidity conditions around year-end. (see Chart 2). It is worth noting that the bank loan market is also attractive at present. Loans pay coupons that are indexed to LIBOR and typically offer greater protection to investors through covenants and collateral security. Steep yield curves and the value of seniority in the capital structure tend to translate into lower running yields than those available on unsecured bonds. The loan market has been less in demand recently given that short-term interest rates are projected to remain constant for the near term. But with a yield to maturity of just under 7% and a current coupon yield around 5%, loans represent an attractive source of income for investors concerned about the potential for rising rates at some stage in this market cycle. Additionally, the secured nature of loans means that, in the event of bankruptcy, investor losses can be significantly lower than they are for unsecured lenders. Historically, recovery rates on loans have averaged around 70% compared to 40% on unsecured high-yield bonds, making them a more defensive investment for investors who are less confident on the global growth outlook and require additional protection against losses in a worsening credit market cycle. Emerging Market Debt Another compelling opportunity for income investors is to reduce their regional bias to home markets, where funding pressures on sovereign issuers have become intense, and broaden their allocation to emerging market (EM) debt. Sovereign credit concerns in developed markets (DMs) are, broadly speaking, a function of too much debt, too little growth in the medium and long term due to deleveraging and weak demographics, and less flexibility to offset the growth impact of fiscal Chart 2: High-Yield Spread vs Default-Adjusted Risk Premium Basis points High yield spread Default adjusted risk premium Source: Credit Suisse and BlackRock 3 Currents January 2012

4 tightening as policy options are largely exhausted. Emerging markets present a different story. Gross sovereign debt is lower and economic growth is higher than in advanced economies, and a combination of stronger productivity growth and favourable demographics ensure it will stay that way. At the same time, higher real rates give monetary policymakers more room to respond should growth slow. EM governments fund themselves in capital markets in two main forms: external debt denominated in US dollars or other hard currencies, and domestic debt issued in the local currency of the issuer country. External EM bonds are credit instruments whose ratings and risk premia reflect the ability of sovereign issuers to service obligations in a currency other than the ones they control and credit fundamentals for these issuers have been steadily improving over the past decade. EM countries have much healthier fiscal balances than their DM counterparts and debt issuance to fund these smaller deficits should be easily absorbed by the market. Many EM countries, particularly the commodity exporters, have shifted to a net external creditor position over the past decade, and the strong growth in foreign exchange reserves will provide a powerful defence against external shocks. These developments have driven an average three-notch rating upgrade of EM sovereigns over the past 10 years, with the result that external EM debt is now an investmentgrade-rated asset class. And with concerns around the solvency of some DM sovereigns, and their ability to refinance maturing debt in public markets questionable, rating convergence with the DM sovereign universe is likely to continue for years. This move to the investmentgrade mainstream for external debt has meant that correlations with other investment grade assets have risen, and today the sector offers Chart 3: Positive Real Yields are More Prevalent in Em Markets Real yield (%) Developed (IPM GBI Global weights) Emerging (IPM GBIEM Global Div weights) Source: JP Morgan and BlackRock 4 Currents January 2012

5 only a small increase in yield over lower-rated investment-grade corporate bonds. But for investment grade credit investors, external EM debt can be a useful and diversifying yield generator (see Chart 3). That said, external EM debt is a mature asset class with relatively little new issuance. EM governments are increasingly funding themselves in local currency debt, meeting growing demand both domestically, as pension systems develop in some key markets, and internationally, as investors seek greater diversification. Unlike external debt, for which access to foreign currency to service the debt represents a risk to the issuer, currency risk on local debt is borne by the investor. As a consequence, volatility in foreign exchange rates is a significant contributor to the risk of the asset class. Over the last ten years, a US dollarbased investor in local currency EM debt earned an annualised total return of 13%, with 11% annual return volatility. Attributing these returns to movements in interest rates and currencies (as in Chart 3), demonstrates the dominance of foreign exchange risk and the comparatively better risk-adjusted return contribution from interest rate risk. The higher yields available on local currency debt are largely a function of the carry associated with the foreign currency exposure; hedging out this foreign exchange risk is a costly exercise given the large interbank rate differentials between EM and DM markets. For investors with a positive view on EM exchange rates who can tolerate the foreign exchange volatility, however, local currency debt can be another important source of portfolio yield. Growing Opportunities in Securitised Bonds Opportunities to invest in other higher-yielding sectors of the fixed income markets could emerge over the next year or two as banks work to Chart 4: Cumulative Contribution to Gbi-Em Returns % FX returns Bond returns Source: JP Morgan and BlackRock 5 Currents January 2012

6 shrink bloated balance sheets by disposing of risky assets. One area we continue to monitor is the market for non-agency securitised bonds backed by residential and commercial mortgages, where new issue supply is limited and liquidity can be challenging. The fundamental picture for the real estate loan sector is more challenging than for the other sectors we consider here. Residential property prices in the US are likely to remain under pressure in 2012, and a combination of growing negative equity and weak household income gains should keep default rates high, while delinquencies on commercial property loans remain elevated despite two years of steady declines. An investment approach that balances the need for yield with some protection against principal loss should focus on collateral quality and seniority in the capital structure. Yields are reasonably attractive on these bonds US prime RMBS carry yields of around 6.5% today, and US and European CMBS offer yield spreads of 5% over benchmarks on bonds with sufficient credit subordination to insulate investors from loss, even in adverse cases. However, given the weak fundamental picture and the potential for bank selling in less liquid conditions, we see few catalysts for performance in the near term. Watch and wait for more attractive entry points in this sector. t 6 Currents January 2012

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