High-yield bonds and global rates

Transcription

1 Fixed Income Focus November 216 FOR PROFESSIONAL INVESTORS ONLY High-yield bonds and global rates Fallen angels and rising stars: finding opportunities in the high-yield bond market High-yield bonds can provide long-term investors with attractive returns despite short-term volatility. Through deep research, analysts can identify opportunities to add value for investors, especially ahead of an anticipated credit upgrade or downgrade. Tara Torrens Portfolio manager Based in New York In this issue: How to find value in the high-yield market Why some global investors are losing interest in US bonds Fallen angel Freeport-McMoRan and rising star Sabine Pass are examples of opportunities where issuer credit trends hinted at subsequent bond rating changes. As the global search for yield continues, yields on most asset classes have fallen. The US high-yield bond market is no exception, producing strong year-to-date returns. Continued inflows and tighter spreads (less compensation for risk) raise a question: are we headed for a period of market weakness? The high-yield market in brief The high-yield bond market is often equated with high-risk investing. The credit quality of issuers is lower than in the investment-grade universe, which tends to increase the correlation between highyield returns and equity market returns and associated volatility. Yet the relatively short duration of the high-yield market about four years tends to lessen the correlation to Treasury yield movements. A slow and steady macroeconomic environment has historically been favorable for the high-yield market. It allows issuers to maintain credit quality and service debt without encouraging the aggressive balance sheet leveraging that can often accompany periods of strong economic growth. So despite annual return volatility that can be elevated in the high-yield market, through a full credit cycle, yields tend to compensate appropriately for the additional risk. This can lead to attractive cumulative returns for long-term investors. High yield versus fallen angels BofA Merrill Lynch US High Yield Master II Index BofA Merrill Lynch US Fallen Angel High Yield Index 2 Cumulative returns (%) /12/4 31/12/6 31/12/8 31/12/1 31/12/12 31/12/14 Past results are not a guarantee of future results. Cumulative returns since 31/12/4. Sources: BofA Merrill Lynch, Thomson Reuters Datastream as at 3/9/16 thecapitalgroup.com/europe 1

2 Our deep fundamental research process to forecast the credit trajectory of issuers and anticipate rating actions allows us to spot investment opportunities. Finding opportunities in the highyield market The high-yield market is characterised by a high dispersion of returns throughout most economic environments. This variance demonstrates a market in which deep fundamental research, which is our focus, is critical to evaluating risk and reward and unearthing attractive investment opportunities. In 216, fallen angels and rising stars have been a significant source of investment ideas. The characterisation of a bond as high yield has little to do with its actual yield, though there s often a correlation. Instead, this classification is determined by the rating assigned by bond rating agencies such as Moody s Investors Service and Standard & Poor s. High-yield bonds are defined as having a rating below BBB-/Baa3, while better rated bonds are considered investmentgrade. Fallen angels are investmentgrade bonds that have been downgraded to high yield as a result of a perceived increase in credit risk. Rising stars are high-yield bonds upgraded to investment grade as a result of a perceived decline in credit risk. This year is shaping up to be an active and impactful one for fallen angel and rising star activity. Large price moves tend to occur as bonds cross the chasm between high yield and investment grade. This is due in part to differences in buyer bases and index inclusion for investment-grade versus high-yield bonds. Differentials in market pricing the average spread on a BBB intermediate corporate bond is 15 basis points, while the average spread on a BB high-yield bond is 328 basis points also play a part. Credit rating changes often lag market price moves. Potential fallen angels and rising stars frequently see their yields move in advance of downgrades, as research-based corporate buyers see credit deterioration occurring. While ratings alone don t drive our investment decisions, we recognise that rating changes especially for fallen angels and rising stars can move markets. Our deep fundamental research process aims to forecast the credit trajectory of issuers and anticipate rating actions. A fallen angel and a rising star Recently examples of outperformance have included bonds of fallen angel Freeport-McMoRan and rising star Sabine Pass. Freeport-McMoRan, a metals & mining issuer, experienced its first downgrade to high yield on 27 January 216. In the six months leading up to the downgrade, yields rose precipitously. But beginning around the time of the first downgrade, yields began to fall relative to the high-yield market, and have continued to do so in dramatic fashion, leading to material outperformance. Not all fallen angels have similar results. But a research-driven view on actions the issuer could take to stabilise its balance sheet and underlying credit quality could help uncover the valuation-driven opportunities created by the downgrades. Alternately, the improving credit quality of liquefied natural gas terminal developer Sabine Pass could also have been detected through researching the issuer. While its bonds strong credit quality generally led them to trade at a fairly tight spread relative to the high-yield market, the company experienced its first upgrade to investment grade on 12 September 216. The bonds demonstrated notable relative spread tightening in anticipation of this upgrade. The relative returns of Freeport- McMoRan and Sabine Pass bonds demonstrates the value of issuer-level research in finding investment opportunities in high yield, despite a challenging market environment. A fallen angel often sees bond yields move prior to a downgrade Relative spread between Freeport-McMoRan bonds maturing in 3/223 and Bloomberg Barclays US high yield 2% capped index 1, Basis points Downgrade /6/15 27/1/15 27/1/16 27/4/16 27/7/16 Source: Bloomberg 2

3 Foreign demand for US bonds may be slowing The impact of negative interest rate policies has been felt across the world. European and Japanese investors have reacted by buying US bonds, thereby pushing down yields in the US. Eric Delomier Fixed-income investment specialist Based in Singapore Rising hedging costs are, however, beginning to lessen the attractiveness of higher yielding US Treasuries to foreign investors. Earning interest to borrow money: could life get any better than that? Until recently, borrowing at negative interest rates had been the privilege of governments and government-related institutions. But in September, Henkel, a German consumer goods group, and Sanofi, a French pharmaceutical company, issued the first corporate bonds with negative yields in modern times. This shows just how much the European Central Bank s quantitative easing programme and negative interest rate policy have depressed yields on all European bonds. In today s highly integrated global economy and financial markets, these developments in Europe matter not just to European investors they are also critical to US bond investors. The decline in US yields Since the Federal Reserve hiked interest rates last December, 1-year US Treasury yields have fallen by 44 basis points. This is unusual in the early days of an interest rate tightening cycle. Two reasons can be singled out to explain much of this unexpected fall in US yields. First, market participants have revised down their expectations for future interest rate hikes. Second, European and Japanese investors, facing depressed domestic yields, have bought large amounts of US dollar bonds. In particular, the US Census Bureau estimates that foreign private investors bought over $5 billion of US bonds in 215 and an additional $35 billion in the first half of 216. The chart below shows that 1-year German and French government bond yields had tracked US Treasury yields relatively closely until 214. Then, the ECB s aggressive monetary policy set tectonic plates in motion: European yields began to diverge from US Treasury yields and converge toward Japanese government bond yields. This has pushed European institutional investors, such as insurance companies and pension funds, to buy a large amount of US bonds to maintain the yields they require to meet their future liabilities. While Japanese investors have made large allocations to US bonds for many years, the introduction of negative interest rates by the Bank of Japan (BOJ) at the beginning of the year led to renewed investments into US bonds by Japanese investors. Selected 1-year government bond yields France 8 % Germany Japan US /12/99 31/12/1 31/12/3 31/12/5 31/12/7 31/12/9 31/12/11 31/12/13 31/12/15 As at 5/1/16. Source: Bloomberg 3

4 Since the first quarter, when the ECB cut interest rates further into negative territory and the BOJ introduced negative interest rates, the yield advantage of US Treasuries on a currency-hedged basis has been shrinking. The chart below suggests that the yield pickup of US bonds over and above other developed bond markets will continue to act as a powerful gravitational force pushing US yields lower. This first impression may, however, be an oversimplification: non-us private investors typically buy US bonds on a currency-hedged basis. They therefore compare domestic bonds to US bonds hedged back to their home currency, whether the euro or the yen. In other words, they buy US bonds because they are better rewarded for extending maturities or for taking some credit exposure in the US, but they do not want to be exposed to the US currency. Comparing yields on a currencyhedged basis For these private investors outside the US, it is more relevant to compare US Treasury yields on a currency-hedged basis. That is essentially what the below chart shows. Like the earlier chart, it compares US Treasury yields to European and Japanese bond yields but this time, non-us yields are hedged back to the US dollar. Since the first quarter, when the ECB cut interest rates further into negative territory and the BOJ introduced negative interest rates, the yield advantage of US Treasuries on a currency-hedged basis has been shrinking. This yield advantage fell further in the third quarter as US Libor rates were pushed up by accelerating outflows out of prime money market funds. In total, about $1 trillion has left prime US money market funds this year. This has increased the funding cost of the non-government money market issuers that they typically invest in, as well as Libor rates. Selected 1-year government bond yields hedged to the US dollar France Germany Japan US 2.5 % /9/15 31/12/15 31/3/16 3/6/16 3/9/16 As at 5/1/16. Source: Bloomberg 4

5 Fixed Income Focus November 216 Markets at a glance (as at 31 October 216) US Treasury yields (%) Month end 1 Quarter end 2 Year end 3 3-Month Year Year Year Year to 1-Year Spread (bps) to 3-Year Spread (bps) US Treasury yield curve (%) Dec 15 3 Sep Oct Sources: Federal Reserve, Thomson Reuters Datastream Spreads (bps) Month end 1 Quarter end 2 Year end 3 Bloomberg Barclays US Corporate Bloomberg Barclays US High Yield Corporate JPM EMBIG Diversified (IG) JPM EMBIG Diversified (HY) JPM EMBIG Diversified Investment-grade spreads (bps) JPM EMBIG Diversified (IG) Bloomberg Barclays US Corporate Oct 11 Oct 12 Oct 13 Oct 14 Oct 15 Oct 16 Sources: Bloomberg Index Services, RIMES Yields (%) Month end 1 Quarter end 2 Year end 3 UK 1-year Government Bond Germany 1-year Government Bond Japan 1-year Government Bond Bloomberg Barclays US Corporate GBI-EM Global Diversified Exchange rates (% change vs. USD) 4 1 month 3 months YTD British pound Swiss franc Euro Japanese yen US corporate spreads (bps) Bloomberg Barclays US Corporate (left scale) Bloomberg Barclays US High Yield 2% Cap (right scale) Oct 15 Dec 15 Feb 16 Apr 16 Jun 16 Aug 16 Oct 16 Source: Bloomberg Index Services Currency contribution (%) JPM GBI-EM Global Diversified Fixed-income index returns 4 Bloomberg Barclays US Aggregate Bloomberg Barclays Global Aggregate Sources: Bloomberg Barclays, Datastream, Federal Reserve, RIMES 1. Month-end: 31 October Quarter-end: 3 September Year-end: 31 December As at 31 October 216 5

6 Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. The information provided is intended to highlight issues and not to be comprehensive or to provide advice. This information has been provided solely for informational purposes and is not an offer, or solicitation of an offer, or a recommendation to buy or sell any security or instrument listed herein. Past results are not a guarantee of future results. This communication is issued by Capital International Limited (authorised and regulated by the UK Financial Conduct Authority), a subsidiary of the Capital Group Companies, Inc. (Capital Group). This communication is intended for professional investors only and should not be relied upon by retail investors. While Capital Group uses reasonable efforts to obtain information from sources which it believes to be reliable, Capital Group makes no representation or warranty as to the accuracy, reliability or completeness of the information. This communication is not intended to be comprehensive or to provide investment, tax or other advice. 216 Capital Group. All rights reserved. CR CIL ACEXCH