Analysis & Trends: High-yield corporate bonds Higher bond yields with reasonable credit risk Understand. Act.
Analysis & Trends Decisive Insights for forwardlooking investment strategies 2
Analysis & Trends Content 4 High-yield corporate bonds 4 Corporate credit 5 Corporate credit value drivers 6 Managing high-yield bonds 7 Recent developments in the high-yield bond market offer buy opportunities 12 Decisive Insights Imprint Allianz Global Investors Europe GmbH Mainzer Landstraße 11 13 6329 Frankfurt am Main Capital Market Analysis Hans-Jörg Naumer (hjn) Dennis Nacken (dn) Stefan Scheurer (st) Olivier Gasquet (og) Richard Wolf (rw) Jochen Dobler (jd) 3
Analysis & Trends High-yield corporate bonds High-yield corporate bonds have suffered from a lack of liquidity and from investor risk aversion. The higher yields these bonds offer are linked to the issuers creditworthiness. High-yield corporate bonds 1. High-yield bonds and investment-grade bonds constitute the two segments of bond debt issued by private companies, known as corporate bonds. Investment-grade bonds are issued by the most creditworthy issuers. High-yield bonds are issued by less creditworthy issuers. 2. In view of the additional risk, corporate bonds have a higher interest rate than government bonds. This difference is called the spread : the less creditworthy the issuer, the higher the spread. The spread of high-yield bonds is therefore higher than that of investment-grade bonds. 3. During an economic and stock market cycle, when the economic situation and credit risk improve, corporate credit becomes a real investment opportunity. When the economic situation and credit risk worsens, corporate credit has the greatest risk exposure of the different types of bonds. High-yield bonds are the most volatile and most risky of the two types of corporate bonds. I Corporate credit Here, we will discuss only listed issues of bonds. Corporate credit, or corporate bonds, refers to bond debt issued by private companies. There are two types of corporate bonds. Investment-grade bonds, known as senior bonds, are issued by the most creditworthy issuers. They have ratings of between AAA and BBB-. Their interest rates are a little higher than those of government bonds. High-yield bonds are those issued by less creditworthy companies. They have ratings of less than BBB- and their interest rates are considerably higher than those of government bonds. The creditworthiness of an issuer is rated by specialised rating agencies, such as Standard & Poor s, Moody s and Fitch Ratings. Their ratings are designed to precisely reflect levels of credit risk: i. e. the risk that an issuer may default on payments. Ratings are reviewed at least once a year. They can be maintained, upgraded or downgraded, or placed under review with positive or negative implications, pending completion of an additional study. 4
II Corporate credit value drivers 1. Corporate bonds and changes in interest rates Like any government bond, corporate bonds are affected by changes in long-term interest rates. Their prices thus depend on the level of economic activity, inflation and key interest rates. When interest rates on government bonds increase, at constant spread, the interest rates of corporate bonds with the same maturity also increase. As is the case with all bonds, their market value will then go down. The more sensitive (the longer the maturity and / or the lower the interest rate) the bond, the greater the drop in price. Conversely, if the interest rate on government bonds falls, the rate on corporate bonds will decrease and their market value will increase. The more sensitive the bond, the greater the increase in its market price. Due to their higher interest rates, high-yield bonds are less affected by changes in longterm rates than government bonds. There is, however, another determining factor. 2. Corporate bonds and creditworthiness The spread and thus the interest rate of a high-yield bond is primarily dependent on the creditworthiness of the issuer, i. e. its credit quality. It is therefore important to hold securities whose creditworthiness will improve. An improvement in an issuer s creditworthiness warrants a lower spread, which tends to result in a lower overall interest rate and an increase in the value of the securities. Conversely, it is important to avoid bonds whose creditworthiness will deteriorate: a fall in creditworthiness warrants an increase in the spread, which tends to result in a higher overall interest rate and an automatic drop in the value of the securities. 3. Study of risk A thorough analysis of a company is needed to assess its credit quality. A company s equity (shares) and mediumand long-term debt (bonds) are what comprise its long-term resources, i.e. an essential part of the company s liabilities. An analysis of the issuer s sector, market positioning, strategy, balance sheets and financial statements must verify that the company s day-to-day operations will allow it to service its liabilities adequately over the long term. A company s equity analysis and debt analysis comprise these same steps. Equity analysis determines the value of the company s shares, which represent ownership of a portion of the company. Debt analysis determines the value of the company s bonds, which represent ownership of a portion of the company s debt. 5
Analysis & Trends 4. Default risk All issuers have a default risk, i.e. the risk of being unable to fulfil the terms of issue of their bonds. The default may result from the delayed payment or non-payment of interest due, or non-payment of part or all of the capital. It can also arise from a change in the terms of issue to accommodate the issuer s inability to meet its initial obligations. The default rate is the percentage of companies having defaulted within a sample defined either by a given rating, or an economic sector, or level of debt seniority. It is not the rate of real capital loss, as it must be supplemented by the recovery rate, i.e. the proportion of the capital affected by the default, but ultimately recovered by the creditor. The default rate and the recovery rate together determine the planned or actual loss on a portfolio of corporate bonds. Deducting it from the spread gives investors the net spread, which is the effective remuneration supplement received compared with government bonds. III Managing high-yield bonds The management of a portfolio benefits from the specific assets it focuses on. 1. Dual nature of high-yield bonds High-yield bonds have dual share-bond characteristics. As a bond or debt, their value is closely linked to the issuer s creditworthiness, i. e. its ability to honour its commitments and to perform. The market also assesses this capacity through price of shares in the issuer. High-yield bonds not only depend on bond markets, but also on company risk, reflected in stock markets. High-yield bond investors must therefore: Be alert to any event likely to affect the issuer s trading and creditworthiness. Verify that a bond s spread matches the issuer s creditworthiness. When they consider that the spread underestimates the creditworthiness, they subscribe to the issue. Conversely, when the spread is insufficient, they reduce holdings in the bond. Diversify their portfolios between sectors and companies, as is the practice of all share investors. 2. High-yield bonds and volatility Another characteristic of high-yield bonds is their volatility. High-yield bonds are more volatile than government bonds. At constant spread, high-yield bonds are less susceptible to rises in long-term interest rates than government bonds, due to their higher interest rates. But high-yield bonds are much more affected by the issuer s creditworthiness, which is considerably more uncertain than that of a country. The impact of creditworthiness on high-yield bonds values and interest rates is in fact decisive. Yet high-yield bonds are, in theory, less volatile than shares, as they are less risky. In the event of liquidation, creditors are in fact reimbursed before the shareholders, so corporate bonds can still be worth something when shares are already worthless. 3. High-yield bonds and liquidity Another characteristic of high-yield bonds is their lack of liquidity. A company s listed debt often comprises several tranches exhibiting distinct characteristics, each with a much smaller capitalisation than that of equity. During stock market turmoil, the lack of liquidity produces distortions between a bond s spread and intrinsic risk. These distortions offer as many opportunities to buy as to sell. Generally speaking, the lack of liquidity amplifies the volatility of high-yield bonds. 6
IV Recent developments in the high-yield bond market offer buy opportunities Recently, the high-yield bond market has been characterised by three simultaneous rises (see Chart 1): the rise in the spread of eurozone government bonds, as shown by the Markit itraxx SovX Index: a family of sovereign CDS indices converting countries. the rise in the spread of high-yield bonds, as shown by the Crossover Index (Xover): a corporate credit index comprising a mixture of high yield and higher yielding investment grade names the rise in the volatility of shares, as shown by the Standard & Poor s 5 Volatility Index (S&P 5 VIX): a popular measure of the implied volatility of S&P 5 index options. It is also known as the fear index. Chart 1: The strong rise in stock market volatility has impacted the debt markets (as in May 21) Xover generic in basis points 8 7 6 5 4 3 2 1 Xover Sovx in basis points 35 3 25 2 15 1 5 SovX generic A correlation can be observed between high-yield bond markets (excluding those issued by financial companies) and the sovereign debt crisis, with stock market volatility increasing and risk becoming systemic. 3/12/29 1/2/21 2/4/21 1/6/21 31/7/21 29/9/21 28/11/21 27/1/211 28/3/211 27/5/211 26/7/211 VIX 4 2 4/12/29 4/2/21 5/4/21 4/6/21 3/8/21 2/1/21 1/12/21 3/1/211 31/3/211 3/5/211 29/7/211 Past performance is no reliable indicator for future results Source: Allianz Global Investors Investments Europe (AllianzGI IE) Global Market Analysis, Bloomberg, 29 / 8 / 211 7
Analysis & Trends Chart 2: Strong capital outflows in June, and even stronger in August, from US and European high-yield bond markets Net buying flows of US high-yield bonds by mutual funds Weekly flows in millions of US $ 8 8 1,6 2,4 3,2 4, 2/6/21 25/8/21 17/11/21 9/2/211 4/5/211 27/7/211 Source: EPFR, 3 / 8 / 211 Monthly European High Yield Fund Flows for last 12 months. mm 2, 1, 1, 2, 3, Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 1% 5% % 5% 1% 15% % of assets under management Monthly Inflow (EUR millions) Monthly Inflow (% of AUM) Source: J. P. Morgan as of January 212 The worsening creditworthiness of governments, whose issues had been deemed risk-free, is affecting the perception of risk related to listed companies and their bond issues. For several months, investors have been massively selling (see Chart 2). Today, high-yield bonds offer high spreads, slightly greater than the spreads seen when Lehman Brothers collapsed, more than three years ago. They are also characterised by particularly high volatility, despite the fact that the default rate remains particularly low, which is clearly inconsistent. Moody s and Standard & Poor s (S&P) expected default rates over the next 12 months are very low, at 1.9 % and 1.6 % respectively. Having reached 12 % at the height of the last financial crisis at the end of 29, default rates have levelled off at 1.4 % in the eurozone and 2.1 % in the United States. Standard & Poor s specifies that its forecast of 1.6 % lies on a scale between a best case scenario of 1.2 % and a worst case scenario of 4 %. In any event, the default rate is expected to be less than the long-term average of 4.6 % (see Chart 4). 8
Chart 3: Low default rate expected by rating agencies Default rates expected in the Unites States (Bank of America (BofA) and Moody s) 16 Default rate on long-term issues (%) 14 12 1 8 6 4 2 31 % 3 % 21 % 1985 1988 1991 1994 1997 2 23 26 29 212 Actual default rate Bank of America forecast Accumulated default rates Source: Moody s Investors Service, 211 Default rates forecast by rating agencies and banks Moody s 1.9 % S&P 1.6 % (*) Source: Allianz Global Investors, 211 (*) 12-month default rate. Chart 4: Default rates expected by Standard & Poor s, according to different scenarios Default rates of US speculative-grade bonds and 12-month forecast % 14 13 12 11 1 9 8 7 6 5 4 3 2 1 1982 1984 1986 1988 199 1992 1994 1996 1998 2 22 24 26 28 21 212 Recession Long-termaverage 4.59 % Default rates of US speculative-grade bonds Forecast for June 212 Pessimistic 4. % (62 defaults) Baseline 1.6 % (25 defaults) Optimistic 1.2 % (18 defaults) The areas shaded in light blue correspond to the periods of recession defined by the National Bureau of Economic Research (NBER). Sources: Standard & Poor s Global Fixed Income Research and Standard & Poor s CreditPro. Standard & Poor s August 211. 9
Analysis & Trends In fact, the worst case scenario seems unlikely, as companies took advantage of the recovery in 29 and 21 to renegotiate their loans and the dates on which the loans were due. Of course, a recession could prevent them from respecting the ratios provided for in their loan agreements. But the banks are currently too concerned with their equity to not be flexible regarding disputes, to avoid claims and losses. Nonetheless, market prices can anticipate an economic crisis. The most representative issuers of the high-yield sector have a B rating (see Chart 5). In Europe, between 1981 and 21, this sample s total default rate over 5 years was 17 %. At 8 basis points taking the recovery rate to be the long-term average of 4 % the current spread anticipates a total default rate of 47 %. The market seems thus substantially overestimating the default risk. Chart 5: Default rate accumulated over 5 years Accumulated average default rate of European companies over a several year period, ranked by rating (1981 21) * A spread of 8 basis points for high-yield bonds implies a default rate accumulated over 5 years of 47 % whereas a long-term average of Standard & Poor s is of 17 % % 25 2 15 1 * 6 5 4 3 2 % 5 1 1 2 3 4 5 6 7 8 9 1 (Time in years) AAA AA A BBB BB B CCC/C (right hand scale) Sources: Standard & Poor s Global Fixed Income Research and Standard & Poor s CreditPro Standard & Poor s 211 Implied probability of default accumulated over 5 years Recovery rate 5 % 4 % 3 % 2 % 1 % 5-year spread on the Xover index 12 68.2 % 61.5 % 55.9 % 51.1 % 41.7 % 11 65. % 58.3 % 52.8 % 48.1 % 44.2 % 1 61.5 % 54.9 % 49.4 % 44.9 % 41.2 % 9 57.7 % 51.1 % 45.9 % 41.6 % 38. % 8 53.4 % 47.1 % 42.1 % 38. % 34.6 % 7 48.8 % 42.7 % 38. % 34.2 % 31. % 6 43.6 % 38. % 33.6 % 3.1 % 27.3 % 5 38. % 32.8 % 28.9 % 25.8 % 23.3 % 4 31.8 % 27.3 % 23.9 % 21.2 % 19.1 % 3 24.9 % 21.2 % 18.5 % 16.4 % 14.7 % Implied default rate = 1 exp (- Spd / (1 recovery rate) * Maturity) Source: Allianz Global Investors, 12 / 9 / 211 1
Chart 6: Comparison between the default rate and VIX (measure of implied volatility of Standard & Poor s 5 index options) Model of the spread of high-yield corporate bonds, basis points VIX 18 % 2 % 25 % 3 % 35 % 4 % 45 % 5 % 1. % 392 424 56 587 668 749 83 911 2. % 433 465 546 628 79 79 871 952 3. % 474 56 587 669 75 831 912 993 Default rate 4. % 515 547 628 79 791 872 953 134 5. % 556 588 669 75 832 913 994 175 6. % 597 629 71 791 872 954 135 1116 7. % 637 67 751 832 913 995 176 1157 8. % 678 711 792 873 954 135 1117 1198 9. % 719 752 833 914 995 176 1157 1239 1. % 76 793 874 955 136 1117 1198 128 Optimal area The market s volatility explains the difference between the implicit default rate and the accumulated historical default rate Source: JP Morgan, Moody s, 12 / 9 / 211 We have seen that under certain circumstances, the high-yield corporate bond market lacks liquidity and experiences a rise in its volatility. According to Moody s, the default rate of 2 % it anticipates would justify, with the volatility range seen in the last four months of between 18 % and 3 %, a spread of between 433 and 628 basis points (see Chart 6). The current spread is 79 basis points. For a default rate of 2 %, it corresponds to volatility of 4 %; or for the current volatility of 3 %, it corresponds to a default rate of 6.3 %, which is considerably higher than the worst case scenario of 4 % and long-term average of 4.6 %. We can again conclude that the market seems overestimating the default risk. investors that are able to wait for the market s return to normal and disappearance of their capital losses would continue to receive a particularly attractive return. Moreover, a return to equilibrium in public finances in the medium term, and a return to slow growth, should mean that the market price of high-yield bonds gradually aligns with their true fundamental value. A decrease in the spread from 79 to 628 basis points, simply justified by the market s current volatility, would generate a capital gain of 16 %. An additional contraction in spreads towards levels consistent with current expected default rates would generate substantial additional gains (see Chart 6). Holding a portfolio of such bonds could provide an attractive annual return. Of course, a market collapse similar to the one in 28 / 29 would trigger a fall in prices. But 11
Analysis & Trends Decisive Insights The high-yield bond market is currently suffering from the sovereign debt crisis, investor risk aversion and a lack of asset liquidity. Doubts concerning countries creditworthiness are undermining the valuing of risky assets. And the required control of public spending is casting a shadow on future growth and issuers future financial performance. However, companies are in good health and the default rate is particularly low. Provided that there is no worsening of the financial crisis, the high-yield bond market should gradually return to normal (see Chart 7). In the medium term, spreads are likely to contract towards levels that are more consistent with the observed volatility of the market and the expected default rate. In addition to high coupons, investors could then enjoy significant capital gains. Olivier Gasquet Chart 7: Low valuation Default rate on European high-yield bonds should remain low in 211 and 212 Default rate on all high-yield bonds & Merrill US HY Master II index (spread compared with the OAS index in basis points) 15 25 2 12 1 5 1/1/1988 1/1/1989 1/1/199 1/1/1991 1/1/1992 1/1/1993 1/1/1994 1/1/1995 1/1/1996 1/1/1997 1/1/1998 1/1/1999 1/1/2 1/1/21 1/1/22 Default rate of high-yield bonds (left-hand scale) Source: Standard & Poor s, Bloomberg, 15 / 9 / 211 Merrill US HY Master II Index 1/1/23 1/1/24 1/1/25 1/1/26 1/1/27 1/1/28 1/1/29 1/1/21 1/1/211 15 1 5
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