High spreads, few defaults
While global growth expectations are being adjusted downwards, corporate balance sheets are stronger than ever in relative terms, making this is an excellent climate for high-yield bonds.
Anyone who took a position five years ago in Robeco’s globally invested High Yield Bonds fund will have averaged annual earnings of 7.5% since then. This strong performance has not gone unnoticed. In the last five years, Robeco High Yield Bonds’ fund assets have increased five-fold from EUR 500 million to 2.5 billion, and no end to this inflow is yet in sight. According to Roeland Moraal, fund manager for Robeco European High Yield Bonds and member of Robeco’s bond team, this inflow is easy to explain. “We have now entered a period in which equities are slightly less popular, while the yields offered by the safer government bonds are low. High Yield is an effective compromise between equities and the safety of government bonds.”
Despite the popularity of High Yield, a bubble does not seem likely. In Europe, many companies - refused access to funds by the banks - are being forced into the capital market. In the US, the high-yield market is big enough to absorb the inflow of extra money this creates. The fact that interest rates on high-yield bonds – at the time of writing 7.25% - are barely adequate has everything to do with the extremely low yield on the better quality of debt offered by government bonds. For instance, the BB-rated Swiss telecom company, Sunrise Communications, pays 5.6% for a five-year credit. This does not seem much on the face of it, yet it is precisely 5.6% more than the Swiss government currently pays for a loan with the same lifetime, i.e. 0.0%.
According to Moraal, the current economic situation is still attractive to investors in High Yield. “While slow growth is a negative factor in the equity market, it is actually an excellent environment for the bond market. In times of slow growth, companies use their profits to strengthen their balance sheets, and they avoid costly adventures.” Companies with the lowest credit rating (triple C) form an exception. Moraal believes that they really are at risk. “This is the reason we choose companies with BB status; the better High Yield.”
As it happens, defaults are not the biggest problem. At 2%, the number of defaults is exceptionally low - so far. The major rating agencies expect the percentage of defaults to increase to 3 – 4% by the end of the year. According to Moraal even this will not represent a major disaster. “Today’s interest rates more than compensate for this.” This does not mean that it makes good sense to maintain just a few high-yield positions, as any default can then quickly represent something of a catastrophe. Diversification is still the best way to reduce risk, even in the high-yield market. Thorough analysis is another way to considerably reduce the chances of 'disappointment'. For this reason, when the crisis started in 2008, Robeco decided to extend its bond team, which now comprises sixteen specialists. Moraal: “Our view is that you earn money by avoiding the losers. The kind of thorough structural research we have carried out at Robeco for decades is indispensable.’’
Robeco’s investors in High Yield invest mainly in companies that generate large amounts of cash and have strong market positions. These include in particular telecom, utility and cable companies, and players in the packaging industry. Despite all the current concerns, Robeco is currently overweight Europe. Moraal expects the euro to survive and that, after a number of minor dips, we will emerge from the crisis. “The market is now worried mainly about Europe, and appears to be forgetting that the United States is not much better off than the average southern European country.” He also thinks that the problems facing China are being sorely underestimated.
Pension funds are reserving 3-10% for high-yield bonds in their various portfolios. According to Moraal, 5% is a fair average. Anyone considering taking a position should remember that the price of high-yield bonds can fluctuate considerably and that they should, therefore, be considered as a longer-term form of investment.