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Four unjustified stress factors for high yield bonds

Four unjustified stress factors for high yield bonds

14-03-2016 | Insight

Investors in high yield bonds should be careful that they do not get carried away by the unpredictable sentiment on financial markets. Sander Bus, Robeco High Yield Bonds portfolio manager, puts this investment category into perspective and looks ahead. "There certainly are investment opportunities among high yield corporate bonds, but it remains important to be selective."

  • Sander  Bus
    Sander
    Bus
    CFA, Managing Director, Co-head Credit team, Portfolio Manager and Head High Yield

Speed read

  • The market for high yield bonds has been punished once rightfully and once wrongfully
  • A market that has overreacted offers investment opportunities
  • Investors will turn to high yield bonds for the returns

"It appears as if concerns have only increased for investors in high yield bonds", Sander Bus concludes looking back at the past months. "The Fed's interest rate hike and the extreme drop in oil and commodity prices had a negative impact on the returns of high yield bonds last year. Four stress factors have now been added to that: a weak start of the year for the Chinese stock market, not very convincing figures on the US economy, doubts whether the accommodating monetary policy of the central banks is still effective and fears of a bubble in the market for high yield bonds. This has led to even more nervousness among investors."

However, according to Bus, the slowing growth of the Chinese economy and the hardly flourishing state of the global economy are the underlying dominant factors this year. The rest is less relevant. "The monetary policy of central banks remains an important theme, but is not changing. For the time being, we will continue to operate in a low interest rate environment and this does not pose a threat. We are not worried about what the Fed may do, as this is no longer the opponent we fear the most. At present, there is still insufficient evidence pointing to a recession in the US. And there is no bubble. Although the market for high yield bonds has grown strongly, this is mainly a matter of a shift. Banks are less willing to provide loans and therefore companies have to turn to the capital market and issue bonds in order to finance their activities. In addition, due to low interest rates, a lot of money has flowed into high yield bonds."

The Robeco High Yield Bonds fund management team is not completely negative about the market for high yield bonds. It recently allowed the beta of the fund to increase from neutral to an overweight position of 1.1. The reason for this is the strong belief that a patient investor can achieve a positive return. A beta bigger than 1 means that the investment fund moves stronger than the market. If the market goes down, the fund will go down more. But if the market goes up, the fund makes a bigger profit. "For a long time, we aimed for a beta of 1. We now feel comfortable with a higher beta", Bus explains.

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Punished by investors twice

Due to the negative sentiment, high yield bonds as an investment category have been punished twice by the market, which has led to significantly lower yields. "The first time was justified, the second time wasn't", according to Bus. Added to that, there was contagion between the types of high yield bonds within the category itself. Bus: "Unjustified, for now the good are suffering along with the bad and Europe is not the US." According to the fund managers the market has overreacted. "But that also offers investment opportunities. As an investor, it is wise not to get carried away by the pessimistic sentiment, but to look what has already been priced in and where the market is changing. To look which companies are handling the economic reality wisely. It is a matter of looking for high-quality companies very specifically and selectively."

High yield bonds got their first hit last year from the strong drop in oil and commodity prices. Understandable, as the market for high yield bonds in the US, and therefore also the index, consists for over 10% of energy and mining names. In particular, the exploration and production companies (E&P) have taken on a considerable amount of debt and investors are justifiably concerned about whether they can repay these loans now that their revenues have decreased due to the oil price.

The high yield bond market suffered the second hit early this year when equity prices fell due to concerns about the Chinese and US economy. "However, the market for high yield bonds had already anticipated this news considerably. It was one of the first markets to come under pressure and one of the first markets to incorporate a recession scenario into its prices", Bus argues, "whereas the stock market has only started reacting to fears of a recession during the last few weeks. Nonetheless, this has had a negative impact on high yield bonds. An unjustified correction."

'The good are suffering along with the bad and Europe is not the US'

Looking for high quality names

The pain was the greatest in the afflicted energy and metals & mining sectors, but it is exactly here where Bus believes that new investment opportunities will occur. "Bonds of energy companies with an above-average, in some cases, investment-grade credit rating are being traded at high yield spreads. As if the risk of default is as high for them as it is for competitors with a lower credit rating. Good companies are being punished wrongfully." The investment philosophy of Robeco High Yield Bonds offers the fund managers the freedom to also invest in investment-grade bonds, as part of the quality approach which Robeco applies in its high yield investment process.

There are also new investment opportunities in the metals & mining sector. Bus: "We see signs of stabilization of commodity prices and that is a positive for recovery. Some individual companies stand out because they are better equipped to deal with the changed circumstances than others and are strengthening their balance sheets by reducing their debt positions. In metals & mining, we have gone from underweight to neutral, to end up being overweight."

However, it remains important to be cautious, Bus emphasizes, as most bankruptcies are still expected to occur in these two sectors. "It is not our investment style to look for the survivors among the companies that are in trouble. We continue to select high-quality companies."

Europe versus the US

Where the problems for high yield bonds between and within sectors are very specific, this is also the case for US and European high yield bond markets. Bus: "European high yield bonds were partially dragged down by the events in energy and mining in the US; however, the problems are not as big. This is due to the difference in the composition of the market."

The energy sector is represented to a lesser extent in the European high yield market. The credit ratings are also distributed differently. The US high yield market contains far more companies with a CCC credit rating. The credit quality of European high yield bonds is generally better.
In addition, US companies have taken on more debt in recent years in order to pay out dividends, to do share buybacks or for mergers and acquisitions. European financial directors are still a lot more conservative and do not leverage the balance sheets of their companies as much.

Consequently, spreads in the US are not only increasing due to less confidence in the economy, but also due to the composition of the market and the index. This explains why spreads in the US are much higher – it is the risk premium that investors demand for high yield bonds compared to safe treasury bonds. "However, when corrected for the composition of the index, US spreads are not worse than European spreads", Bus explains.

In recent weeks, spreads have widened. However, according to Bus, this is not always due to less favorable starting points. "Among banks and financial service providers, we now see spreads increasing to levels of the euro crisis in 2011 and the financial crisis in 2008. But this is not always justified. Here again, the good are suffering along with the bad. For Robeco High Yield Bonds, we can also invest off-benchmark in investment-grade bonds and in financial service providers. And, therefore, we do that. In doing so, we prefer subordinated bonds issued by investment-grade banks from Northwest Europe. We avoid banks in the periphery of the Eurozone."

In their search for returns, investors will turn to high yield again, Bus believes. High yield bonds have been punished severely, however, they are now returning to high single-digit to low double-digit returns. The market has come to its senses again."

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