The fundamental objective behind the creation of the bond market is to serve as a mechanism for the long-term financing of private (corporate) and public (government) expenditures. All major bond markets, most notably the investment grade (IG) sovereign and investment grade corporate bond markets, have witnessed exponential growth over the last few years. However, the growth and importance of the high yield bond market since the early 1980s has been unparalleled.
The US and European HY bond markets constitute the majority of outstanding HY bonds
The creditworthiness of a bond issuer is rated by agencies such as Standard & Poor’s, Moody’s and Fitch. These ratings are designed to reflect the levels of credit and default risk inherent with an exposure to any particular corporate issue.
IG bonds, on one hand, are issued by the most creditworthy issuers, having credit ratings between AAA and BBB. High yield bonds, on the other hand, are issued by less creditworthy companies, having credit ratings lower than BBB- and which generally have to pay higher interest rates than IG issuers.
Before the 1980s, the majority of HY bonds were those issued by firms which were once considered to be of IG status but which were subsequently downgraded to below IG (also known as fallen angels) as a result of deteriorating balance sheets, free cash flow concerns and/or eroding profitability, which ultimately pointed towards a heightened possibility of issuer default.
During the last decade of the millennium, however, traditional bank lending started to become increasingly expensive and difficult to obtain. In view of this, corporations sought other measures of raising finance. This led to a remarkable shift towards raising capital in the HY market as an alternative source of capital.
Companies were also encouraged to issue HY bonds as it proved to be less restrictive as opposed to the stringent conditions on borrowing imposed by banks.
The increasing number of leveraged buyouts as well as the ever-increasing number of European small to medium-sized enterprises that lacked the size and earnings necessary to obtain IG ratings contributed further to the growth and evolution of the global HY market as we know it today.
Across the Atlantic, many analysts consider the introduction of the euro and its use as a common currency as one of the driving forces that fuelled the growth of the European HY market, which until then was practically inexistent.
Furthermore, structural changes within the regulatory framework of financial institutions (such as Basel III) resulted in further reduction in bank lending due to the reassessment of risk exposures at various financial institutions. Today HY bonds have become a core component of the capital structure for US and European companies.
Over the past decade, the universe of outstanding HY bonds has increased significantly, most notably in the European HY bond market. The BAML European Currency HY Index has increased almost fourfold, from €62.14 billion as at 2003 to €247.92 billion as at 2012, whereas the BAML US HY Index almost doubled in size.
The Bank of America Merrill Lynch European Currency High Yield Index is a total return index which tracks the performance of EUR-denominated sub-Investment grade corporate debt. The Bank of America Merrill Lynch US High Yield Index is a total return index which tracks the performance of USD-denominated sub-Investment grade corporate debt.
To put things into perspective, US HY bond gross issuance in 1990 was ‘only’ $150 billion, whereas issuance for 2012 totalled $876 billion, with 40 per cent of all outstanding global corporate bonds being HY bonds as at the end of 2012.
Unsurprisingly, the US and European HY bond markets constitute the majority of outstanding HY bonds as at the end of 2012, encompassing 62 per cent and 32 per cent of the HY universe respectively. Apart from growing in size, the HY bond market has also increased its appeal to investors as it provided the widest opportunity set in terms of geographical and sector allocation, enabling investors to diversify their bond allocations.
The increase in demand for HY bonds of late has rendered their risk/reward profile more favourable to other asset classes, providing equity-like returns with less volatility. At a time when yields on cash deposits and the safest government bonds are yielding close to record lows, the prospect of a higher coupon payment and the potential for a capital return are encouraging investors to move down the ratings ladder in search for yield.
What is even more interesting is that, on a historic basis, HY bonds have been lowly correlated to IG bonds and negatively correlated to benchmark sovereign bonds, such as German Bunds and US Treasuries.
This means that HY bonds can also serve as a powerful and attractive asset class, for diversification purposes, in a strategic approach to investing in the bond market, which would function across varying economic and interest rate cycles. However, to the detriment of many long-term investors, it transpires that many basic asset allocation models remain still unallocated, under-allocated or misallocated to HY bonds.
This could, at least in part, lend itself to the fact that the assessment on the creditworthiness of HY issuers requires thorough financial data analysis by trained professionals and hence a relatively sophisticated level of knowledge and experience.
US and European HY bond markets were among the best performing asset classes in 2012, posting yearly returns of 13.5 per cent and 22 per cent respectively, as investors sought to reap the effects of accommodative monetary policy undertaken by the Central Banks in the US and in the eurozone.
The US Federal Reserve’s lower for longer stance and the European Central Bank’s statement that it would “do whatever it takes” to save the euro in the summer months led to a pronounced decline in risk aversion and a global hunt for yield, which ultimately led to a rally in the global HY bond market and significant spread tightening, which scenario persisted for most of the latter part of 2012.
While there seems to be some concern that the HY bond market might be overheating, there are a number of factors that support a benign outlook for this asset class in 2013. Despite the positive performance of the HY bond market in 2012, low spreads have been historically followed by prolonged periods of attractive HY performance on a risk-adjusted basis.
HY companies are poised to perform reasonably well during times of lacklustre GDP growth as record low interest rates allow corporates to maintain revenues and keep costs under control.
Market consensus is that, although the remarkable 2012 performance in the HY bond market is not expected to repeat itself this year, there still remains potential for positive returns as credit metrics are expected to improve.
Additional significant co-ordinated quantitative easing could lead to further demand for HY bonds on one hand, while a pronounced increase in default rates on the back of a sharp global economic contraction could however result in a change of fortune for this asset class.
Calamatta Cuschieri & Co Ltd is licensed to conduct investment services in Malta by the Malta Financial Services Authority. This article is prepared for information purposes only and does not constitute investment advice or marketing communication. It does not constitute an offer or invitation to any person to buy or sell any investment or to enter into any business relationship with CC. This article is based on information obtained from reliable sources but which have not been independently verified. CC is under no obligation to update the information in this article. CC does not accept liability for any actions, proceedings, costs, demands, expenses, loss or damage arising from the use of all or part of this article. The information in this article is valid as at February 14, 2013.
Mark Vella is an investment manager at Calamatta Cuschieri.