Last week, Vivendi Universal successfully raised finance to the tune of e1.35bn. In itself this is n...
Last week, Vivendi Universal successfully raised finance to the tune of e1.35bn. In itself this is not a particularly newsworthy event, but Vivendi is a B rated company that was able to raise these funds by paying interest of just 6.25%, or 330 basis points over government bonds.
According to Merrill Lynch indices, the average B rated company should yield 560 basis point more than gilts, so you would think that investors were getting a raw deal. However, the market clearly thought otherwise because the deal was more than five times oversubscribed.
Such is the demand for high yield at the moment that companies like Vivendi are able to refinance existing debt at much cheaper levels. Rhodia and Heidelberg Cement have also employed this tactic in recent weeks, easing liquidity pressures as a result. The obvious theory when a B rated issue pays just 330 basis points over gilts is that the market is over-bought.
Certainly some ratings categories do appear to be overvalued, notably C-rated bonds, which have returned around 60% since October 2002. These ratings categories are more tightly priced than their historic long-term average, which seems poor value given today's relatively high default rate.
However, B-rated bonds are priced in line with their historic average and BB-rated bonds are priced wider. Logically therefore, if credit quality continues to improve, high yield spreads should tighten further. But will credit quality improve from here? The economic environment offers support. Modest economic growth is ideal for high yield bonds, providing just enough momentum to prevent recession, but not so much as to tempt management into gunning for growth. Instead managements are content to focus on cost control, paying down debt and improving liquidity. Fallen angels such as ABB, Invensys and Vivendi have all improved their credit quality by undertaking asset disposals.
But regardless of better credit quality, the demand argument is a forceful one. We have already seen the impact of demand on recent new issuance. Much of this has emanated from cash rich US mutual funds seeking meaningful levels of income in an environment of declining yields. High yield corporate bonds are one of the few asset classes that can still deliver a high and relatively reliable income stream.
Despite several supportive factors, high yield bonds face a number of risks. Deflation for example would be disastrous for heavily indebted bond issuers, because falling prices raise the real cost of funding debt. Another risk is that credit quality fails to improve or worse still deteriorates.
A rising default rate would suddenly render many high yield bonds expensive. However, neither of these outcomes is particularly likely and although we would not expect returns in the second half of the year to rival those of the first, talk of an imminent sell off in high yield is probably wide of the mark.
Huge demand for high yield with low rates.
Modest economic growth ideal.
Credit quality improving.
Two global vehicles
'Further plug advice gap'
Must appoint separate CEOs and boards
Advisers do come out well
Will report to Mark Till