Despite a bad start to the year for high-yield corporate bond managers, the outlook for the sector looks good with short-term interest rates forecast to rise
It could be argued that the first two months of 2002 have not been kind to high-yield corporate bond managers. The interest rate cycle in both the UK and the US has turned, with short-term rates forecast to be higher by the end of the year.
Recent inflation data suggests prices are rising. Added to these supposed macroeconomic woes, fourth-quarter results from some companies have fallen short of expectations and downgrades have consequently continued apace. Most disappointing, however, has been supposed better-quality issuers such as Energis failing to live up to expectations and consequently announcing possible restructurings of their business and debt.
While it is easy to get bogged down by this negativity, investors should look forward to what we continue to believe will be a fruitful, yet volatile, 12 months for the high-yield sector.
Government bond markets are already anticipating an upward move in short-term interest rates because both the gilt and US Treasuries yield curves have steepened in recent months. In Europe, there appears to be further scope for another downward move by the European Central Bank, but we anticipate that rates will rise over an 18-month timescale.
Rising interest rates (and inflation) are generally seen as bad news for bond investors with the expectation of capital losses. This is true of government bond and highly rated investment grade credits.
However, the current economic environment and outlook suggests that corporate bonds on the edge of investment grade (BBB-rated) and some sub-investment grade issues should perform well, despite a rising interest rate environment.
Higher yielding corporate bonds are more susceptible to lower economic growth, rather than rising interest rates and a steepening yield curve, with lower earnings having a much more significant impact on a company's ability to service its debt. This is particularly the case with companies in newer markets, with no real established earnings base.
As a result of economic slowdown over the past 18 months, defaults and rating downgrades increased dramatically, which was reflected in a widening of spreads.
Ironically, a small rise in interest rates may be seen as a positive indicator for corporate bonds, signalling economies are recovering. Despite negative newsflow stemming from fourth-quarter company results, in all probability the US economy has bottomed.
Data from the US, such as the ISM New Orders (previously NAPM), US leading indicators and Michigan Consumer Confidence figures, have all recovered more strongly than consensus expected. Forecasts suggest US growth in 2002 will be below 2%. While we may continue to see rising unemployment and bankruptcies, these are historic issues, sometimes peaking 12 months after economies begin to recover.
A recovery in the US will be key to drive forward growth in Europe and the UK. The UK is probably the best positioned of the world's key economies. Swift action by the Monetary Policy Committee to ensure the softening global economy did not have a dramatic effect on the UK domestic economy, does seem to have softened the blow.
Recent data has continued to hold up well. Consumers are generally remaining fairly buoyant, though it is not clear whether the recent strength associated with the Christmas period will be sustained through the first quarter. However, the manufacturing sector remains very weak, underlining the two-speed nature of the UK economy to date.
In Europe, we are marginally above consensus in our estimates for economic growth in Continental Europe (1.3% for 2002). However, we are below consensus in inflation expectations and therefore more optimistic on the prospect for further interest rate cuts and the potential for them to remain low for longer. This translates to a conservative expectation of 5% earnings growth for 2002 ' not profitless, but not particularly exciting either.
Overall, investors can be cautiously optimistic regarding the macroeconomic outlook for the second half of the year onwards, with the result of economic growth improving company balance sheets, and consequently their ability to service their debt.
Despite this relative optimism, it is understandable that recent corporate newsflow has led to a certain amount of nervousness regarding the high-yield sector. However, market capitulation is always unpleasant, but is a necessary evil, sieving out those companies that will not survive into the next cycle from those that will.
Once this period is over, market visibility is likely to be much clearer with price changes based on fundamentals, rather than contagion resulting from the disappointing performance of specific company impacting on the whole sector. This has been particularly the case within the telecoms sector.
On the upside, the level of defaults in the US appears to have peaked, while forecasts for the European market suggest that peak levels will be reached in the first half of this year. This view is based on the number of companies that have already defaulted, those that are still candidates, and the expectation of an improving global economic environment in the second half of this year.
The default picture in the US during 2001 has been very reminiscent of the last recession in 1990/91, with default heading through the 10% level and the figure for 2001 being 10.2%, according to Moody's.
The picture in European high yield defaults has not been pleasant, with a default count of 16%, the split being industrial defaults 7.8% and telecom defaults 19.4%. These numbers amalgamate European currency and sterling high-yield bonds. This compares with a number of only 2.4% in 2000.
Defaults in both the US and Europe may have peaked (or neared their peak), but volatility is likely to continue. In this kind of environment, it would be prudent to focus on better quality companies further up the credit rating scale. Despite favouring better quality credits investors can still receive a high level of income.
Bonds within the triple B credit range ' which have come under pressure following economic weakness ' are now trading at their cheapest levels for some time. Within this part of the market, credit rating downgrades have been rife, some names have seen their ratings downgraded to below investment grade.
Other credits are trading on yields that are higher than their current ratings would normally command. Some will fall into the lower rating category justifying the higher yields, while others should maintain their investment grade status, enabling a rally. However, there are some attractive yields to be locked in at the moment.
Further down the credit scale, investment decisions need to be made on a case-by-case basis. There are many single B credits that have robust and successful business models to not only survive into the next cycle, but to perform well. However, these kind of single B credits, such as Alfa Laval and William Hill, are tightly held and do not offer new investors much value.
Similarly, in the triple CCC, those credits likely to live to see the start of another economic cycle have already seen some price appreciation. The hard part is identifying those credits, with problems still hanging over them, which are likely to be resolved without the company defaulting on interest payments to creditors.
Overall, the macroeconomic environment, assuming a second-half recovery, is favourable towards corporate bonds, despite the prospect of interest rate rises later in the year. It has to be remembered the high yield sector enjoyed its best ever year in 1991 returning 34.58%, according to Merrill Lynch, despite a record high default rate and negative US GDP growth.
While we are not forecasting a similar level of return in 2002, spreads will narrow and even a conservative estimate of about 8%-10% compares favourably with other asset classes. But the market will be volatile.
Longer-term, the outlook for corporate bonds is healthy. Supply is likely to continue apace as companies seek to finance their businesses, while on the demand-side investor appetite for income is increasing in line with changing demographics.
In addition, an increasing number of investors are looking at corporate bonds as total return securities. As highlighted in the recent Barclays Equity-Gilt study, corporate bonds outperformed equities over the past 10 years. Because of expectations of lower returns from equities in the future compared with previous periods, we would expect some institutions to increase their exposure to credit.
While the past two months may have been unpleasant for high-yield managers, overall it is better to get any short-term pain out of the way and focus on the rewards to gained from the sector in the coming cycle.
A small rise in interest rates may be seen as a positive indicator for corporate bonds.
Defaults in the US and Europe may have peaked, but volatility is likely to continue.
Supply in the corporate bond sector is likely to continue as companies seek to value their business.
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