A quickening of activity is becoming apparent in the high-yield corporate bond market, which saw the largest ever non-technology, media and telecoms sector new issuance last month
After a quiet period in August, signs of quickening activity in the new issue market for high-yield corporate bonds are beginning to appear.
Last month saw the largest ever non-technology, media and telecoms sector new issue of this bond category in Europe, with Jefferson Smurfit scheduled to raise E900m, denominated in a mixture of US dollars, sterling and euros. It is a measure of investor enthusiasm and the perceived value in the issue, a B-rated stock coming on a likely 10.5% yield, that demand is anticipated to be strong.
A favourable reception for the Jefferson Smurfit issue would be the green light for a number of non-technology, media and telecoms offerings, mainly originating from leveraged buyouts (LBOs).
Demand for high-yield bonds among US investors has already started to revive, which serves as a helpful indicator for the much smaller and less mature European market.
Given the current low level of long-term interest rates and the favourable terms open to potential issuers, companies would be likely to respond quickly to improvements in the market. Supply and demand in the high-yield debt market are rarely matched, which has led to short-term problems, such as lack of liquidity.
New issues are an important source of new ideas, although buyers have to exercise great caution. In 2001, for example, we bought only 10 of the 36 new issues. These produced capital appreciation of 3.5%, whereas buying into every issue would have resulted in a capital loss of 12%. This clearly illustrates the need for selectivity.
So far in 2002, we have bought eight out of 14 new issues. As a leading investor in the market, we have access to the senior managements of all the issuing companies. Our credit analysis team plays a critical role in analysing the merits of each issue and face-to-face meetings are an essential part of this process. We favour bonds issued by well-managed companies in stable businesses with strong finances and the ability to generate effective cashflow.
In essence, we are seeking a stable capital base, capable of sustaining a high level of income, and look at every issue on a case-by-case basis.
Even a slight relaxation in the current degree of risk-aversion would enable investors to focus on the generous yields on offer in this market, which stand in marked contrast to the low level of income available elsewhere. Yield spreads on BB and B-rated issues have widened since the start of the year, whereas spreads on investment grade corporate bonds, which have avoided being downgraded by the credit rating agencies, have been fairly stable.
The M&G High Yield Corporate Bond fund encompasses both sub-investment and investment grade bonds, in the proportion of 60% to 40%, although the core of the portfolio is in BBB, BB and B-rated issues.
Spreads on a typical BBB bond are 200 basis points, whereas the spread on B-rated issues currently stands at 500 basis points. Even when spreads have widened, the impact on holders has been mitigated by falling yields on government bonds.
In the case of 10-year gilts, this has declined from 4.9% at the start of the year to around 4.5% at present. In addition, since the portfolio is spread over more than 100 different credits, the impact of the few defaults incurred has had only a minimal effect on income payments to holders.
High-yield corporate bonds have been unsettled this year by the deteriorating equity market conditions, although, protected by their high yields, their modestly negative total returns compare favourably with the heavy losses delivered by even blue-chip equities.
The continuing high incidence of defaults, which have peaked at around 10% after signs of a slight improvement in February and March, directly reflects the pressure facing businesses from a combination of lack of pricing power and a hangover from the 1999/2000 technology, media and telecoms bubble. A sustained upturn in the US European high-yield market would herald a similar trend on this side of the Atlantic.
However, in the absence of a decisive turn for the better, only modest positive returns are likely. The 39% return in 1991 from US high-yield debt as investors discounted economic recovery seems unlikely to be repeated in the coming year, unless there is a dramatic strengthening of business conditions.
High-yield bond holders are thoroughly familiar with the need to look closely at the relationship between risks and rewards, in a way that equity analysts are only coming to focus on after more than two years of bear market conditions.
The high-yield corporate debt market is evolving steadily. Its composition has undergone substantial change, which has greatly improved its overall sectoral balance. First, the failure of many alternative telecoms providers has reduced its technology, media and telecoms content to well below the former 65% level. Second, new issuance has increased the weight and diversity of the industrial and other traditional sectors.
However, the most dramatic development has been the rising proportion of fallen angels, downgraded former investment grade bonds, within the index. With the inclusion of bonds issued by ABB, Alcatel, British Airways, Vivendi Universal and others, the index weighting of fallen angels has risen to around 35%.
We have taken a cautious stance on these stocks, holding the view that their debt and trading problems are unlikely to be speedily resolved. Their sudden arrival on the scene also threatens to distort the index, thereby creating a dilemma for fund managers using it as a benchmark.
With this in mind, Merrill Lynch has created a constrained index, which limits fallen angel representation by capping each company's weighting to 3%.
High-yield bonds have proved relatively resilient during difficult times, showing themselves able to contend with a challenging economic and business environment. The European (UK and Continental) markets, which are only in the process of becoming fully established, have survived a testing period and both investors and issuers have learned plenty of hard lessons. They are well paced to benefit from improving equity market conditions, whenever they arrive.
Buying into new high-yield issues in 2001 would have resulted in a capital loss of 12%.
Yield spreads on BB and B-rated issues have widened since the start of the year.
High-yield corporate bonds have been unsettled this year by deteriorating equity market conditions.
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