It is hardly a revelation to say that high yield bonds are more likely to default on interest paymen...
It is hardly a revelation to say that high yield bonds are more likely to default on interest payments than investment grade bonds. After all, that is what credit rating systems are all about. But credit ratings can only take a fund manager so far.
They are limited by the fact that they offer only a snap-shot of a company's financial position and include no assumptions about its future trading position. Similarly, while there is no question that high yield bonds are more towards the nail-biting end of the market, it is a fact that the risk of default assumed to apply to UK and European bonds bares little relation to the actual risks.
Credit Ratings only ever provide a historical snap shot of a company's solvency. They take no account of a company's likely future prospects, the value of its business model or the expertise of its management.
Default figures bear little relation to the actual risks attached to the European bond markets as they are based on historical US experience. This is crucial as the US has a completely different definition of default. As a result, defaults are far more frequent in the US But the market inefficiencies caused by modern credit rating and default data provide the margin in which an experienced bond fund manager can look to add value through stockpicking. This is particularly so for high yield bonds.
One of the key factors that has contributed to the growth of high yield issues is the huge investment into infrastructure that is being undertaken by communications companies. TMT stocks, such as Colt Telecom, BSkyB and NTL, have led the way here but activity is definitely on the rise in other industry sectors.
This is one of the ironies of the high yield bond market. While it remains poorly understood by investors and ignored by many advisers because of its perceived risks, many of its residents are, in fact, the same familiar stocks that helped to first ignite the technology boom.
So while advisers have been more than willing to pile their clients into technology funds, happily accepting the market's volatility as part and parcel of the growth story, they have ignored the fact that these same companies offer far more stable earnings to their bondholders than to their shareholders.
And of course, if such companies do reward their investors' patience by delivering their promised business models, any improvement in the share price will inevitably help lift the company's credit rating. Such positive event risks, as they are known by fund managers, will only increase the value of the bonds they hold.
The last two years have also quietly seen the rise of a new corporate paradigm which has helped swell the ranks of the high yield market.
Ironically, the pressure on today's management to deliver true shareholder value has accelerated the growth of the high yield bond market. There has been a steady rise in the average level of corporate debt as companies switch to debt issuance as a more cost efficient alternative to issuing new shares.
But as companies increase their gearing, so their credit ratings fall. This has triggered a credit migration as previously investment quality bonds drift down the rating scale.
Companies such as Marks & Spencer and BT are good examples of this trend. Both were formerly AAA rated. To meet the cost of its 3G licence, BT saw its credit rating drop from AAA to A in the space of a year and may even end up rated BBB next year, rapidly approaching the high yield sector of the market.
Of course, while companies struggle to deliver shareholder value through increased gearing, highly geared companies will want to reduce the cost of servicing their debts by improving their credit rating. The only way to do this though is for such companies to retain more of their dividends, so reducing the return for equityholders.
The cost of delivering this bondholder value has contributed to the rising volatility of equities as many companies lose the ability to offer an earnings stream. This raises the question of whether equity investment can any longer support the income-hungry as bondholders continue to extract the marrow from the best of the company market.
Whatever hidden value a bond issue might offer, it is still the case though that, the single biggest risk of default is from the kind of financial fraud perpetrated by the likes of Robert Maxwell or Nick Leeson. That is why, in this new age of bond management, it is imperative to meet the management of any bond issuer. In the new market paradigm, any bond manager that cannot talk you through the equity story on a given stock should be given a wide berth.
James Foster is director of credit strategy and research at RSA Investments
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