While there are signs the next 12 months will be better for high-yield investors following a turbulent 18 months, it will remain crucial to mitigate against downside risk
The past 18-months has been a volatile period for equity and bond investors.
The economic slowdown has seen significant falls in equity and high-yield bond markets as investors have sought a safe haven, typically in government bonds or highly rated corporate bonds.
Unless there is a major equity market rally between now and the end of the year, 2002 will be the third consecutive year of positive returns from gilts and negative returns from UK equities.
So far this year, the FTSE British Government All Stocks Index has returned 5.5% compared to -17.1% from the FTSE All-Share Index. The extent of the outperformance in 2001 was 18.8%, an increase from 14.4% in 2000.
Despite this weakening economic environment, which has not been positive for credit fundamentals, investment grade corporate bonds have generally performed well over the past 18 months, with spreads narrowing, particularly in the double-A and single-A universe. This contraction of spreads and consequential outperformance over gilts can be attributed to the strong demand for credit as a safe haven from other volatile markets, but also underlying shifts in investment policy by institutions, both pension funds and life companies.
At the extreme end, the Boots pension fund sold its entire equity portfolio valued at £1.7bn over the 15 months to July 2001, reinvesting into bonds. This was in response to changing accounting rules for pension fund liabilities, and will not be reversed.
At the same time as government bonds and investment grade credits have rallied, sub-investment grade markets have shadowed equity markets down. This has been disappointing for a sector that only emerged as a new asset class in the UK and Europe as recently as 1998 and proved an instant success as the search for income intensified. In the face of deteriorating business conditions, the sector has not quite lived up to investors' expectations in recent times.
Over the past 18-months, spreads have widened significantly (representing capital losses) and the number of defaults has increased greatly.
The source of many of the high-yield issues between 1998 and 2000 was the telecom and cable sectors. Technological improvements and the phenomenal growth expected in the market led to massive spending by telcos on 3G licenses and the required infrastructure.
Telecoms used the bond market to fund their activities, which resulted in enormous supply. However, the economic slowdown resulted in a scaling back of what now appear to be overly optimistic assumptions of market pricing and growth. This in turn led to a deterioration in the credit quality of many issuers and in most cases ended in defaults.
While the telecom and cable sectors were the main casualty of the global economic slowdown, issuers from more traditional industries have also encountered problems.
Many companies have seen their credit ratings downgraded by the credit rating agencies. In some cases, companies, such as Polestar (printers), have defaulted on their debt.
High-yield default rates in the European Union (EU) rose to a record high in the second quarter, surpassing both the global and US default rates for the first time since the second quarter of 2001. So far this year 38% of the nominal value of the European high yield market (valued as at the beginning of the year) has defaulted, compared to with a figure of 10.9% for 2001.
All of the above may paint a gloomy picture for higher yielding bond investors. While market volatility is likely to continue, price weakness in credits at the bottom end of the investment grade universe (triple-Bs) and within the high-yield market has created opportunities for investors.
Although the default rate increased in the second quarter, the majority of defaults are now likely to be behind us and any that are likely to occur have already been priced into the market.
Surprisingly, there are also positives to be taken from the past 18 months. Some companies have taken the opportunity to address balance sheet concerns. Elsewhere, particularly within the sterling market, several companies have tendered for their bonds after an IPO, such as HMV Media and William Hill. Other companies have indicated they are planning IPOs once equity markets stabilise or strengthen and subsequently would tender for their bonds.
The European high-yield market is also more diversified than it was, for two reasons. First, its exposure to telecom and cable issues has significantly fallen, from 71% at the beginning of 1998 to 26% (as at the end of July 2002). Second, the global slowdown not only affected the credit fundamentals of high yield corporates, but also those of investment grade issuers.
So far this year there have been a huge number of fallen angels, those credits that have crossed over from investment grade to high yield. In some cases, companies have suffered merely from the weak economic environment seeing their revenues fall and consequently their credit fundamentals deteriorate.
However, their long-term business models remain reasonably robust and assuming economic recovery it can be expected that they will perform well in the future. Considering that some of these so-called fallen angels are trading at attractive levels, investors have the opportunity to lock into excellent yields with the potential for capital upside once the economic and market environment improves.
Indeed, these opportunities also extend into the investment grade universe. While many credits have been spared the embarrassment of being downgraded to sub-investment grade some are trading at levels more commonly associated with high-yield issues.
Obviously, the main risk is another severe downturn in the economy, caused either by sluggish corporate earnings or geopolitical events. Many issues are linked to cyclical sectors that would encounter problems in such a scenario.
While accepting, in the short-term, that there could be a further period of economic weakness as economic data continues not to point conclusively to recovery, over the medium-term the likely economic scenario is one of a slow, steady recovery ' an environment that should be beneficial for corporates.
Although we are optimistic regarding the performance of higher yielding credits over the next 12 months, it is still crucial to mitigate against any downside risk. To this end the portfolios of Aberdeen Fixed Interest Unit Trust and Aberdeen High Yield Bond Unit Trust will continue to be well diversified with over 150 and 200 holdings respectively.
Despite the weakening economic environment, investment grade corporate bonds have performed well over the past 18 months.
The source of many of the high-yield issues between 1998-2000 was the telecom and cable sectors.
So far this year, 38% of the nominal value of the European high-yield market has defaulted.
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