Which will be the best performing bond market this year? The safer investment grade or the riskier h...
Which will be the best performing bond market this year? The safer investment grade or the riskier high yield? Our view is the high yield market should outperform this year for a number of reasons, not least because of the event risk inherent in investment grade issues at the moment.
Investment grade bond performance is more influenced by government markets than high yield bonds are, so further good government bond performance will help them.
The current lack of government bond supply is creating a scarcity value for gilts and treasuries. Although this helps their performance, it has a negative impact on the swap market, pushing swap spreads wider.
Swap rates dictate the level a corporate issuer can issue in the fixed rate market and swap back into floating rate obligations. As swap spreads widen, so do the spreads on investment grade issuers bonds. With swap spreads historically wide, investment grade bonds look cheap but it is questionable whether the situation will improve in the short term as government supply abates.
Event risk is the big problem for these bonds though. The issuers are basically old economy stocks. Many have seen their equity prices slump dramatically with the rise of the new economy stocks and the perceived threat of the internet to their businesses. There is then greater pressure on management to maximise shareholder value. This could lead to more debt issuance to buy back shares, M&A activity, LBOs or taking the company private.
With the exception of M&A activity, these are all negative for credit ratings and bond holders. Increased debt increases the financial risk in the company. LBOs put large levels of debt in the structure relative to equity and taking the company private makes it much harder to get information on what and how it is doing.
The effect of M&A activity depends on how it is structured. A mainly debt-financed bid for another company is generally bad news, while an acquisition by a better-rated company or an all-paper merger is usually good news. Covenants can help but many bonds outstanding have no such protection.
High yield bonds do not have such a problem with negative event risk. Any event risk for them is likely to be positive. They are already lowly rated, so any acquisitor is likely be higher rated and so credit positive for them. With high levels of debt already in their structures, they are unlikely to raise more and pay down equity.
Many have little equity in their structures so are less affected by shareholder value concerns and depend far more on high yield debt markets for their funding making them more bond holder focused. Combining this with their greater correlation with equity markets and you have bond performance well suited to the current global environment. Growth looks set to be synchronised across all major economies and inflation is well behaved at low levels.
Weak tech stocks remain a problem as such large proportions of the issuers in this fledgling market are such companies. The losses on the Nasdaq recently caused a fall out in high yield bonds. More stock market weakness would be bad news.
Alix Stewart is investment director at Standard Life Investments
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