Marketed in the late 1990s as the next big thing, the high-yield corporate bond market is currently suffering from a lack of investor interest
Novelty has a limited lifespan and the new toy that appeared so appealing as a Christ- mas gift can soon become tarnished and unwanted.
There is something of this in the current attitude to high-yield corporate bonds. They emerged as virtually a new asset class in the UK as recently as 1998 and proved an instant success as the search for income intensified, but, in the face of deteriorating business conditions, have not quite lived to up to investors' rosiest expectations in recent times.
Current yields of 8% or more in this investment area are clearly attractive, but investors require reassurance over the near-term outlook before taking a more overtly positive view. They also need clear guidance from the past.
Lacking a long history of its own, investors in sterling and euro-denominated high-yield bonds must search for precedents in the US, where corporate bonds have long played a key investment role and the high-yield market is much larger and more deeply rooted.
So we are reliant on US data to illustrate the impact of various stages of the economic cycle on the fortunes of this asset class.
In the US, they have proved as sensitive to equity influences as to factors such as inflation and interest rates, which largely determine the fortunes of government bond prices. High-yield corporate bonds typically suffer in recessions as mounting pressures on issuing companies result in rising default rates and a corresponding widening of their yield spreads required to offset higher risk.
However, as economic recovery strengthens, default rates tend to decline, although this trend lags behind the turn in the economic tide. The resulting reduction in the yield required by investors can give rise to a substantial turnaround ' in 1991, the total return on US high-yield debt was 40%, while total returns over the 1990s averaged approximately 15%.
This shows what high-yield corporate bonds can deliver given a favourable economic environment.
UK investors, unlike their North American counterparts, have not had the opportunity to hold high-yield bonds through the economic cycle. It should therefore come as no surprise that inflows into US high yield funds have risen significantly this year, but that European buying interest in the same asset class is more hesitant.
While the weight of evidence points in the direction of a US-led economic pickup, high-yield bonds are currently taking a much more cautious view of business prospects than equity markets. Indeed, yield spreads on high-yield corporate bonds remain stubbornly above the levels reached during the Asian crisis of 1998.
Ironically, sovereign bonds of emerging countries, which were at the centre of the 1998 crisis, have been fundamentally re-rated since then and have delivered record returns to holders.
That re-rating of what was once a despised asset class should give heart to high-yield corporate bond holders, since it clearly shows that dramatic shifts in sentiment can occur, reflecting changing fundamentals. As Keynes famously declared: 'When the facts change, I change my mind.' So will investors in high-yield debt markets.
Default rates for high-yield bonds declined in February and March 2002, although there was a slight setback (to 10.4%) in April, reflecting specific problems for Argentinian companies and the final death throes of alternative telecoms providers. There is an extremely strong likelihood of a decisive turning point in the rising trend of defaults which has been in place since August 2000, the very time that US business fortunes suddenly turned sour and ushered in a phase of sharply declining corporate profitability.
An improvement in the business environment usually lags the turn in the economic cycle, hence the current caution of CEO outlook statements.
But we are confident this will emerge in the second half of the year and that rising interest rates will be a signal of central bank belief in corporate renewal. The two leading credit rating agencies, Moody's and Standard & Poor's, are both forecasting that default rates are set to decline significantly.
Standard & Poor's sees light at the end of the tunnel as economic recovery drives significant reductions in default rates through 2003 and 2004. These forecasts are bullish, but, as yet, the market appears loath to believe them. Investors, it seems prefer to sit on their hands, unwilling to act before they are presented with solid proof.
The current problem is one of newsflow. Corporate failures tend to make the headlines, especially when they are focused on a narrow range of sectors, such as cable operators and alternative telecoms providers. This impact has been heightened by credit downgrades suffered by companies with investment grade status, notably established telecoms service groups, like Deutsche Telekom and France Telecom.
Such investment grade bonds currently stand at yields indicative of a further decline in status. This gives a misleading picture. Yield spreads on the bonds of leading telecoms groups are stabilising and issuance is resuming to satisfy investor demand. Among issues in other sectors (consumer, industrial and retail) spreads have steadily narrowed.
The current pipeline of equity IPOs includes names like Focus Wickes and Yell whose bonds stand to benefit from balance sheet improvements that the issue of new equity will bring.
At the current stage of the economic cycle, there is a strong case to argue that buying a selection of high-yield corporate bonds is a safer way of playing the recovery theme than taking the equity route. At least if economic hopes are confounded, holders of these bonds will have a generous yield to fall back on.
Furthermore, it is particularly apt that credit analysts tend to focus on risk to a much greater extent than their equity counterparts, whose antennae are directed mainly towards reward.
There are, of course, ways to limit risk. Holding a well-diversified portfolio invested across a large number of credits (the M&G High Yield Corporate Bond Fund holds over 100 credits) is critical. Effective research and stock selection also play a vital role in minimising exposure to defaults and determining whether the market is correctly pricing in risk.
To return to our opening theme, new concepts inevitably face redoubled problems when tested by adverse economic and market circumstances. High-yield bonds have certainly faced a stern test, but, despite widespread concerns, they have typically proved more defensive than equities during the past four challenging years.
The prospective turn for the better in the default rate brings a promise of higher returns.
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