The prospects for the high yield market over the next couple of years are good. Retail demand has be...
The prospects for the high yield market over the next couple of years are good. Retail demand has been incredibly strong and investors are hunting for yield as government bond yields have fallen so sharply.
This is despite a credit crunch last year, which was precipitated by the collapse of Long Term Capital Management and the default of Russian bonds.
The future now looks far more encouraging despite a steady issuance flow through 1999 and further issuance expected next year. The dominance of the concept of shareholder value across the UK and the gradual acceptance in Europe, is encouraging the high yield market.
The principles of shareholder value focuses management time on maximising total returns to the shareholder. To achieve this, a fund manager needs a highly efficient capital structure. Historically, that implied a predominance of equity. Now, with inflation and yields lower, a far higher proportion of debt is needed to produce the most efficient balance sheet structure.
The birth of the euro has served to encourage competition between all European companies.
This has reinforced the need to restructure corporate balance sheets and led to an increase in euro high yield bond issuance. In the US, the same philosophy developed a high yield market over 10 years ago. The US is now well established with an active market and has produced some very good total returns over the last five years.
Traditionally banks have been the natural source of debt finance. Banks are limited in the amount of capital they can provide, particularly for highly capital intensive companies. The role of the bank is changing, especially in Europe, as they increasingly become providers of short-term liquidity, rather than long-term finance.
This year has seen E6.4bn of sterling and euro high yield bond issuance according to Barclays Capital, comfortably exceeding the total in 1998.
The trend is for even greater issuance in 2000. The level of demand from institutional and retail investors has absorbed much of this supply. Further, the US fund management groups have played an important part in the success of new euro issuance.
Diversification is the key to managing high yield bond portfolios. Too high an exposure to an individual company, which then falls out of favour or even defaults on payments, would have a very significant effect on the overall fund performance. Defaults in the US have been increasing, however, this is due to an increase in the number of very lowly rated companies.
The range of companies issuing bonds is expanding rapidly. One of the big concerns, however, is the focus on individual sectors. For instance, telecoms companies have seen a large number of issues, as cable and mobile companies need capital to build their networks. The current outstanding market value of these bonds is 51% of the European market. There is a danger of too much specific risk to sectors.
Recent evidence has demonstrated how well European and UK companies are performing. Default rates in the UK and Europe are low and company profitability has been stable over the past 12 months, despite recession fears in 1999.
The prospect for the high yield sector into 2000 is very attractive. Firstly, demand is strong from a range of sources. Secondly, low inflation and interest rates combined with good growth prospects across Europe and the UK are very positive for the high yield market. High yield funds will become the mainstay for many investors seeking income.
James Foster is senior fund manager at Royal & SunAlliance Investment Management.
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