By Stephen Snowden, portfolio manager on the fixed income desk at Aegon Despite rising yields in...
By Stephen Snowden, portfolio manager on the fixed income desk at Aegon
Despite rising yields in the gilt market, corporate bonds flourished in the final months of 2002. All sectors experienced some degree of spread tightening against the government benchmark. Perhaps surprisingly, the star performer was the sterling high yield market, ahead by 5.7%. However, that was against a 10% fall in the third quarter. And, over the year as a whole, the sterling high yield market has returned a woeful -1.5%.
Things could be worse ' and in continental Europe they certainly have been. The euro high yield market fell 14% in 2001, after a 16% drop in 2000, mainly because of the continued fall from grace of the European technology, media and telecoms sector.
During the 1990s European bond investors grew used to high returns, through investing in Spanish and Italian government bonds, for example. With the advent of the euro, high yielding bonds appeared to provide a suitable alternative.
In hindsight, European bond investors did not subject the high yielding bond issues to appropriate critical scrutiny. The result is that when recession loomed, many telcos threatened default. Cable and telecom stocks were devastated. For example, NTL's bonds started the year at £80 and ended at a woeful £30. A default by NTL is highly likely during 2002.
Thankfully, the UK high yielding market has some important differences, such as a broader range of sectors, not only telcos but also industrials. While the market is small it is less exposed to cyclical industries such as telecoms ' hence the relatively better performance. However, the UK market remains too small for a solely high yielding sterling fund aimed at the UK retail market.
There are, of course, risks. High yielding bonds may be less risky than equities but are considerably more so than investment grade corporate bonds, and the last few weeks of 2001 were the most volatile for high yield bonds since September 1998. First, there was the widely-publicised collapse of Enron: while this was an investment grade issuer, its sterling high yield subsidiary Azurix fell by a third after an adverse ratings agency report.
Then concern about other power producers spread. Calpine, more than 5% of the index, fell a third before rebounding. AES Drax halved in December on a completely company-specific issue. In addition, technology, media and telecoms has once again fallen from grace.
All told, the sterling high yield market underperformed the investment grade market by more than 3% in December and 11% in 2001 as a whole.
Nevertheless, there remain opportunities for managers with experience of the asset class, who are prepared to subject potential investee companies to rigorous equity-style analysis. What is the company's interest coverage and its capital expenditure? What covenants are in place and how is its debt subordinated?
The sterling high yield market looks better in the near future than continental Europe or the US. It seems assured of a strong demand in the months ahead, bolstered by the various 10% per annum income funds offered by UK banks and insurance companies.
Much of the TMT pain has been suffered.
Strong demand for high yield.
The market continues to grow and diversify.
NTL default is highly likely in 2002.
UK too small for high yield bond fund.
High yield remains a high-risk asset class.
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