With high-yield bonds significantly less exposed to interest rate rises than their government and investment grade counterparts, they should outperform if sentiment changes towards a rising interest rate environment
Revelations of accounting misdeeds among a number of large multinational global corporations, including the high-profile scandals at Enron and WorldCom, have dented investor confidence in many asset classes.
Sentiment has plummeted and global equity markets have tumbled. Meanwhile, the negative impact of these accounting misdemeanours has similarly been felt within the fixed income markets. While government bond markets have remained a relative safe-haven, the backdrop of corporate uncertainty has spilt over into both the investment grade market and even more so into the high-yield market.
Poor accounting compromises a company's ability to service its debt repayments and its dividends, which is negative for both bond and equity holders alike. As a result, we have witnessed a much stronger correlation between the performance of the equity and high yield markets than has historically been the case ' so much so that investors now appear unsure of where best to invest their money.
Many commentators would argue that at this stage of the economic cycle ' as economic activity begins to re-accelerate ' the best place to put one's money is into equities. But for a number of reasons we do not believe this is necessarily the case this time around, especially given current market circumstances.
First, the concept of shareholder value is dying. Historically, shareholder value had pushed companies into raising their gearing levels at the expense of credit ratings.
For example, companies would buy back shares or issue a special dividend, deliberately increasing their levels of gearing. Sentiment has now reversed however. Companies with low gearing are being rewarded by a comparatively better share price performance than that of their peers (although their share prices have probably still fallen in absolute terms).
This environment encourages companies to reduce their gearing by all means possible, including rights issues, cuts in dividends and aggressive cost cutting techniques. This scenario is not positive for equities but must be treated as being positive for bonds. Falling debt levels are associated with improved ratings over time.
British Telecom is a very good example of this, where in 2001, dividends were cut as a rights issue was introduced. As a result, its credit rating now looks set to improve. Second, the inflationary environment remains very benign. Global interest rates are unlikely to rise in the short-term and this means that companies are unable to raise prices.
Instead, they are forced to cut costs to achieve growth for their businesses, which may not be sufficiently successful to enable them to increase their dividends. Dividend growth in a low inflation environment looks set to stay low, reducing the attractiveness of equities.
Bonds meanwhile have a fixed coupon and this needs to be paid, otherwise the company will fall into insolvency. This is similar in the way an individual has to pay their rent or mortgage, which therefore tends to focus the attentions of management.
The 14 August deadline for the leaders of the US' largest companies to attest to the accuracy of their financial statements passed without incident. Confidence in accounting numbers has only partially been restored however, with bond investors appearing to remain on the sidelines as they await news of the next big scandal.
Now, with the prospects of an impending global economic recovery and the likelihood of higher interest rates, equities are likely to continue to suffer from a de-rating, particularly in light of the fact valuations remain stretched (especially if you look at historical price to earnings ratios). So while many say that now is the best time to invest in equities, we believe that there is excellent value to be had from the high-yield markets at present.
Government bonds (thanks largely to their safe-haven properties) and investment grade bonds (which like government bonds are highly geared to the interest rate cycle), have already had their strong run and market upside now appears limited. While domestic interest rates remain at very low levels, the Bank of England may yet reduce interest rates even further, but the bottom of the cycle is in sight.
So, if sentiment changes towards a rising interest rate environment, investment grade bonds like government bonds will tend to underperform high-yield bonds. This is because the high-yield bond markets are significantly less exposed to interest rate rises than their government and investment grade counterparts, as a greater proportion of the overall yield is represented by company specific credit risk.
Instead, the performance of high yield is increasingly affected by the global economic cycle. In light of these factors, we believe that there is a stronger case for holding high-yield bonds within an investment portfolio.
Admittedly, the global high-yield market has suffered considerably during recent times. Question marks surrounding the sustainability of the global economic recovery have plagued the market, while harsh business conditions and the telecoms market debacle have led to a dramatic increase in default rates. However, the market now appears to have priced-in the worst of the news.
Growing expectations of a benign economic recovery and an improved corporate backdrop should lead to a reduction in default rates.
In fact, credit rating agencies such as Standard & Poor's and Moody's are beginning to see evidence that suggests we are close to the trough in the default cycle. Another measure is the ratio of companies that are being downgraded relative to those being upgraded.
The evidence here demonstrates that the downgrade cycle appears to be slowing. Therefore, going forwards, positive sentiment on the back of an easing of credit quality concerns should more than compensate for any increases in interest rates that an economic recovery may bring with it.
There are some risks however. First, if the global economy falls into a harsh recession, then default rates will again rise and high-yield bonds will not be an attractive asset in which to invest.
Second, if there is a spate of deflation, similar to that seen in the telecoms market over the last 12 months, high-yield bonds will again also suffer. This is because high levels of fixed-rate debt will need to be serviced by a falling income stream and this could ultimately lead to the company becoming insolvent.
Both of these risks are perceived as being unlikely. However, while the market is discounting a war with Iraq, a protracted campaign would further dent confidence and would also result in the underperformance of high-yield assets. We think that this is doubtful and that the market is discounting too much bad news. In fact, a point worth noting is that historically, the first signs of aggression have often provided fund managers with the best buying opportunities.
All in all, the high-yield markets appear to offer investors excellent value. Yields are very attractive, while the prospects of an improvement in global economic fundamentals offers the potential for some capital growth.
In the longer-term, experience has also shown that the volatility of high-yield bond markets remains comfortably below that of equities and therefore offers a greater stability in returns.
With recent accounting scandals having made investors increasingly aware of the balance sheet positioning of global corporations, bond markets look set to benefit further from calls to reduce financial gearing. In contrast, equity markets could be held in check as companies instead look to raise finance on the equity markets
Government bonds, thanks to safe haven properties, and investment grade have already had their strong run.
Dividend growth looks set to stay low, reducing the attractiveness of equities.
If sentiment changes towards a rising interest rate environment, investment grade bonds will tend to underperform high yield.
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