Timing the call before spreads rise

The downturn hit returns on the European High-Yield Index but the asset class is less volatile on the downside than equities. However, investors should wait before increasing exposure.

In the 12 months to the end of July 2008, the European High-Yield Index (EHYI) has felt the pain of the credit crunch, with a total (sterling) fall of 5.4%.

This is no surprise considering that, at the end of May 2007, the spread on the index (over underlying Bunds) had narrowed to an all-time low of 193 basis points (bps).

Given that high-yield default rates over an economic cycle tend to average about 4-5%, a spread of 193bps was too tight and high-yield investors were not being compensated enough for the credit risk they were taking. At the other extreme, the spread on the index, at 834bps as of August 20, 2008, is pricing in a lot of bad news.

The spread is pricing in default rates in excess of 6% for 2008, compared with a trailing (past 12 months) default rate of about 0.7% in Europe.

Although default rates will rise from these low levels, barring an extraordinarily sharp and sudden downturn in the eurozone and emerging Europe regions, it is unlikely that we will witness the 6% rate implied by these spreads in either 2008 or even 2009.

This is because most European high-yield companies refinanced in 2006 or early 2007 on generous terms and were able to push back debt maturities towards the end of 2010 and beyond. However, if the capital markets remain closed for the next two years, defaults will exceed their historical norm as a flood of companies refinance in late 2010 and early 2011.

However, if normality returns to capital markets at some point within the next two years, European high-yield default rates may not edge up to 6% any time soon.

High-yield versus equities A high-yield bond is a hybrid between the debt and equity of a company. Similar to an equity, it enjoys the benefit of a material upside in terms of capital appreciation in a favourable macroeconomic environment (in which companies are generating ‘excess’ cash and are therefore incentivised to refinance and take out their most expensive debt at a ‘premium’).

In a bear market, high-yield bonds’ defensive, fixed-income characteristics kick in, making them less volatile on the downside than equities. Unlike a dividend payment, the coupon on high-yield debt is not discretionary and, if the company is not able to meet its interest payment obligations, management loses control of the company to its creditors.

Over the past 10 years, the EHYI has outperformed the FTSE 100 index and the FTSE All-Share index on a cumulative basis, but it has underperformed the Dax index.

The annual equivalent return from the EHYI has been 4.8%, compared with 4.0%, 4.7% and 5.8% from the FTSE 100, FTSE All-Share and Dax indices respectively. On a risk-adjusted basis, the EHYI provides a ratio (of just below 1.5) which is well above any of the three equity indices.

Potential buyers of high-yield The European high-yield market does not have the same depth as that of America. In America, new high-yield deals were being priced at the height of risk aversion in early March 2008. This is because high-yield bonds are considered to be a viable alternative asset class with dedicated pools of ‘real’ money; rightly so, considering that, since the early 1990s, American high-yield bonds have provided similar returns to the S&P 500 index, but materially better returns on a risk-adjusted basis.

In Europe, the total size of the high-yield bond market is about €90 billion (£73 billion) including floating rate notes and payments in kind.

Precise figures are hard to determine, but it is estimated that European real, unlevered money appetite for high-yield bonds is about €70 billion, of which 20% is either in cash or investment grade.

Apart from real money buyers, the other big participants in the market have been hedge funds, collateralised debt obligations and investment banks’ proprietary desks.

It is almost impossible to measure the appetite of these groups, but it is safe to say that their active participation played a significant part in the tightening of high-yield spreads to roughly 190bps in May 2007. These groups will gradually return to the asset class as the pricing in by the market of a high default rate provides an attractive entry point.

‘Carry’ is important for any fixed-rate instrument, but even more so for high-yield bonds when evaluating their total return potential. It is because of carry that high-yield bonds could provide attractive returns even in a rising default environment.

Below are three scenarios of the potential total return (if money was invested today) from high-yield bonds over the next 12 months.

European high-yield bonds would provide a positive return in all three negative scenarios. Moreover, it is even possible to achieve double-digit returns in a widening spread environment by timing an optimal entry point into the market.

For example, over the period from July 2002 (spread at 1,077bps) to July 2008 (spread at 807bps), European high-yield bonds provided an annual sterling return of 11.1% and, during this period, spreads ranged from about 190bps to 1,200bps.

In the same period, the FTSE 100 provided an annual return of 8.2%. However, in a rising default environment, it is important to invest in a diversified fund to ensure that returns are not adversely impacted by event risk.

Attractive entry point in late 2008 or early 2009 As with all risky asset classes, the market tends to take extreme positions at both good times and bad times. In European high-yield, we are close to the bottom, but we do not suggest we are there yet. Timing the exact entry point is more an art than a science since it depends on market sentiment.

However, on a fundamental basis, our model suggests that European high-yield spreads will rise to about 880bps by June 2009. However, spreads tend both to ‘undershoot’ and ‘overshoot’ and, given the weak economic backdrop, we would look for the index level to be trading at a spread in excess of 950bps, which would imply a default rate in excess of 8%, before we recommend being neutral or overweight the asset class.