Rathbones’ Jones: High-yield default rates too optimistic

Jones Bryn Rathbones 700The guy from the John Lewis advert, sitting all alone on the moon, was once a bond fund manager in 1994. I think the Oasis-cover soundtrack was a hint of that – the original was released that year.

Our unfortunate lunar friend was banished after the bond market tanked in the 1990s. The US Federal Reserve decided to hike rates and he wasn’t ready; he was catapulted to obscurity as yields ballooned. Now, using his telescope he can look back at Earth to see what’s become of his old haunt. Just like the young girl in the ad, many bond managers will be looking back at him, more nervously than sympathetically, as they try to glean lessons from the past.

Our man on the moon could, just as easily, turn his sights on other planets. There he would find the lonely victims of the recent market ructions from US monetary policy: the latest spike in treasury futures and the accompanying expectation that the Fed will move rates higher in December has sent many assets wobbling out of orbit. REITs have ended up on a lonely bench on Mars, gold is melting away on Venus, and emerging market currencies are somewhere out past Pluto.

Some investors have already been burned by these moves and there could be more pain to come, particularly in high-yield bonds. There are several reasons for this, but the central one is the price of risk.

The risks we take differ, but each has a price to pay. Sometimes the market undervalues that risk and other times it puts too much of a premium on it. At the moment, the market does not offer enough return to offset the risks of default and poor recovery rates from high-yield debt, in my view.

The market is implying a 6 per cent default rate for investment grade bonds over the next five years. To put that in to context, the long-term average is just 1 per cent in Europe and 2 per cent in the US; the worst-ever rate was 4 per cent and 5 per cent, respectively. Compare that with implied defaults for high yield of 23 per cent in Europe and 30 per cent in the US over the next five years. Both regions had a worst-ever five-year default rate of 37 per cent.

While this number is above their shared long-term average default rates of 22 per cent, it belies a completely different picture to what we have seen in the past.

The high-yield market, particularly in Europe, has fundamentally changed. In trying to solve the ‘too-big-to-fail’ conundrum of modern banking, regulators have spawned a massive issuance of additional tier one capital and hybrids that are categorised as high yield. Coupons for this low-quality paper can be suspended or cancelled, and capital exchanged for equity or written down to zero, if the company gets into trouble.

This kind of quasi-debt has swelled five-fold in Europe to almost €100bn (£70bn) in the past three and a half years. This risk is being sold in monumental quantities by the banks. High-yield spreads above are much too thin to compensate for the risks these instruments carry. I believe the altered make-up of the high-yield market could make estimates for defaults, and the amounts recovered in such circumstances, far too optimistic.

Meanwhile, another menace for bondholders is the wave of mergers and acquisitions that is cresting over the equity market at the moment. These deals are usually predicated on debt and a way of offering better equity returns through financial engineering. Bond fund managers are simple people, we like to get a decent coupon and get our money back at the end. M&A usually lessens the chances of the latter.

Because of these reasons, I am not swayed by most fixed income opportunities apart from investment grade bonds. I prefer to wait for the post-Christmas sales – after the Fed hikes rates – there could be much better value elsewhere by then.

Bryn Jones is head of fixed income at Rathbones.