"Volatility and momentum are the two things that a fund manager needs to make money," Tim Webb, head of the global alpha fixed-income group at BlackRock in London, told a gathering of journalists last month. "When an asset class behaves in a non-normal manner it becomes very difficult to trade. Beware of the crowded trade. If you see a trade that lots of people are talking about it is probably one to avoid."
If there is one trade that everyone is talking about at the moment it is high yield. The average annual return in European high yield since 2003 has been 14.4%, compared with 11.9% for US high yield, 8.7% for the S&P500 and 6.4% for Euro Stoxx over the same period. The year-to-date return for the Markit iBoxx Global Developed Markets High-Yield Index on November 22 was 12.981%.
|Robert Marquardt, chairman and co-chief investment officer at investment manager Signet Group|
"Everyone dips into high yield for outperformance," says Steve Logan, head of European high yield at Scottish Widows Investment Partners (Swip) in London, although he points out that double-B credits are more akin to a hedge against a falling market than a source of outperformance. "There are a lot of tourists in this asset class."
This raises several questions familiar to any beachside hotel owner: how long will the tourists stay and how much damage will they leave behind?
In Europe, high-yield flows turned negative for the first time in 23 weeks at the end of November.
Despite growing signs of overcrowding and some sign of pull-back, they are likely to stay a while because there are very few other places to go. "Should one stay out of a crowded market?" asks Alex McKenna, head of fund structuring at Deutsche Banks db-X Financial Products. "You might find yourself not doing very much from time to time."
He argues that by focusing on relative yield as well as absolute yield there is still nuance to be found. For example, Deutsche Bank launched its Sovereign Optima fund last April to capitalize on pricing differentials not driven by credit quality in the SSA universe and cites this as an example where value can be found. "You could call this an example of smart beta," he says. "Pricing anomalies can eventually be squeezed out [in a crowded market] but if there are solid reasons for the anomaly to exist that can take some time," says McKenna.
To find value in high yield, investors now need to look for smart beta there too. "People have migrated to high yield via ETFs and high-yield mutual funds where they are probably getting 6.5%," says Marquardt. "But this is for generic, on-the-run issuers. There is not a lot of inflation at the top or defaults at the bottom, so 6.5% yield is probably not bad, but 6.5% can go to 5.5% very quickly it has been there before.
"As soon as you move off the run, spreads get 200bp to 250bp wider and lesser-known names can earn you 8% or 9%."
Signet launched a new high-income bond platform in November that will take advantage of under-researched and off-the-run opportunities in European and US high yield, and Asian and Russia/CIS bonds. "You need to look at unrated bonds, complicated balance sheets, bonds that may be called or firms that need to refinance," he says. "There is a large mass of bonds out there that are not widely followed now that the prop desks and many research functions have gone. As soon as you go off the run things start to get a lot less crowded."
At the single-B level, high yield represents a very asymmetrical risk: you either get par or better if the firm is bought out or you get 35c to 40c in the dollar if it defaults. There is a large imbalance between demand and supply and a strong lobby to encourage firms to issue. "Banks are pushing companies into the high-yield bond market but it can be quite expensive for them to issue," says Daniel McKernan, head of UK and European credit at Swip. "Underwriting fees are 2% and there are auditors fees, rating agency fees and execution risk. This is expensive but we are seeing potential issuers such as housing associations every other week."
The mismatch between issuance and investor appetite has meant that yields have fallen from around 9% at the beginning of the year to 5.5% now. "We are bouncing along the lows for yield," McKernan observes, and now he questions how long the tourists will stay. Volatility and defaults could tick up particularly if the number of fallen angels starts to rise. Arcelor Mittal was downgraded by Moodys to Ba1 on November 6, becoming a large new entrant to junk territory. "Fallen angels are an issue for high yield," McKernan adds. "When Arcelor Mittal fell out of investment grade the whole high-yield curve moved 1% lower. But this is an opportunity as well as a threat and so far the market has coped with it."
Logan suggests that equities might now start to be a viable alternative to high yield for asset managers, maybe relieving some of the overcrowding in the space. "High yield starts to look a bit challenged if you look at large-cap equity," he says. "You can get 5.5% from high yield but you can also now get that from large blue-chip equity, which will have a better balance sheet than a double-B rated high-yield issuer."
For investors with the ability to really reach down the curve, issuance of payment-in-kind (PIK) notes has revived this year a sure sign if one was needed that the market has overheated. In the US, $6 billion-worth of PIK notes have been issued so far this year, $2.1 billion in September alone, according to Bloomberg. The issue of a $200 million PIK note by Polish telecoms group Polkomtel in February heralded the return of the product in Europe. At the end of October, Barclays was marketing a £550 million ($877.7 million) 10-year PIK note as part of the £1 billion takeover by private equity group Terra Firma of residential property firm Annington Group. The deal was upsized from £500 million, with initial price talk indicating a 13% coupon.
The deal will be the largest global PIK note this year and the second-largest sterling high-yield trade ever. It will also leave the firm with a highly levered capital structure: 16% equity to 84% debt. Moodys has rated the PIK notes Caa1.
The emergence of deals such as this does introduce a level of unease into a market already seen as very frothy. "Everyone is going for the same trade," warns Webb at BlackRock. "High yield is a good asset class but I would be wary," he tells Euromoney.