Has the rally in investment-grade European credit year-to-date – leaving little room for downside protection and interest-rate risk – helped to boost real-money demand for high-yield corporates?
That’s the hope from high-yield debt syndicate bankers amid an expected deluge of leveraged loans from lower-rated corporates that will need to be refinanced in the bond market in the coming years.
Citing low yields for investment-grade corporates, with the iBoxx non-financials yield now at a record low of 2.71%, analysts at Société Générale offered some hope with the following recommendation on Tuesday:
“At the moment, we prefer to invest in solid BBB or BB corporates in short maturities (three to four years) with a 3% to 4% yield, than in long-term paper of single-A corporates that offer under 3%, and also like the T1 bonds of the solid core national champions.”
Eurozone fears have moderated the pace of new European high-yield bond supply with just €3.6 billion between April to mid-June, according to Dealogic.
However, SocGén notes that the probability of corporate defaults is relatively low – and less than what iTraxx indices imply – while corporate cash balances remain high across the corporate credit spectrum. These forces should boost the allure of lower-rated issuance for yield-starved, real-money investors in Europe, the bank argues.
At the same time:
“... the low yields [in high-grade debt] pose a problem for 2013. They mean significantly less carry, the tighter spreads leave less room to improve, and with the sovereign crisis still raging and the economy slowing, generating the strong returns of the past will become increasingly challenging”
As a result, high-yield bonds offer upside potential, the analysts say.
However, if the eurozone crisis triggers a dislocation on the scale of Lehman Brothers collapse, take note – between August 2007 and February 2009, high-yield markets failed to see a single public offering, underscoring risk aversion and the lack of liquidity in Europe relative to the US.
Finally, here’s a timely reminder why corporate credit, and high-grade bonds, in particular, have been the jewel in the crown for cross-asset class investors in recent years. It’s all down to the volatility of equities – a stubbornly high-beta asset class – as well as the new-found instability and bifurcation of eurozone government debt markets, SocGén says:
“Corporate credit has become an increasingly important investment over the past five years with non-financial corporates emerging as the preferred choice. With an air of crisis engulfing the financial markets since the sub-prime meltdown, the non-financials sector has taken over the defensive duties in its attempt to weather uncertain economic and financial market conditions.
We are of the opinion that while the sovereign crisis continues to hold centre stage, at a time when the economy is slowing down, there is unlikely to be a major shift in attitude from non-financials that will compromise much of their hard-won balance sheet integrity. In that sense, we would look for releveraging risks to remain low, rating transmission risks to be slow, M&A activity to remain subdued, with investment and capex largely funded conservatively and where possible, from recurring free cash flows.
While these fundamental factors remain supportive, technical ones do too. Capital (re)allocation has seen heavy inflows (capital preservation and a fixed return) and they have supported a doubling in size of the €-denominated corporate bond market to €1.3trn in just three years. The fall in the bund/swap yield and the shift towards adding credit risk has reduced the refinancing risk for corporates in investment grade and high yield, allowing them to achieve their lowest-ever funding costs. Additionally, with safe haven government bond yields set to remain at very low levels for a long time, and equities volatile and vulnerable to the slowdown in the economy, IG credit is emerging as the asset class of choice.”
Low yields on high-grade corporate bonds reflect investor demand, in particular, for multinational corporates with diverse revenue streams and large cash piles, as well as the impact of ultra-loose G7 monetary policy. With financial repression here to stay, analysts are united in their belief that monetary policy will centre on depressing yields on conventional assets to try to galvanize animal spirits, which could serve as a potential cyclical boost for high-yield bonds. That's barring a freezing of global credit markets if the eurozone crisis intensifies further.