11th April 2012
High yield bond funds have been the big hit of 2012. In the first quarter alone, corporate bond funds at the riskier end of the spectrum have attracted as much money as in the entire twelve months of 2009 – when cash cascaded out of equities and deposit account interest rates crashed to record lows.
According to EPFR Global, a data company, $30.7bn flooded into high yield corporate bonds – just a billion or so short of 2009, the best ever full year which attracted $31.8bn.
But the fast flow into the riskier end of the bond markets comes against a background of several warning signs.
· Goldman Sachs has forecast that the coming year will be better for equities than for bonds. It has placed European high yielders high up on its sell list.
· Most UK investment professionals say government bonds are either somewhat or very overvalued. Half of the same group believes corporate bonds are in these two categories – only 1% believes bonds are very undervalued.
· Default rates are currently low – history suggests they are more likely to rise from here than to fall further.
· Fund managers say that unless there is an improvement in economic data, a market reversal could be close.
The definition of high yield bonds can vary. But most investors opt for Standard & Poors ratings starting with B or C. Currently, they can yield as much as 7.2% for US bonds and 8.4% in Europe. This is equal to 520 basis points (5.2%) above the US Treasury ten year benchmark while the European average (which contains a number of bonds in Euro danger zones) stands nearly 670bp above the ten year German bund.
High yield compensates default risk
Investors in these bonds rate the default risk as more than compensated by the spread over risk-free government bonds. A bond can be in default if it is late with a payment. And even if the corporate is bust, there may still be some return. Bondholders stand before equity buyers when a company goes under – they often salvage some or all of their investment, sometimes with the help of their combined muscle.
Bond buyers believe that the current low defaults will stay – or even trend lower. Over the past year, the default rate has dropped to as low as 2 to 2.5%, half typical period and a quarter of the percentage seen in the immediate carnage after 2008.
The fund manager confidence that this will continue is based on buying into strong balance sheets. Companies now retain cash rather than spend on acquisitions or new projects.
Insurance companies are also switching out of their remaining equities to chase high yields, driven partly by the European Union Solvency 2 directive.
Risk-on beats risk-off
And at the more speculative end, the flow into high yielders reflects the "risk-on risk off" investment style. Because investors have become more optimistic, they are switching from the safest assets such as US Treasuries or UK Gilts into riskier bonds, taking the risk-on side of the equation. I
The fall in market volatility also directed money into higher yielding bonds but much of this was rolled-over refinancing rather than new money to fund fresh projects. Investors figure that ultra-low interest rates will enable corporates to re-finance at low rates well into the future. This gives a cushion against defaults.
And some bonds in the high risk spectrum are effectively linked to equity prices. The logic is that if companies at risk of default do well, their share prices rise and this drags up their bonds, reducing their yields and making them more attractive to lower risk investors. So bond buyers can get the comparative security of the bond on the downside with an equity-like exposure on the upside.
The big surge into high yield corporate bonds came despite many investors labelling them as "junk".
Buying overvalued bonds
But are institutional investors any better than those private investors who buy at the top and sell at the bottom? With all that contradictory data flying around, it is always possible to justify any decision.
CFA UK, which describes itself as "the UK's leading association of investment professionals" has just published the results of a survey showing members have turned against bonds, regarding them as over-valued and hence likely to fall.
They are most doubtful about government bonds with 43% saying they are very overvalued and 35% rating them as somewhat overvalued. Only 8% believe they are somewhat or very overvalued.
The corporate bond statistics are somewhat less extreme but still gloomy for bond bulls. Almost half (49%) say they are somewhat or very overvalued while 19% believe there is some price action left to chase.
Jenna Barnard and John Pattullo are joint managers of the Henderson High Yield Monthly Income fund. It yields 5.4% with under 10 per cent of holdings rated A or above. They believe that we have experienced exceptionally strong periods for the credit markets, buoyed by good economic data, lower systemic risk in Europe (Greece faded from the headlines) and, perhaps above all, "huge doses of liquidity from central banks around the world."
But colleagues Stephen Tariyan and Philip Payne of the Henderson Sterling Bond, yielding 3.6% fund are cautious.
They say: "Current investor appetite [for bonds] suggests markets are set to remain firm in the short term although recent years have taught us that confidence can quickly vanish and, with it, market liquidity. With economic data lagging the improvement in sentiment, unless we see an improvement in the data, a market pull back is unlikely to be too far away."
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