Much like other risk assets, high-yield bonds have delivered volatile returns year-to-date. While the European market hit a low on 12 February at -3.2%, moving in tandem with falling oil prices, it has since bounced back by more than 6% for a 3.3% return for the year to 15 April. On a positive note, the correlation with oil prices has loosened. Clamouring for more return, investors are now turning to the European Central Bank’s corporate bond-buying programme as the new reason to be optimistic about European high-yield.
To be clear, the ECB has not committed to buying high-yield bonds and will only target investment-grade non-financial corporate debt. Also, we are still waiting for the details of this part of the quantitative easing (QE) programme to be made public. However, that has not stopped the market from trying to front-run the ECB by loading up on bonds that could be the object of QE-related buying.
An ECB-induced squeeze-out
One group of high-yield bonds which have started to benefit indirectly from the programme, is that of hybrid bonds of investment-grade companies (examples are Enel, Gas Natural, Telefonica, RWE, etc.), which would typically be rated two notches below the issuer's senior debt. While those hybrid bonds will not be bought by the ECB, the senior bonds of those companies will be eligible and purchases should result in spread tightening. That could lead some investors to switch their appetite to the hybrids.
Such a squeeze-out effect might be applicable to the wider high-yield market, not just the corporate hybrid segment. We think one of the ECB’s intentions is to increase investors’ corporate risk tolerance as the search for carry pushes them outside of their comfort zone. It could also help banks improve the 'velocity of their balance sheets' by allowing more difficult credits to return to the primary bond market, reversing the constrained access after high-yield spreads started widening in the summer of 2014.
B or BB for yield?
So, is this rising tide lifting all opportunities related to the high-yield asset class? Not necessarily, according to investors. So far, we view the recent gains more as a bear market rally as BB-rated bonds have produced very similar returns as B-rated bonds year-to-date, outperforming the lower-rated group on a risk-adjusted basis. Why would you buy lower-rated debt if you can get the same return buying the higher quality debt on an unlevered basis? The consensus is saying buy only the best quality, higher-rated bonds in high-yield as the outlook is too uncertain for the smaller, more leveraged issuers.
The flows and buying appetite have been very much skewed to the BB issues so much so in fact that the spread premium of B-rated bonds over BB-rated bonds is now the highest it has been for the past 12 months (see exhibit 1 below). Investors are getting close to twice (1.9x) the level of spreads by switching from BB bonds to B bonds, which is a 1.4 deviation from the long-term mean. Inflows have come back to the high-yield asset class, exacerbating the tightening move.
Exhibit 1: Spread of B-rated bonds over BB-rated bonds
Source: BAML indices
So what’s the trade in the high-yield segment and what are the risks?
We think investors are better off buying B-rated debt for several reasons.
For a start, the consensual trade to buy BB is making that market segment expensive in relative terms (see exhibit 1 above) and vulnerable to a turn in flows and sentiment. As we have seen with the sell-off in German government bonds (Bunds) in April 2015, crowded trades can be reversed aggressively when the trade starts to get questioned and liquidity deteriorates.
It is also important to consider that BBs carry one year of additional duration (four years) versus B-rated bonds (three years) and thus would be more sensitive to a duration sell-off as well. Also, issuers from the oil, metals and mining sectors are very much concentrated in the BB category after many of these companies were downgraded from BBB to BB in the commodity sell-off. For some, further downgrades are clearly possible. However, we find that the recent bounce in commodity prices has led many of those bonds to be priced for perfection now and not offering much downside protection, or even appropriate risk compensation for what is generally a fundamental environment that is still deteriorating (overcapacity, balance sheet plans that rely on asset sales in a buyer’s market, etc.).
Also, B-rated bonds are now a shrinking investment opportunity, while the stock of BB debt is continuing to increase (see exhibit 2 below). This is because new issues in the past 18 months have been much more concentrated in BBs, while a lot of 'fallen angels' debt has grown the ranks of BBs. Meanwhile, B-rated companies have reduced their issuance and in fact have returned cash to bondholders in the form of tenders, calls and natural redemptions.
One final reason to be comfortable with the switch from BBs to Bs is the default rate expectations. The default rate in European high-yield now stands at 0.4% and we expect it to stay below 1% over the next 12 to 24 months. So the premium of spreads enjoyed by B-rated bonds over BBs should not be reduced by loss of capital on default.
Exhibit 2: Size of B vs. BBs
Source: BoA Merrill Lynch Global Research, HE10 andHE20 indices
It is okay to pick B-rated bonds
In summary, by buying B-rated bonds, investors are getting exposure to an asset class that has recently underperformed higher-quality peers and that is more than compensating for default rates which are expected to remain extremely low. There are fewer of these bonds available, which makes the segment a valuable commodity in a declining liquidity environment. A risk to our view and positioning would be a recessionary, deflationary environment that would bid up the value of duration and increase the spread compensation required for the default risk of lower-rated bonds.