The global single B default rate has, since 2010, been significantly than both the long-term average of around 5% and the lower 10-year average, which is hovering around the 2% level.
Stefan Isaacs, manager of the M&G High Yield Corporate Bond fund, said this is largely a function of accommodative central bank policy, limited refinancing risk and growing investor maturity, with spreads over-compensating as a result. However he noted that many presentations gloss over the fact that much of the good news, from the perspective of default rates at least, has arguably already been priced in. “The market is unlikely to be surprised by another year of sub-2% defaults.” Rather, said Isaacs, the risk lies in an outcome that sees a higher default rate than anticipated by the consensus, even if that is difficult to envisage right now.
Projections show US high yield will outperform other fixed interest asset classes over the course of 2014, returning between 5 and 6%. “Refinancing, rather than new borrowing, is driving the majority of issuance in the US,” said Isaacs. “Refinancing accounted for 56% of issuance in 2013, though down from 60% in 2012. The need for income in a low interest rate world is providing a strong technical support, evidenced by $2 billion plus of mutual fund inflows into the US high yield market year to date. Significant oversubscription for the vast majority of new issues has also been a notable feature of the market for some time now.” The short duration nature of the asset class is also particularly attractive in an environment of potentially rising interest rates.
There are, though, a number of headwinds faced by high yield bonds. “Challenges are presented by liquidity,” Isaacs continued. “While this has improved since the immediate aftermath of the credit crunch, investment banks are still reluctant to offer liquidity given the high capital charges they face and the low yields currently on offer.” He also highlighted the lack of leverage available to end investors compared to 2006-7, when banks had the ability, strength and desire to lend to those investors on margin; and by the increasing negative convexity the market faces at present.
“Perhaps in this environment, with inflation ticking along comfortably below 2%, investors should accept that a nominal return of 5 to 6% looks decent,” said Isaccs. “That said, returns this year are likely to be driven by income rather than capital appreciation, and may well look skinny versus previous years. I’m still constructive on high yield, but after the stellar returns in the past few years, we must be careful to avoid being blinkered.”
