Corporate high yield : still far to go

Like most financial asset classes, corporate bonds have on average rebounded substantially since economies generally bottomed out in the Spring. The most spectacular returns have been seen in "below investment grade" or high yield corporate fixed income securities. To October 31 2009, Barclays Capital U.S. Corp High Yield (2% Issuer Cap) index is up 52.2%. Even so, if the economic recovery really takes hold, much higher prices for high yield are in prospect in the medium term. The moment seems right for investors to reconsider the importance of the sector in their strategic asset allocation.

As it is true that high yield securities are generally more correlated with equities than other fixed income instruments, they offer investors more stable returns over time when carefully selected and managed in a portfolio. As a result, they play a significant diversification role in an asset allocation, by contributing to more stable returns over time. This is especially true because their correlations with other asset classes than equities are quite low.

From a peak of 2000 basis points in September 2008, when Lehman Brothers collapsed at the height of the financial crisis, spreads of US high yield corporate bonds (i.e., the yield premium over equivalent maturity US treasuries) have come down to about 700 basis points. The move in the European high yield market has been similar. But it leaves room for a further yield contraction of about 300 to 500 basis points to return historical averages during periods of steady economic expansion.

The credit cycle: a wealth of opportunities

But achieving consistent, repeatable and high returns in the high yield space over longer periods of time requires both skills and an extensive experience of financial markets through the credit cycle. Experienced managers can take advantage of four predictable stages of the credit cycle.

In the current cycle, the first stage occurred towards the end of last year. Availability of credit dried up throughout the economy. Banks stopped underwriting issues or lending money. Fear of defaults caused fixed income spreads of corporate issues to widen abruptly and prices to fall simultaneously. Businesses went bankrupt and rating agencies downgraded debt. For investors and fund managers, opportunities emerged as some issues fell to prices not justified by the underlying businesses' quality of assets, nor by the sustainability of their cash flows, and sometimes not even by the credit rating granted by rating agencies. Securities labelled B- tend to offer the best risk/return profiles at that particular stage of the credit cycle, just before the recovery begins.

A virtuous cycle is beginning Today, we're in the middle of the second stage of the credit cycle, called the "credit remediation stage". Investors and banks have already hesitantly begun to take on exposures and spreads have begun to normalise and remediate. Liquidity in the markets have improved. So have corporate earnings. Most promising opportunities have arisen in the B+ segment and a virtuous cycle has been established.

The next stage of the credit cycle can be characterised as the most favourable for investors. Although a gradually higher degree of selectiveness must prevail during the investment process, high returns are easier to achieve than under any circumstances of the credit cycle. Lending standards will progressively loosen up, and so will underwriting. Spreads will continue to narrow as risks in the economy continue to decrease and the market slowly ceases to focus on asset coverage. Most attractive opportunities will begin to appear in the BB segment of the market.

Managing high yield corporate bonds in the final stage of the cycle usually becomes progressively more challenging. This future stage of the cycle is generally called a vicious cycle. But we're far from there yet. It begins to emerge just when lending standards begin to tighten and banks become nervous. As a result, high yield spreads widen and investors become more and more discriminating. At that stage, securities rated BB- generally start to appear as the most promising. Needless to say, during this stage of the credit cycle, recessionary conditions start to take effect.

In this stage of the cycle, yields increase as economical conditions deteriorate and so do the default rates. However, as the graph shows below, default rates tend to lag spread movements by 6 to 12 months.

With experience and skill, it is entirely possible to manage the risks related to spreads and defaults throughout the credit cycle. Default is without doubt a significant risk, but investors must remember that high yield corporate bonds provide investors with better downside protection than equities. The reason is that bondholders have a senior claim on a company's assets compared to shareholders in case of liquidation. In addition, investors may minimise defaults losses by carefully choosing asset-rich companies.

Why favour high yield in the current environment Year-to-date, nearly EUR 20 billion worth of corporate high yield has been issued in the European primary market, compared to nil last year. With economic growth picking up and fading credit risk, companies are able to progressively borrow at lower rates. For investors and investment managers, a revival of both the primary and secondary markets spells opportunity.

Many attractive high yield instruments can be found in the US telecommunications and utilities sector. The same is true in Europe, along with commodity, packaging, chemical and cable companies.

It follows that the timing for increasing an allocation to the corporate high yield segment looks fully warranted. Compared to the extremely low yields offered by investment grade fixed income and money markets, corporate high yield bonds are the asset of choice, assuming the economic recovery establishes itself.