Serious season: high yield bonds remain in the spotlight

Serious season

Was there a time when ‘news’ just stopped in summer? A time when only ‘silly season’ stories of crop circles, pigs on the run and killer chipmunks prevailed with little else to trouble us. If those halcyon days ever existed, they’ve not returned this year. In common with recent summers, markets have wobbled – not to the same extent as the Eurozone/tantrum years – but with a disturbing geopolitical edge. Moreover, there is a definite fin de siècle mood building, especially in high-yield debt, as we continue THAT countdown.

Nervy investors have treated good and bad news with Kipling-like equality of late – at least in the sense that they have sold on both types. Although, good news can no longer be judged on merit since it’s now the harbinger of those higher interest rates. Of course, they won’t be a surprise, but that doesn’t mean the impact is certain….and it’s that uncertainty that makes it nigh on impossible to ‘price in’ the effect.

High yield canary sings louder

It’s this fear of the unknown that’s helping to drive investors to the high yield bond exit, although there is a complex picture behind the headline numbers.

As we’ve been highlighting for a few weeks, there’s some pushback in primary markets, but deals are still getting away. It’s in secondary markets that we’re seeing the greatest investor concern, with further record outflows of $7.1b from US high-yield bond funds last week. Behind the outflows are investor fears that higher interest rates will lead to an exodus too big for the market to absorb. Behind this fear is the rapid increase in non-traditional investors coupled with the increasing exit of banks from the high-yield arena.

High-yield bond demand has grown phenomenally in the low-interest rate era, helping many a leveraged company out of a refinancing jam. Low-returns elsewhere and low-default rates have pulled in new investors along the yield curve. These conditions still largely hold, encouraging some to hope that recent moves represent a short-term correction. Last week, S&P reported just 33 defaults so far in 2014, compared with 53 at this point last year. There are still few alternatives for investors looking for decent returns. The long run into the Fed’s first interest rate rise could allow the market to adjust.

However, outflows can quickly become self-fulfilling.RBS research shows 1% loss in high-yield markets typically leads to a $1.5b outflow from high-yield mutual funds. That necessary doesn’t lead us to “crash”, but given the increasing tightness in the secondary markets, it does lead us to “amplification”. With banks increasingly regulated out of HY by capital conditions and unable to mop up sales, the usual shock absorbers are out of action. No liquidity, no sales, no prices, no confidence….sounds somewhat familiar and it remains a risk.

Meanwhile, Europe is marching to a beat of a different central bank drum. It is still seeing outflows from high-yield funds, although at what appears to be a slower pace those linked to just European names. The rise in European primary demand is also faster than the US, according to Fitch, no doubt based on expectations of much longer ECB support. This differentiation may survive if money exits US funds in an orderly fashion, but surely not in a disorderly exodus that dents the ability of the market to price with confidence.

Bumpy ride for HY investors

With a certain irony, central banks and regulators have picked the high-yield bond market as one of their chief areas of concern. Given the tightness of secondary markets, it would surely be remarkable if investors did just drift gently back down the yield curve without incident. But it seemed remarkable back in 2010 that so many leveraged companies would be able to refinance. There’s still a chance of further can kicking or of another kind of intervention to help or hinder. US authorities are apparently considering exit fees for bond funds, which will almost certainly lead to a run for the exit.

All of which makes the ultimate path hard to predict, but it is unlikely to be smooth. To use the current newspeak it’s a fluid and fast moving story and one that has wider resonance. According to Federal Reserve data, households and mutual funds now own around 37% of credit markets, up from 29% in 2008. Millions of American investors use money market mutual funds as a kind of higher interest-bearing savings account. More than half of US employees work for a corporate bond issuer, nearly 10% for a high yield-rated firm.

Cash in the attic.

Citigroup research shows UK companies’ cash balances at 77.1% of their bank debts, the highest level on record. Many articles in response to these figures include a reference to an upcoming corporate spending ‘spree’. Certainly increases in both M&A and investment spending are significant compared to post-crisis years, but still relatively modest in a longer context. UK business investment moved up 5% in Q1, but from a low base. Lower capital costs in IT may have some impact. UK deal value has returned to its highest level since 2008, but volumes remain relatively flat as companies opt for quality over quantity – a trend we expect to continue through 2008.

There is suggestion that UK companies may choose to hold larger cash buffers. At least whilst the geopolitical outlook remains uncertain, perhaps in preparation for higher interest rates and in response to ongoing pressures on profits, like the stronger pound. In Moody’s latest global economic outlook, they predicts that UK and US corporate preference for holding large cash reserves may curtail the pace of the recovery.

China falls off the wagon

China loosened monetary conditions last quarter at the fastest pace in almost two years, according to Bloomberg. Lower than expected inflation providing wriggle room of sort and aggregate financing grew at its slowest pace in July since October 2008. However, June’s lending figure was especially strong and there are still concerns over the build-up of debt across the economy as debt tops 250% of national income.  The recent surge in exports also highlights limited rebalancing.