The high-yield fixed income market is at the crossroads
Although the high-yield compartment of corporate bonds enjoys the advantages of extremely robust macroeconomic and microeconomic fundamentals, various uncertainty factors should be taken into consideration: the "high prices" of a part of the market, the impact of the rise in interest rates and the political risks impel the adoption of a selective and carefully studied "bond-picking" investment approach.
For several consecutive quarters, the high-yield fixed income compartment has benefited from a favourable environment. The fundamentals are solid, with the simultaneous signs of recovery in the economic indicators in all western countries, confirmed by improved microeconomic outlooks. “The appetite of investors for this asset class is particularly sustained by increases in company profits: the growth in net income is stronger than the growth in their debt, and the global process of corporate debt reduction is continuing,” observes Stephan Mazel, Head of Credit Management at Groupama AM. The fact that interest rates were still low in the first quarter also helped to reduce financial costs on companies, allowing them to improve their repayment capabilities. “The good health of companies is reflected in a clear drop in default rates to modest levels. For example, Moody’s anticipates a default rate of 2.5% at the end of 2017 for the issuers on the global high-yield market.”
On the question of political risk, Stephan Mazel explains that it remains relatively difficult to anticipate. After the French presidential election, the next political decisions in Europe will be even more important, with legislative elections in France in June and in Germany in September. “A priori, investment grade is more exposed to political risk than is high yield. This fact is due in particular to its sectoral structure, composed of a large number of issuers from consumer staples the banking sector and utilities. Additionally, we estimate that the long Brexit process will continue to weigh down British issuers.”
The evolution of monetary policies will cause a reorientation of investment flows
Under these conditions, the high-yield market has rallied, leading some segments to rise to valuation levels that are now judged to be too high. “The high prices of high-yield bonds raise questions today, in both absolute and relative terms.”. It is true that in the wake of the sovereign debt rates, which are still very low, and after their continuous valuation over the last few months, high-yield rates are currently at threshold levels. “This is particularly the case in Europe, where a BB-rated security now offers a return of about 2.5% for a maturity of 3.5 years, compared to almost 6.5% historically,” says Stephan Maze, in illustration of the point. This comparison is also true against investment grade, since the investment grade/high yield spread is historically low on the European market, with a ratio of less than 3, indicating a steady decline in the relative premium in favour of high-yield, despite its higher risk.
The risks relating to the monetary decisions of the central banks, and to political uncertainties will also affect this asset class by the end of the year. A large number of investors rushed to high-yield bonds in search of high returns and diversification when the European Central Bank deployed its celebrated asset purchase programme. This ECB’s security purchase programme is expected to slow again in in early 2018. This reduced support of monetary policy, which is coming soon in Europe and has already been implemented across the Atlantic – is expected to lead to a reorientation of investment flows, via arbitrage operations unfavourable to the asset class, in particular to “BB”-rated securities. “The first signs of this movement can now be seen: some investors have already pulled out of high-yield, while others are preferring loans to take advantage of their lower sensitivity to interest rate risk,” he indicates.
Prudent positioning on the asset class
These prospects confirm that the Groupama AM team made the right choice in adopting a selective, analysis-based investment approach – “bond-picking” – on the high-yield market. “Our positioning today is globally neutral on this asset class with regard to valuation levels and risk factors. We are attentive to the notion of specific risk and are considering investment opportunities on a case-by-case basis). The bonds issued by Loxam and Ellis are two examples of recently invested instruments.
Prioritizing the short end of the curve, which is less sensitive to interest rate risk, is one of the strategic choices of the team. “We also regularly have recourse to the derivative markets, with CDS options as partial hedging for our portfolios”. Finally, in terms of geographical allocation, prudence regarding American securities is currently the order of the day. “Since the election of Donald Trump, American corporate bonds markets have been sustained by the thematic reflation trade, due to his promised pro-growth programme. But the implementation of this programme seems to be lagging. So, disappointment from the markets cannot be ruled out in the medium term,” concludes Stephan Mazel.
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