High yield remains the most attractive bond option in 2011, although periodic corrections are expected, according to Schroders’ Wesley Sparks.
The group’s head of US fixed income highlights several ongoing drivers for the sector but says macroeconomic data is still sufficiently mixed for the Fed to remain supportive.
Overall, a lack of income available elsewhere is key to high yield’s popularity – in the last months of 2010, the global index was yielding 7.33 per cent with emerging market debt the closest to that with just over 5 per cent. In contrast, US investment grade credit was yielding 3.38 per cent and Treasuries just 1.37 per cent.
“Credit fundamentals continue to improve with many companies still focused on balance-sheet repair and their interests aligned with bondholders,” says Sparks.
“Supply/demand dynamics are also positive, with recent reports showing high yield issuers using cash to buy back bonds and new issues largely to refinance existing debt. Another positive secular trend is the over-allocation of US pension funds to equities, with around 5-10 per cent of assets expected to move to fixed interest in the coming years.”
All this means institutional demand and fund flows are likely to continue outpacing supply over the course of 2011.
Supply has grown substantially after a dip in May/June but 70 per cent of this has been for the purposes of refinancing.
Sparks also highlights a background of falling default risk, with Moody’s predicting the global rate will drop as low as 1.9 per cent by October – from a high of 13.5 per cent in November 2009.
Trends in rating changes are improving and there were more rising stars ($31bn by par value) – high yield bonds promoted to investment grade – than fallen angels ($23bn) in 2010. In 2009, the respective figures were $13bn and $150bn.
On the risk front, sovereign debt problems remain, particularly in Europe, and there are still fears of a US double dip but Sparks says fundamentals indicate more of a muddle along environment.
He says: “There remain various macro overhangs but data points to slow-growth rather than a double dip.
“Against that backdrop, we expect periodic corrections in the high-yield market and will look to add to positions during periods of weakness. Recent issuance of less volatile senior secured bonds also provides an opportunity to move up the capital structure while maintaining attractive yields.”
Overall, the manager expects a potential total return from high yield of slightly more than 10 per cent for the next 12 months.
This is based on current yield levels of 8.08 per cent and a possible further 50 basis point rally yields over the next year producing a 2 per cent capital gain.
Sparks says this fall in yields will be due to solid fundamentals in the high yield markets and will come through once the current wave of high volatility subsides and the risk premia demanded by investors declines again.
He says: “Many detractors claim yields in the sector are too low to be attractive but it spent three-and-a-half years below current levels in 2004-07 and we feel high yield offers potential for strong coupon income plus moderate capital gains in the next 12 months.”
In Sparks’ ISF global high yield, he has recently increased exposure to bonds expected to do well in a slow-growth environment and cut cyclical and higher-beta credits.
Favoured areas include what the manager calls stable cashflow credits in sectors such as wirelines, consumer products, food and beverages.
Other key themes include deleveraging stories – companies paying down debt after recent acquisitions such as Reynolds Group – and upgrade candidates.
These include BB rising stars, such as Macy’s in the retail sector as well as various CCC names likely to be upgraded by major agencies, which can be slow to revisit the lower end of the credit scale.
Meanwhile, Sparks has reduced his exposure to paper, commodity chemicals, metals and mining, wireless and tech and trimmed bonds that have rallied through price targets.