Last updated: 18:12 / Monday, 4 May 2015
Column by Henderson

An Early Upgrade in Bonds Will Prove Rewarding

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An Early Upgrade in Bonds Will Prove Rewarding

Over the last few months we have been raising the quality of high yield bonds in the portfolio. At this stage in the credit cycle it seems sensible to avoid undue risk while at the same time acknowledging that unconventional monetary policy is elongating the cycle. While we do not see an imminent risk of defaults, we believe an early upgrade will prove rewarding and have been reducing our weight in CCC in favour of BB rated bonds.

What has prompted the rise in quality?

  • Energy sector: Deutsche Bank estimate that a third of US single B and CCC energy high yield bonds are at risk of restructuring or default if the current low oil price persists for a few quarters. While we see the energy sector as a special case, it is likely to have a knock-on effect on sentiment towards lower rated bonds as pressures among energy borrowers cause US default statistics to deteriorate.
  • Liquidity: Banks have stepped back somewhat from their traditional role as market makers. This role is a victim of well-intended regulation having the opposite desired effect as stricter requirements on bank capital and trader remuneration has led to a reduction in banks’ willingness to take risk onto their own books. We need to be mindful that liquid assets can become illiquid if everyone trades in the same direction. Premiums will be paid for better quality assets so it makes sense to own them early.
  • US monetary policy: The US Federal Reserve (Fed) is preparing the way for an interest rate rise. In March, the Fed scrapped its pledge to be “patient” before lifting rates, although this was tempered by rate projections being pushed out. The Fed has been good at providing guidance but we are wary of complacency. Rewind back to summer 2013 and investors may recall the taper tantrum when bonds sold off on suggestions the Fed would taper its asset purchasing program. Tightening still has the capacity to shock!

Recent weakness in some of the US economic data means expectations of a rate rise have drifted out somewhat, but we want to own the better quality bonds before investor concerns rise. A rise in interest rates in the US is likely to lead to tighter credit standards at banks and this may make it harder for some companies to refinance. There has been a close relationship historically between tightening credit standards and the default rate as shown in the chart below.
 

 

Regional differences

The shift in credit quality improvement within the portfolio is primarily among US bonds because the credit cycle in Europe is younger and the monetary policy background is different. They say “don’t fight the Fed” but we don’t want to fight the European Central Bank (ECB) either.

The ECB’s quantitative easing (asset purchases) is pushing down yields on sovereign bonds, such that €1.7 trillion of Eurozone bonds were negative yielding in mid-April. This figure is several times larger than the entire euro high yield market, as shown in the chart below. With ECB quantitative easing set to remain in place until September 2016 this creates strong technical support for European high yield bonds. This is because a cascade effect takes place with investors moving down the credit spectrum in search of a positive yield, supporting our overweight position to the region.
 

 

 

Identifying improvement
 
Credit ratings are not static and as active managers we have the opportunity to benefit from identifying bonds with improving credit quality. During 2014 the fund profited from ratings upgrades to bonds issued by GKN, the automotive and aerospace group, and Grand City, the real estate investment trust.
 
We hold perpetual preferred stock in Ally Financial, formerly GMAC, the auto financing group. We expect an eventual move to investment grade status due to improvement in the auto business, growth of the bank and successful refinancing of the capital structure resulting in a lower cost of funds and improved net interest margins. We also look at valuation opportunities where industry or stock-specific shocks have led to excessive pessimism but where credit fundamentals remain sound. This explains our holdings in bonds issued by Tesco, the supermarket group, which is reinvigorating its business after losing market share to discounters, and Chesapeake, the energy company, which was caught up in the negative sentiment towards energy companies, despite its strong balance sheet.
 
Taken together, the adjustments to the credit quality of the portfolio strike a balance between reducing risk while retaining exposure to the returns potential of high yield. The portfolio now has a weighted average yield and spread that is slightly lower than the benchmark.

 

Kevin Loome is Head of US Credit at Henderson Global Investors.

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