From a top down perspective we expect spread compression to continue, i.e. a reduction in the yield that corporate bonds offer over corresponding risk-free bonds. This is likely to be driven by ‘lower for longer’ interest rates, especially in Europe where the European Central Bank appears to be taking a more dovish stance and diverging somewhat from the US Federal Reserve. Additionally, declining corporate bond supply in investment grade, particularly amongst financials, continues to create a demand for higher yielding assets further down the credit spectrum
Within high yield bonds – those that are rated sub-investment grade – Moody’s, the credit ratings agency, expects default rates to remain low. The global trailing 12-month default rate for sub-investment grade bonds was 2.8% for the year to October 2013 and Moody’s expects this to fall to 2.4% by October 2014. We share a similarly benign outlook for defaults within high yield and are therefore happy to move down the credit spectrum on a selective basis to pick up incremental spread/yield.
Taking into consideration the value within high yield bonds at the fundamental level, we prefer B/CCC credits relative to BBs for a number of reasons. First, they have fewer call constraints. What do we mean by this? Well, a lot of BB rated bonds are trading at prices that are close to, or in some cases above, the call price (the price at which the issuer has the option to redeem the bond). When an issuer calls in a bond it pays the bondholder the face value of the bond plus accrued interest, so when prevailing yields in the bond market for similar bonds fall below the rate on the callable bond, the issuer has an incentive to redeem the bond early and issue a new one. This can limit capital appreciation for the bondholder. In a world where yield is scarce we are keen to have greater control over the yields we receive.
Second, the issue sizes lower down the credit spectrum are typically much smaller at $200-300m. Since this is too small an issue size for the very large funds there tends to be fewer analysts following these bonds. This can create opportunities for those funds with strong analytical expertise to add value.
Third, there are fewer “tourist” investors in high yield such as exchange traded fund (ETFs) and investment grade funds. Again, this is often a reflection of the smaller size of the issues.
Finally, many of the B and CCC rated companies are new to the high yield market. They have effectively moved from bank loan to bond refinancing and so are less well known. This gives those asset managers with expertise in loans, such as Henderson, an advantage because the loans team who have already been analysing the companies can share their knowledge of a company ahead of a new high yield bond issue.
The above views are expressed within the Henderson Horizon Global High Yield Bond Fund, Henderson Horizon Euro High Yield Bond Fund, and Henderson Credit Alpha Fund, whilst within the investment grade Horizon Euro Corporate Bond Fund we have 8% of an available 20% off-benchmark allowance invested in high yield.
Opinion column by Thomas Ross, fixed income portfolio manager, Henderson Global Investors.