After a strong start to the year, the risk of a correction in the high yield bond market was rising, and whilst not every year is the same, the market has historically tended to be softer going into the summer. The strength in high yield in May and June of this year, despite significant new issuance volumes, was therefore somewhat surprising given the seasonal weakness that was evident last year (see chart).
Just as it seemed the market could shrug off any seasonal weakness, a number of factors have combined to contribute to the recent sell-off:
- New issuance. For the second successive year there has been a huge rise in high yield deals. In part, this is a lagged response to strong positive sentiment earlier in the year encouraging companies to tap the markets, plus deals postponed in spring due to geopolitical concerns. The heavy supply has arrived at a time when the market is not particularly liquid, and as a result we are seeing some indigestion from investors.
- Flows. Flows in the US have changed dramatically: high yield funds have seen year-to-date flows move from a solid net inflow to an overall net outflow in just three weeks in July. To put this in perspective, prior to July there had been inflows in 20 out of 21 of the previous weeks. Approximately $11bn has been redeemed in the US since this run broke.
- Consensus positioning. High yield is still a consensus long position, i.e. a large spectrum of investors own high yield because it is one of the few areas left offering attractive real yields. We concur that there are plenty of ‘tourists’ in high yield: tactical high yield bondholders looking for additional yield or beta. Whatever their reasons, they are likely to be more transient investors and may exit when the market corrects. We may be seeing this now to some extent.
- Interest rate concerns. The market seems to have brought forward concerns about interest rate rises, in particular in the US. We believe this discussion has been brought forward too soon, given we do not expect a rate rise in the US before early-to-mid 2015.
- Geopolitics. Uncertainty created by events in the Middle East and Ukraine has sapped confidence, making investors reluctant to invest in riskier assets.
- Event risk. High profile events such as the Banco Espirito Santo (BES) debacle have led to bondholders demanding a higher risk premium. This is understandable given that subordinated bondholders in BES (much as we have seen previously for SNS, the Dutch bank, and HAA, the Austrian bank) learnt on 4th August that they have effectively suffered a large loss of capital, with optionality over the future success of the assets of a new “bad bank”.
What might cause positive sentiment to return?
First, we need to be realistic and accept that August, which is the main holiday season, is likely to be a weak market for high yield, with liquidity depressed. Second, we need to accept that flows tend to follow performance, so a couple of months of weak returns from high yield is likely to mean that flows remain negative or suppressed for several more weeks. That said, during the taper tantrum in summer 2013, high yield flows turned negative for a couple of months but rapidly bounced back into positive territory for the remainder of the year.
Corrections are unwelcome but they do have the benefit of creating value in the market. Already the yield on the wider European high yield market has backed up by 60 basis points to 4.6%, and a number of bonds are starting to look very interesting from a valuation perspective.
From our perspective, we expect the summer lull to pass. As managers of relatively young and, therefore, small high yield funds, we are in the fortunate position of being able to use this correction as an opportunity to buy selectively in the secondary market at some attractive prices.
By Chris Bullock, co-manager of the Henderson Horizon Euro High Yield Bond Fund and the Henderson Horizon Global High Yield Bond Fund