As a result of the convexity conundrum, which is exacerbated by shortening call periods, the return generation potential of high yield managers is decreasing. “The asymmetric nature of pricing risk (or lack of convexity) is a growing issue,” Aon Hewitt’s Datta says. “Expected returns are now quite low, especially taking slightly longer holding periods over which default rates are expected to rise meaningfully from current low levels. High yield spreads are now at levels which appear rich in valuation terms from the viewpoint of likely default rates over a number of years.”
Although low cost financing through both loans and high yield effectively reduce the immediate likelihood of repayment problems, businesses are still exposed to weak conditions, so these sorts of conditions are a deferral of credit risks rather than a mitigation of them.
“This is especially so if corporate leverage increases as a result,” Datta warns. “Issuer quality at the margin is deteriorating in both the US and Europe, even though it may not have reached dangerous levels yet.”
Tighter capacity in the future
The quality of the average new issuer in the European high yield market has also changed in recent years, which may not be immediately obvious. The massive contributions made to the overall outstanding debt of a few big fallen angels, whose credit ratings were cut following the financial crisis, but remain in the BB-range, has masked the transition towards smaller mid-single-B names. Telecom Italia’s €38bn debt is one example of a fallen angel, but new issuers are not just increasingly coming from the €50-100m EBITDA range, they are also coming from Europe’s peripheral jurisdictions.
“This is not necessarily a concern if you are paying the right amount,” McGuckin says, “but at the moment it’s not worth reaching down the risk spectrum as you’re not getting paid. We are increasingly picky about the names we select.”
In the wider industry however, McGuckin believes there has been a tendency to take a “lemming approach” of buying anything anywhere. This issue is greater for larger funds, whose need to put capital to work makes them increasingly dependent on the primary market, where it is easier to transact significant size fairly rapidly.
But the primary market could see contraction in the coming years. Some experts expect net issuance to be down this year compared to 2013. JP Morgan Asset Management high yield portfolio manager, Peter Aspbury, believes a pick up in M&A activity could see the removal of some names from the market while more IPOs will mean that debt repayments will increase.
“Credit upgrades will also decrease the amount of opportunities in the secondary market,” he says. “Much of the growth in the European high yield market has been fuelled by large corporates that were downgraded following the financial crisis. The rating trajectory for many is decidedly upwards, which will see three, four, five and six billion euro issuers leaving the market.”
Where that occurs, it will further tilt market technicals in favour of sellers by leaving managers with large cash holdings to reinvest in a smaller market of smaller issuers. “The weighted average credit quality of the universe will also continue to decrease as the better credits are upgraded,” Aspbury adds.
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