Taking a contrarian approach
Category: Global, U.S.A.
By Hui Ching-hoo
Industries favoured demonstrate solid fundamentals and reasonable valuations
The spike in the ten-year US treasuries yield driven by the downturn in US Federal Reserve asset purchases triggered a sell-off of high yield (HY) bonds worldwide in May and June. Despite the capital exodus from credits, however, HY credit still has real appeal as one of the most favourable assets for yield-seeking investors in a low interest environment, due to its yield premium and capital appreciation potential.
Cecilia Chan, fixed-income CIO, Asia-Pacific of HSBC Global Asset Management, notes that the capital outflow from bonds and HY credits escalated in Q2 amid deteriorated market sentiment, a function of widening credit spreads and liquidity woes.
“There was a healthy price adjustment for bonds between April and June on the heels of the prices being overshot early this year. After that, the value of US treasuries has been better reflected in the current economic fundamentals; credit bond prices look to be more sustainable in the second half,” she says.
Market sentiment has recently improved. The JP Morgan HY Corporate Index’s average yield level became more competitive at around 7.6% in late July. Ms. Chan remains positive about fundamentals in the fixed-income space, saying investors are still buying the ‘yield carry’ story for bonds in particular. Deposit rates have less appeal for yield-seekers, however. They prefer HY bonds to equities from a buy-and-hold standpoint.
On the supply side, Ms. Chan estimates that total issuance of investment grade and HY credits for the year will be in line with last year’s volume. However, the sporadic nature of the issuance pattern reflects changing market sentiment. For example, a significant proportion of the issuance came on line early this year; then new supply fell sharply between May and June as a result of the market slump.
Wesley Sparks, head of US taxable fixed income and a fund manager with Schroders ISF – global high yield fund, recommends that investors should not chase returns in the HY asset class, but rather view periods such as the wave of outflows in June as a contrary indicator, and watch for buying opportunities during market corrections: “It is important for investors to differentiate between conditions which could contribute to a prolonged bear market versus those that are likely to accompany mere short-term market corrections. The best prospective returns in HY can be had by buying during or just after a market correction rather than after a prolonged rally – no matter how comfortable the latter market conditions might make one feel,” he says.
Anand Subramanian, a senior trader in Asia high yield at Deutsche Bank, says: “So far this year we have seen a significant amount of capital inflows into Asian HY credit. To put things in perspective, issuance in 2012 was approximately US$8 billion compared to roughly $30 billion in 2013. We’ve also noted increased participation by real money emerging market funds and private banks from within Asia and outside of the region. Real money participation has been helped by record fund flows due to the low rate environment. Flows from private banks have also increased as they shift more of their assets from equities into fixed income.”
He continues: “HY credit issuance may be driven by a number of factors, including a low interest rate environment, which has resulted in increased fund flows to this asset class as well as opportunities for issuers to issue at compelling rates. Restrictions on borrowing in the local market can also lead some issuers to tap other markets, like the US-dollar market. Ultimately, debt issuance is just part of a natural progression as markets become more mature and issuers look to diversify their funding sources apart from simply equity and bank loans.”
When asked if the rising yield in the US had led to a shift from riskier investment to US credits, Mr. Subramanian says that investors in Asian HY and emerging market corporate bonds typically run separate mandates from those looking to invest in US credit. “While the spike in ten-year US treasuries did spark significant fund outflows, it’s difficult to say that they rotated their investment into US credit. The increase in treasury yields have definitely put a pause on the record inflows into emerging market funds for the moment, but as yields stabilise we should continue to see good support for emerging markets and Asian high yield,” he says.
HY credits in Asia
Mr. Subramanian goes on to say: “One of the challenges in Asia HY is the inability, or limited ability, to borrow bonds or go short. That feeds into secondary market liquidity. Since dealers are unable to go short, price action tends to be very spotty on the way up and down. Dealers are unable to offer bonds by going short and consequently are not able to bid for bonds, as there is no short base to cover.
“Another significant challenge is the relatively covenant-lite structure of Asian HY bonds. This creates problems when investors need to enforce control over the leverage, acquisitions and dividends of issuers so that they can protect these bond investments. Lastly, transparency and the corporate governance of issuers can be a concern. While this has significantly improved over the years, there is still more progress that needs to be made around access to company management, regular bond investor updates (particularly after any significant price action in equity or bonds) and proper disclosures.”
Ms. Chan claims her company’s Asian HY bond fund portfolio is well balanced with an average BB credit rating. The funds are overweight in Hong Kong credits’ and Mainland properties’ sectors as well as in Mainland investment grade industrial credits. They are also underweight China HY industrial credits, sensing possible downgrade risk.
“The HY funds have up to 30% weightings in Mainland properties’ corporate bonds. The funds mainly select leading players in demonstrably sound financial condition and with quality land banks to minimise the default risk,” explains Ms. Chan. “Despite the property sector in China being very fragmented with a high gearing ratio, all in all I think this is unlikely to trigger a sharp deterioration in in terms of defaults for HY. We think the credit environment is broadly stable this year.”
Pointing to the development of the Mainland onshore bond market, Ms. Chan observes that many RQFII participants prefer to invest in the bonds with a triple-A local credit rating: “Domestically ranked triple-A bonds in China are at best close to low investment grade by international standards. Also, the yield differentiation of onshore debts is too small to reflect their basic fundamentals.” She goes on to say that a spike in the overnight Shanghai Interbank Offered Rate (or SHIBOR) earlier this year led investors to be more cautious about liquidity woes. So they are tending to ask for a higher premium for riskier fixed-income assets moving forward.
According to Mr. Sparks of Schroders ISF, even in advance of the widely-expected tapering of US Fed purchases of treasuries and mortgage-backed securities in September, there are several reasons why the company believes that US HY bonds will remain an attractive investment option over the next year for investors who have the appropriate risk tolerance to withstand some market volatility, which are as follows:
Credit fundamentals remain supportive of current valuations;
Yield and total return potential;
A good equities substitute for constrained investors;
Renewed price appreciation potential after the recent correlation;
Better outlook than that in other regions;
Better return potential than investment-grade cooperates, government bonds or cash equivalents;
Better return potential than loans.
In terms of investment strategy, Mr. Sparks says he would expect dispersion of industry returns to increase as industries with healthy dynamics outperform those industries that are experiencing either secular decline or negative cyclical forces – such as paper, publishing, and certain segments of technology impacted by significant shifts in consumer spending trends.
“We are focussed on investing in industries where deleveraging is still underway, where there are stable profit margins or how an industry is considered relative to a few large companies exerting price discipline,” he reveals. “We also seek out companies that have pricing power because of strong brand names, or large order backlogs which contribute to earnings visibility; similarly where companies have some control over input costs or the ability to pass on cost increases to customers. Industries we currently favour – where we find solid fundamentals and reasonable valuations – include cable, wireless, construction machinery, oil field services, retailers (through specialty retailers), and life insurance.”
He continues: “In terms of credit quality, we expected that single-B rated credit will outperform other ratings categories in 2013. The more highly-leveraged and often more cyclical credits rated CCC and CC may have a difficult time deleveraging any further in the slow growth environment we expect in 2014. Double-B credit may perform reasonably well although not keeping up with the return generated by Bs, simply because of the lower yield and the fact that many BBs carry high prices and have become call-constrained. As a result – rather than a strategy of focussing on maximising yield, or alternatively a defensive stance focussing on higher-rated, interest-rate sensitive credit – a middle-ground exposure in HY credit may lead to the best return in 2013.”
Aside from HY credits, Mr. Sparks believes that the market still has many alternatives for yield-seeking institutional investors. “For investors who have the research expertise, investing in leveraged loans, HY municipal bonds (tax-exempt bonds in the US), select non-investment grade emerging market bonds, and select non-investment grade non-agency mortgage-backed securities can all potentially produce attractive returns,” he says. “But typically, such investments are appropriate only for sophisticated institutional investors rather than individual investors. Our target is only selecting what we believe to be the best HY corporate opportunities anywhere in the world – and then hedging out all current risk.”