Weekly Bond Update: Will high-yield market stay hungry and foolish?
- Today's high-yield bond market is marked by a big appetite for yield
- ECB's corporate bond-buying programme has kept rates very low
- Low rates induce borrowers to repay early and refinance at better rates
- Some corporates are entering the bond market to get better terms than with loans
- Bond market is getting the junk names that banks don't want
- Risk of higher interest rates looms; junk bonds would be first to suffer
If you are passionate about the financial market, you must have seen some of those old-fashioned Wall Street movies where the trading floor at the exchange was full of screaming people pushing to buy and sell assets. Unfortunately, this romantic image of the financial market we grew with has been killed by technology, and those screaming men have been replaced by computer screens. However, if you close your eyes and think about the high-yield bond market today, you can still hear those men, except that this time they are screaming for bonds, and they are hungry for yield.
The European Central Bank's corporate bond-buying programme has kept rates very low, making capital markets incredibly attractive, inducing borrowers to tender outstanding debt early, and refinance their debt at better rates. This is the main reason why, year to date, we have seen a record-high supply of bonds and, even though yields are tighter and tighter, investors are fighting to get a piece of the cake, and nobody wants to be left behind in this race to primary market.
In these extraordinary market conditions, we see some corporates turning away from the loan market and knocking on the doors of the bond market to get better terms. For instance, the French publisher Infopro Digital raised €500 million of new five-year junk bonds at a yield of 4.5%. The new bond issue significantly reduces the company's cost of funding as it replaces a term loan with a yield of 5.75%. Similarly, the Dutch retail group Maxeda, which underwent restructuring in 2015, was able to replace its restructured lines with €475 million of new bonds at 6.125%.
This is happening even though most of the loan deals in the past few years have become “covenant-lite”, meaning that lending banks are not imposing special conditions on the loan, giving more flexibility to the borrower for repayment. It is actually quite rare to see a company moving from loans to bonds as companies with high leverage usually get better terms in the loan market. However, it seems that nowadays highly leveraged companies can turn the bond market's lack of supply to their advantage. Unfortunately, this implies that the bond market is getting the junk names that banks don't want.
It is hard to predict whether this pattern will continue for longer, as we are now getting mixed signals from the market.
Electric car-maker Tesla recently scored an enormous success in raising $1.8 billion at a yield of 5.3% to fund the rollout of its Model 3 car. Initially the company had planned to raise just $1.5 billion at 5.25%. Apparently the orderbook for the new bond was nearly four times bigger than the issued amount. The success may stem from the fact that it was technology darling Tesla's debut in the bond market; however it seems investors where so hungry for yield that they didn't pay much attention to the company's negative cash flow. The bond is now priced at 97.3 in the secondary market, showing a bit of weakness that could indicate that maybe something is starting to change.
In July, paper and packaging distributor Antalis International was unable to raise money in the bond market because investors demanded higher yields than the company was willing to pay.
Declining oil prices, the risk of geopolitical conflicts and the political instability in Washington are pushing investors to be more selective and cautious. Although it seems a far-fetched possibility, the risk of higher interest rates also looms, and, when that happens, the first assets to suffer will be junk bonds. However, are these cataclysmic events going to happen anytime soon?
According to Moody´s, the actual default rate in global junk bonds is low, but has not reached the bottom yet. Indeed, the rating agency predicts that it will further decrease to 2.2% by July 2018. Steady economic growth and sufficient credit liquidity are supporting weaker corporates. This does not mean one should buy recklessly anything with a nice spread over government bonds, but one can look at opportunities and find the right balance between risk and return.
In short, there is junk and there is junk. To benefit from higher returns and avoid losses it is important to be selective. First, an instrument's liquidity is a crucial aspect as it represents one's ability to sell a bond when in need of cash. More liquid products will have a higher amount outstanding and will preferably be in hard currency. Second, the rating represents the quality of the asset, so bonds just below investment grade (BB) will give more security than those with very low ratings.
The lower down in credit rating, the more a bond is sensitive to volatility. For example, the highest-yielding emerging-market sovereigns right now are Venezuela (Caa3, Moody's), with a yield of about 60%, and Mozambique (Caa3u, Moody's), with a yield of about 75%. But it is important to bear in mind that any significant macroeconomic events, such as political tensions and low oil prices, could affect a country's ability to repay its debt.
The same reasoning applies to sectors. As energy prices are decreasing, one may not want to buy debt from companies whose revenues are tied to commodities prices, making energy and utilities less attractive than more stable sectors, such as healthcare, technology and consumer staples. Furthermore, it is not necessary to look at EM when it comes to high-yielding bonds, because good high-yield corporate spreads can be found in more solid economies, such as Europe and the US.
In brief, stay hungry but don't be foolish.
— Edited by John Acher
Althea Spinozzi is a sales trader at Saxo Bank