High yield’s fall from grace

A sudden reversal in high-yield spreads has halted the seemingly unstoppable momentum of the market. LBO risk, a healthy pipeline of new issues and waning demand from hedge funds are some of the factors behind the turnaround, but a major concern is the arrival of General Motors and Ford debt into the sector. Oliver Holtaway reports

Please note that market participants interviewed for this article commented before S&P’s downgrade of GM and Ford.

Spreads in the high-yield sector have widened since mid-March, in line with high grade, and are now back at 2004 levels. From tights of 270 basis points over mid-swaps, the high-yield index now stands at around 385bp over mid-swaps. In percentage terms, the recent widening is among the sharpest shifts ever seen in the market.

“The market gave up in the last 15 days of the first quarter everything it had made in the first 75 days,” says Anton Simon, head of European high-yield investment at Putnam Investments.

The high-yield spreads face the triple threat of a healthy forward calendar, event risk in the form of leveraged buyouts and the entry of GM paper into the high-yield index. All these factors have brought a note of caution to the market as investors try to work out where high yield is headed. Like their high-grade counterparts, junk buyers are asking whether the recent wides are just a little local difficulty, or a bona fide turn in the cycle.

There are two points to bear in mind when reading headlines and editorials announcing the end of the credit cycle. The first is that hardly anyone in the market actually believes this is the case. The second is that, even when people in Europe are talking about the end of the credit cycle, they are talking about high-grade investors – who generally speaking are not natural risk-takers – having second thoughts about the risk/return profile of investment-grade debt. High-yield investors are by their nature made of somewhat sterner stuff.

“The jury’s out on exactly how it will pan out, but the single-B flank of the high-yield markets usually travel right through these things,” says Simon. “The market has already come back a little, and it will be reasonably stable in the medium term.”

Correction

Early signs suggest the high-yield market is taking the recent spread movement in its stride. “This is a long overdue correction,” says David Newman, head of high-yield research at Citigroup. Newman called for a high-yield sell-off at a conference just two days before the market widened.

Martin Reeves, head of European fixed income and credit research at Alliance Capital, agrees that we are not seeing a turn in the cycle. “It’s just one of those bouts of volatility you get from time to time,” he says.

Some are a little more bearish. “We won’t see spreads go back to February tights,” says Roger Webb, fund manager at Morley Fund Management. “There is more room to give, especially with the event risk facing the sector.” The key issue for 2005 is valuations, he adds.

While analysts believe that spreads could weaken further, they note that investors are now able to focus more on name selection. The quality names in the sector are therefore likely to outperform the weaker single-B or triple-C credits.

Some investors welcome the end of the seemingly indiscriminate hedge fund investment that the asset class saw over January and February, even if it has meant wider spreads. “To be honest, watching blind buying continue, as in February and early March, would be more worrying than watching blind buying tail off,” says Putnam’s Simon.

After all, investors are more than aware that high-yield paper was trading at very expensive levels until recently. With its low default rates, a general move away from equities on the part of asset managers, and the increasingly fruitless hunt for yield in the debt markets, the high-yield asset class unsurprisingly became something of a sweet spot. By the time Eco-Bat et al were pricing payment-in-kind deals with 10% coupons, investors had all but given up on being properly compensated for their risks. But now that the high-yield index has moved out by 100bp or so, investors say that valuations are starting to look more comfortable.

The fundamental health of the sector remains robust. While rating agencies have warned that the euro-denominated high-yield default rate is set to rise, this is largely because it cannot get much lower: Standard and Poor’s trailing 12-month European high-yield default rate stands at zero. The earnings season, meanwhile, has been kind to high-yield issuers, more so than investment-grade firms at least.

“On a purely technical basis, high yield remains attractive compared to equity,” says Chris Garman, high-yield credit strategist at Merrill Lynch. “400bp is appropriate compensation for the anticipated rise in default rates, which will probably rise to 3.3% by early 2006.”

General Motors

Despite these positive signs, high yield faces a singular event risk. General Motors’ €19 billion of euro-denominated debt is casting a shadow over the market. While high-yield investors are doing their best to price the well-telegraphed downgrade into the high-yield space, they admit that they are still trying to work out the precise implications of European high yield’s largest ever fallen angel.

The index-linked high-yield investor has cause for concern: as soon as GM enters the high-yield index, he will be compelled to buy GM bonds that are already trading at cheap single-B levels. As GM bondholders with investment-grade-only mandates are forced to sell, the price could well plunge even further – and push out other high-yield spreads at the same time.

The impact of these technical factors can be overplayed, however. In the sterling market, for example, pension funds often prefer not to tie their fund managers’ hands in this way, as their experience has taught them that forced selling often ends up costing them money. “There will be forced sellers,” says Webb from Morley Fund Management. “They aren’t shouting about it, but they still have this paper on their books. But there may be less than you think.”

And forced sellers will not necessarily flood the market with paper immediately following the downgrade. Many have relaxed their rules to allow the selling to take place within a fixed period. Some of these investors will be able to wait up to 90 days before selling, allowing them to pick the most opportune moment to offload GM paper from their books. This should reduce the potential for volatility.

Another mitigating factor is the increased use of constrained indices by European index-linked high-yield fund managers. The Merrill Lynch European Currency High Yield Constrained Index, for example, caps the maximum exposure to any individual name at 3% of the overall index, even if the name represents a larger percentage of the high-yield market.

The practice of capping name exposure in an index became popular in Europe after heavyweights such as Fiat, Alcatel and Ericsson became fallen angels in 2002 and 2003. When Fiat fell, for example, it took up around 15% of the high-yield index.

“After the experience of 2002, the vast majority of European high-yield fund managers now use constrained indices for diversification purposes,” says Merrill Lynch portfolio strategist Patrick Trezise.

GM would take up around 18.5% of Merrill Lynch’s unconstrained European Currency High Yield Index (which includes both euro- and sterling-denominated debt), says Trezise. But with the constrained index, investors will not have to clear out 18.5% of their portfolio to make room for the new debt.

“With a 3% capped index, you don’t actually need to buy that much,” explains one analyst. “It won’t necessarily screw up your returns.”

“Without an uncapped index, the problem would be bigger, but buying GM debt will be largely optional,” says Citigroup’s Newman. He adds that index players only represent about half of the market anyway.

Appetite for GM

The use of constrained indices may be good news for wary fund managers, but it is bad news for existing bondholders, as the forced buying would have buoyed prices of GM paper. Whether high-grade investors sell by mandate or by choice, it is not clear who will be willing to take the paper off their hands.

Analysts doubt that traditional high-yield investors will be enthusiastic buyers of GM debt, at least during the first few weeks of uncertainty. Newman predicts that GM debt will initially trade like ABB or Corus debt a few years ago. “It will trade separately from the rest of the market, and will fall as low as it can,” he says.

“There is a fear that GM paper could fall between two stools,” says Garman. “If high-yield buyers decide only to buy enough to reflect the index, then the price of the remaining debt will go lower than it otherwise would.”

Ultimately, the markets are rational: at the right price, GM debt is bound to attract some high-yield buyers. The question is who will bear the cost of adjustment.

There is a diversity of potential buyers, but it seems that hedge funds might be better placed to take early overweight positions on General Motors than traditional index-linked buyers. Hedge funds have been active on the name already, and there is also a great deal of US money keen to take exposure to European distressed debt. But in time, traditional high-yield buyers may find value in holding GM paper.

“They’ll do their research, and they’ll buy it if they like the credit,” says Alliance’s Reeves. “It could be anyone buying it, not just hedge funds.”

One sweetener is the fact that much of the outstanding euro-denominated GM paper, is issued from its GMAC subsidiaries. GMAC is marginally more palatable to many investors than straight GM exposure, as debt issued from subsidiaries has better recovery prospects in a default scenario.

Difference from 2002

While GM is set to be Europe’s largest ever fallen angel, the European high-yield market has experienced the destabilising effects of sizeable fallen angels before.

Today’s high-yield market differs from the high-yield market of 2002, which was rife with fallen angels. The global default rate was much higher back then, reaching 13% in late 2002. The high-yield market was smaller and less diverse – and still reeling from the collapse of the high-yield telecom, media and technology sector. The market was far more volatile, widening to over 1,000bp at one point.

Now, both default rates and interest rates are lower, and underlying credit fundamentals are stronger. There is more natural demand for the high-yield asset class, pushing spreads tighter and decreasing volatility. This demand is coming more and more from outside the traditional high-yield investor community.

“From a high-grade perspective, the big lesson of 2002 was not to get rid of fallen angel paper too quickly,” says Webb from Morley Fund Management. “We don’t expect GM to default – there is bound to be some value at some point. GM paper will be worth holding on to, for some more flexible high-grade accounts at least.”

Newman from Citigroup also believes the diversity of the investor base will make it easier for the market to absorb the shock. “It will be different from the fallen angels of yesteryear because hedge funds are now such dominant players,” he says.

Putnam’s Simon claims that the GM downgrade will be “a fantastically expensive lesson”, but good for high yield in the long run. “The good news is that the line between high yield and high grade is melting: people care less and less about the distinction,” he says.

Simon adds that most people holding triple-B paper now are holding it for the first time. “A lot of people tobogganed into our market on the back of Fiat. At first, they wanted to get out as fast as possible. But once they were in the high-yield space, they were able to get used to it.”

A healthy pipeline If the high-yield market is suffering from a bout of turbulence and uncertainty, no one seems to have told high-yield issuers. The new issuance pipeline is robust, with around €4 billion expected in May and June. The strong supply may be yet another factor preventing a rally back to February’s tights, but high-yield investors are not unduly concerned. For the most part, they are pleased that the quality and pricing of deals is starting to favour the buyer. The market had already seen €6.7 billion of supply from 24 issues in the first quarter, before the market started to widen. After Swiss cable TV operator Cablecom’s €375 million issue on March 23, the primary markets froze as high-yield spreads widened. The hiatus lasted for three weeks, as issuers and investors tried to work out what was going on. But on April 15, French water company Saur restarted play with a €265 million issue. Several other deals followed hot on its heels, including Scottish telecommunications equipment maker Damovo and Italian automotive firm Piaggio. Investors now say that total high-yield issuance for 2005 could reach €20–25 billion. “The environment in Europe is starting to look like the US in the mid-‘80s,” says Chris Garman, credit strategist at Merrill Lynch. “The euro is strong, resulting in competitive pressure on the corporate sector – giving firms the incentive to retool, float new debt and engage in M&A activity.” The market correction of recent weeks has had an impact on the pricing of recent deals, as issuers pay a premium for market volatility. “Investors have become more cautious,” says Youssef Khlat, head of European high-yield at BNP Paribas. “Issuers recognise that the market has backed up, and the market is in the process of repricing risk to more normalised levels.” Damovo, for example, saw price talk on the €218 million fixed-rate portion of its €358 million issue widen to 11% from a proforma price of 9.75%. Standard & Poor’s rates the credit CCC, while Moody’s rates it B1. Single-B rated Piaggio, meanwhile, priced its €150 million offering at 10%, up from initial price guidance of 9%, although price talk had hovered around 10.25%. Of course, some issuers have gone back to the drawing board as a result of the spread widening: German cable operator Iesy, for example, pulled a €525 million bond in late April. Private equity firms will have to rerun their calculations on their LBO models now that they can no longer factor in 8.5% debt yields. But as Khlat points out, many LBOs are bridged, and issuers have no choice but to take out those bridges. As well as getting a better deal on price, investors are also seeing signs that, after a long period of deterioration, the quality of high-yield issuance is improving. “The payment-in-kind market seems closed; there is now a healthy pipeline of more traditional deals,” says Robert Jones, high-yield analyst at Barclays Capital. While there are still some indifferent deals, investors are at least in a position to choose between the good and bad, rather than picking the least of several evils, as was the case until recently. Investors are focusing on higher-quality names. The Saur bonds, for example, are rated B1/B+, one of the higher-rated LBOs to come to market. Cablecom, meanwhile, offered high-yield investors the chance to buy senior secured paper – again, a rarity for an LBO. “I think we will see tighter covenant packages as spreads correct,” says Khlat. “We are mindful of the change in sentiment and the need to satisfy both issuers and investors.”

Pension funds’ caution In 2003, when high-yield bonds were returning 27.9% and the sub-investment-grade default rate had fallen from 25.1% to 6.4%, European pension funds could not get enough of the asset class. Indeed, by the end of that year, most funds had increased their exposure to high-yield debt considerably, while some funds – particularly those in Denmark – had increased their holdings to more than 10% of total assets. More than 12 months on, however, that picture has changed. The spreads on high-yield bonds have fallen to historic lows, the latest research from the rating agencies show that the sub-investment-grade default rate is on the climb and the European pension fund community is in the process of scaling back its exposure to the sector. “We have been selling high-yield bonds since the end of 2004,” says Frank de Waardt, managing director of the €1.5bn Heineken pension fund in the Netherlands. “On January 1, 2004 we had a 7% exposure to the asset class and by the end of that year it had been cut down to 3%. And we will continue selling in 2005.” Pekka Siltala, fixed-income portfolio manager at Etera, the €4.9 billion Finnish mutual insurance fund, agrees: “We have been quite careful and have invested very modest amounts – 1% of total assets – in high-yield bonds. At the end of last summer we had planned to increase our exposure to the market but spreads quickly tightened and we decided against it.” Siltala adds: “While spreads continue to narrow and the credit quality of deals weakens, we have shifted our focus from the high-yield market to other areas, such as government debt from emerging market nations.” But as the pricing on new issues falls to record lows, some institutional investors are not happy to just cut into their current high-yield portfolios. They want to get out of the market altogether. “We are in the process of selling off all of our high-yield bonds right now,” says Henrik Franck, investment director at the €3.5 billion lawyers and economists pension fund in Denmark, which at one time had a 7% allocation to the sector. “The time is right, not just to reduce holdings but to sell them completely. We expect additional spread tightening and further increases in US interest rates and, as far as I am concerned, the risk/reward ratio is just not good enough.” The pension fund managers are not alone in their findings. The asset management community, which has been marketing high-yield bond products to institutional investors in Denmark since 2001, is also taking a more than cautious look at the sector. “We are looking to reduce our number of [high-yield] positions from around 110 to 70,” says Roman Gaiser, manager of a European high-yield fund at F&C Asset Management. “Last year and 2003 were great years for high-yield bonds, with strong inflows of new money driving the direction of the overall market. But, while 2005 has got off to a good start and we continue to favour high yield over investment grade, the days of investors being rewarded for simply being in the asset class are over. From here, we see performance being even more dependent on stock selection and our focus is very much on assessing the downside risks.” Helen Roberts, head of government bonds at the investment house, agrees: “The hunger for yield and the diversification benefits of high-yield bonds have led to enormous buying. We believe that spreads are now in expensive territory but we are still moderately positive on fundamentals and technicals and our strategy this year will be to concentrate on optimal stock-picking.” But the dilemma that faces pension fund investors, who had relied heavily on high-yield paper in the past but who are still nervous about equity market volatility, is what to do with that money now. Some are indeed braving the stock markets, while others favour domestic government bonds. Peter Preisler, head of European sales at T. Rowe Price, believes investors should leave their money where it is. “Of course there has been spread tightening and we have started to see a few funds reducing their exposure to the sector but that is because they had an overweight position in the first place,” he says. “I would be surprised if we see many funds getting rid of their investments completely as they would face big problems trying to find alternative assets that provide them with the same level of return for the risk.”