Alistair Wilson predicts what will occur in the European high yield bond market for 2013

Having enjoyed such a strong rally in 2012, and now reading the numerous articles on the ‘bond bubble’, we thought it was worth looking at the investment case for European high yield bonds.

Firstly, we think it is worth dealing with the term ‘bubble’. True bubbles are created when an originally sound investment proposition attracts so much demand and attention that the price becomes highly inflated. At this juncture there can become worries that the bubble may burst, but typically this tends to happen once the original sound investment case is no longer supported by fundamentals, not when the asset class is still underpinned by a robust investment case.

From where we sit, the only part of fixed income markets that could come close to being bubble like are the core government markets, eg gilts and bunds. These are expensive because of the highly challenging and unique environment that we have been operating in for the last few years. In the case of gilts we can add the fact that one buyer has steadily bought up 30 per cent of the market and is relatively indifferent on price. In fixed income we can also be a little more quantitative on just how inflated a bubble can realistically get. Five year bunds at 0.33 per cent will return a maximum of 1.65 per cent over five years; in theory investors could have all of this today if rates drop to zero, but this is ultimately all that is available from this particular bubble.

Clearly there is very little value left in these core markets and investors are probably holding them for other reasons. These ‘reasons’ need to stay in place to keep yields this low. Our view is that investors are going to be fortunate to see a positive total return in the next 12 months.

Therefore we should be focusing attention on those areas of fixed income where investors do not have to take the ‘gilt risk’; which points us nicely to the high yield sector of the market.

The £ HY Index currently has a yield of 7.83 per cent, with an expected maturity average of 5.86 years. Whilst this yield by historical standards is indeed low, the asset swap spread (ie the fixed rate or gilt risk stripped out) is a fairly healthy 636bp.

Putting this into context, the HY Index, which began in 1997, averaged a spread of 424bp in the 10 years prior to the credit crunch. In 2008 it ballooned out to just over double today’s spread whereas at the end of 2010 it had contracted back in to 564bp. So we are still some way short from either the historic average or recent tights. We also have a default rate today that is remarkably stable given the economic backdrop that we have endured.

This is largely due to the interventionist policies that have kept huge amounts of liquidity flowing through the system. We do not see this latter dynamic changing in the near term. Because such a large component of the total yield in high yield comes from the credit spread, high yield bonds typically do not trade as a spread to core government markets and therefore are less duration sensitive, which offers investors some protection from potentially rising gilt yields.

However, in our view the strongest driver for high yields is the technical demand for income and the intervention that we see in the markets almost every day which is making income more and more scarce. Demand is by far outstripping supply with central banks buying up large bond portfolios and financials shrinking their balance sheets, which has a profound impact on supply in the market’s largest non-government sector. This dynamic is firmly in place for 2013 and we believe this to be the primary driver of prices in the year ahead.

On the flipside though, Europe has an earnings problem ahead of it and we would expect high yield corporates to be most affected by this. The key ratio that bond investors look at is ‘net debt to EBITDA’ and with lower earnings, this ratio is likely to increase for many companies in the sector over the following 12 months. This increases the likelihood of ratings downgrades, hence high yield can be expected to face a fundamental headwind in the future, but they do start the year in reasonable shape which will keep the default rate under control in our opinion and therefore credit deterioration should be offset by the technical demand for the asset class.

Investors will not see the types of returns enjoyed in 2012, this is just not mathematically possible, but a stock picking approach to the asset class will produce the most attractive returns from the sector in the coming 12 months and that should comfortably outperform both corporate bonds and gilts.

Written by Alistair Wilson, head of institutional business, TwentyFour Asset Management

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