Fears of sharp rise in high yield bond defaults should the economy slip back into recession are overblown, according to a leading corporate bond fund manager.
Fatima Luis, whose £224 million F&C Strategic Bond Fund invests across the credit spectrum, believes that despite the prospect of short term volatility high yield remains an attractive asset class due to the exceptionally strong balance sheets of many issuers and her fund is currently positioned with a 42% exposure to high yield.
Luis points out that the valuations of high yield bonds are now in line with a mildly pessimistic macro outlook with spreads having widened significantly on the back of reduced risk appetite and uncertainty surrounding solutions to the current European government debt crisis.
"While fears over government indebtedness have cast a shadow over risk assets generally, recent earnings announcements for high yield issuers have actually been encouraging. Most measures of credit quality have improved. Leverage has come down and cash to debt measures are near historical highs. Credit quality can continue to improve in a low growth environment if that turns out to be the case", said Luis.
She added: "We think default rates may rise again moderately over the next few years, but remain well below the historical average of 4.7% with Moody's base line forecast being below 3%. Low defaults are also underpinned by the fact that since the reopening of the new issue market most high yield issuers have refinanced debt to at least 2014."
"What investors tend to forget is that all high yield issuers are not alike. The risk of default is heavily skewed to the lowest grade, CCC where the average default rate is 13.7%, as opposed to BB rated entities where the average default rate is 0.73% according to Moodys. Naturally, being invested in a portfolio where the average rating is BB is not a bad place to be given the levels of income on offer," she said.
Luis points out that even where an investor has the misfortune of owning a bond that is about to default, the recovery rates have also improved. For example in 2009, owners of senior secured bonds that defaulted saw an average recovery of 37% and in 2010 that had improved to 62%. Luis argues this demonstrates how the market structure has improved.
She concluded: "The development of the European high yield market has accelerated as a result of the credit crisis. As banks have been reluctant to lend, corporates have turned to the bond markets. This in turn has led to a wider investible universe for fund managers, enabling us to hunt out issuers with solid business models and good cash generation with yields which are attractive. While the European debt crisis continues to pose a significant and real risk to the financial system, we believe high yield has the potential to be more resilient than it is often perceived to be. Any political solution to the Euro debt crisis would see spreads tighten. We therefore continue to believe high yield has an important role to play within a diversified credit portfolio."
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