Commentary on the European high yield market from Ben Pakenham, European high yield portfolio manager at Aberdeen Asset Management:
Overview
There has been much talk recently of a bubble emerging in the high yield space. As is the case for much of the fixed income universe, both sovereign and corporate names, it is certainly true that investors thirst for income has pushed up the prices of so-called junk bonds. Benchmark returns last year ranged between 25-30% so a pause for breath, at the very least, would be welcome.
Unfortunately investor demand has led to a decline in the average credit quality of new issuance as companies look to take advantage of accommodative conditions. Year to date, the net leverage (net debt / earnings) of primary deals has risen to 4.2 times on average versus 3.6 times in 2012. Another indicator of this can be seen from the use of proceeds with nearly a third of new issuance funding Leveraged Buy Outs (LBOs) or dividends versus less than 20% last year. Nevertheless, these figures compare very favourably to 2007 which saw companies come with 6 times net leverage on average and 40% of debt deals being used for LBOs or dividend recapitalizations.
More positively, default rates and interest rates are expected to remain low. Low interest rates mean high yield spreads remain around the long term average of 500 basis points, which compensates for annual default rates of around 5% per annum, even though yields are at all-time lows. JP Morgan recently published European default forecasts of 2% for both 2013 and 2014. This seems counter-intuitive given the economic environment but when one considers the triggers for default (failure to refinance liabilities or pay interest expenses) then it becomes easier to comprehend. Refinancing risk is low and even though the macro-economic environment is tricky companies are, in the vast majority of cases, perfectly able to fund their debt burdens even when stressed. Furthermore, the highly leveraged companies likely to face genuine turbulence remain in the loan rather than bond market. Finally, when central banks do decide to raise rates high yield is less interest rate sensitive than say government and investment grade bonds.
Our view is that valuations have shifted meaningfully over the last 15 months and therefore it is sensible portfolio management to reduce risk. Our new issue hit-rate in Europe has been relatively low at around 15% and we have continued to cut our exposure to lower rated bonds. But a case can still be made for high yield to be part of a diversified portfolio, particularly one with a need for income.
Ben Pakenham, European high yield portfolio manager
To view the Aberdeen Global II - Euro High Yield Bond Fund Factsheet please click here
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