Institutions have been “going down the credit ladder” for around three years, according to Mr Brils, head of European high yield at ABN Amro, which runs close to €1bn in global high yield debt. Nicholas Lyster, head of marketing and sales for Europe at Principal Global Investors, puts the US market at approximately $850bn, with the European market around $100bn.
Institutions, Mr Brils explains, “have been getting comfortable with investment grade, then going into high yield to diversify a portfolio or to gain additional yield. They have stalled a bit since the General Motors downgrade last year, but the trend is slowly continuing.”
F&C Asset Management, which now runs $1.5bn in high yield debt for institutions, has seen “quite substantial inflows over the last two years,” according to head of high yield Kevin Matthews.
Mr Lyster concurs. He adds: “It is not a particularly good time to be in US fixed income, but they are better off in high yield than they would have been in other corporates or government bonds. This is really a long-term asset allocation. They have learnt that they need to take more risk in fixed income.”
The average US institutional allocation has grown from about 5 per cent to closer to 8 per cent, Mr Lyster says.
Within this, institutions are looking increasingly at the riskier end of the scale. Guidelines that have insisted on only BB and B investments are adjusting to allow managers to buy CCC bonds. “They can’t seem to get enough of it.”
But those familiar with the cyclical ups and downs of the high yield market are worried. These bonds, Mr Lyster stresses, “are CCC for a reason, and although the credit climate has been fairly benign for the past few years, it is not that long since we had a real bust up.”
He refers, of course, to the turn of the century, when returns plummeted into the negative after a period of low default risk, inauspiciously similar to the past few years. Chris O’Hare, portfolio manager at Investec, explains: “If you look at the previous cycle, in 1995, 1996, 1997 we saw a similar phase with low default risk. There were acquisitions at higher multiples. Deals were lower rated. There was higher leverage. It wasn’t such an issue there and then, but two to three years into the new deals the conditions got worse and some of these companies became distressed. It is not too wild a leap of the imagination to see such a situation at the moment.”
Mr Lyster warns that, amid the “massive new issuance” of the last two years, in the face of demand, too little attention has been paid to the details of contracts. “In times like that some very sloppy deals are done,” he says. “Companies don’t give very strong covenants. We expect some of those to come undone.”
Default rates, then, are set to increase. Currently just under 2 per cent, they should rise to around 3 per cent this year and next, according to Kevin Akioka, principal at Payden & Rygel, which runs $2.5bn in high yield debt. Moody’s, according to Mr O’Hare, predicts a global default rate of 3.3 per cent at the end of January 2007.
 | Akioka: predicting a 3 per cent rise in default rates this year and next |
While some experts are cautious on particular industries – Mr Matthews dislikes airlines and automotives, while Mr O’Hare thinks auto suppliers are “most at risk”– others are confident that this default cycle will differ from the last one.
“In that previous period there were very specific problems with certain industries – telecoms and some of the energy sectors, media and cable,” says Mr Akioka. “I think the rise in defaults we will experience next will be related more to individual companies getting into trouble.”
Ken Monaghan, managing director and senior portfolio manager at ING Investment Management in New York, agrees. “When defaults increase, which they always do and eventually will when we approach the end of the credit cycle, we do not expect the industry-concentrated surge in defaults which we saw in 2000-2002. Defaults are more likely to be found among some of the over-leveraged LBOs financed in the last several years.” ING runs $3bn in high yield credit assets.
One thing is clear. When the defaults come, they will hit the CCC end of the market. Defaults, according to Mr Brils, will “in particular impact on B and CCC bonds”. Mr Akioka adds that “obviously the most vulnerable part of the market is low B and CCC. So we are pretty cautious on that.”
Payden & Rygel’s portfolio is 55-60 per cent B, with almost all of the rest BB, and only 1-2 per cent exposed to CCC bonds. F&C is similarly cautious, “significantly” reducing the large overweight it has had in CCC for the past few years.
So what should institutions do? Mr Lyster says: “Our view is that if you are going to take that risk you have to be very, very careful. It is not so much picking the winners as not picking the losers.”
He argues that institutions need a manager who “really understands credit research” and who pays detailed attention to the contracts, including, crucially, to where the investor stands on the balance sheet.
“Can they issue debt above you?” he asks, warning against private equity firms who “buy a company and then issue huge amounts of bonds to pay themselves a dividend. This is not helping you as a bond holder.”
But it would be a mistake, it seems, to back out of the high yield debt market altogether. “I would say, if you have an allocation, maintain the allocation,” says Mr Akioka. “There is a lot of value in a lot of parts of the market. There are B and some BB bonds where you can get very nice yields – 7.5, 8 per cent.”
Institutions, according to Mr Lyster, “just need” high yield: “The yields are so low on government bonds; they have their liabilities and they need more risk. Risk-adjusted returns on BB and BBB bonds are very attractive compared to the higher rated bonds.”
BRINGING TOGETHER THE BEST OF BOTH WORLDS
For institutions who want the best of both worlds, hybrid securities combine features of both equity and debt.
According to Nicholas Lyster, head of marketing and sales for Europe at Principal Global Investors, the first hybrid, or preferred, security was created by Goldman Sachs for Banco Santander in the early 1990s, with the first US version coming from Texaco.
The hybrid market now accounts for some $275bn in the US, approximately $80bn in Europe and around $20bn for the Sterling market, Mr Lyster estimates. He expects it to grow by around $40bn this year. Principal’s subsidiary Spectrum Asset Management specialises in hybrid securities, with $13bn under management.
The idea, Mr Lyster explains, is to offer debt with some equity features – quite long maturity (“quite often perpetual in Europe; 30-40 years in the US”) and the ability to defer interest payments.
“If a company defaults you can force it into bankruptcy straightaway if you are a bond holder,” Mr Lyster adds. With hybrids, the company can defer for up to five years. “It is like cancelling a dividend; the company can keep some cash flow. As a result they are quite popular.”
He says: “Companies can issue hybrids and they might get 30 per cent equity credit from a rating agency, so they can get money without affecting the equity debt ratio. They do this rather than issue bonds, which would be cheaper but might push them over into a downgrade, or equity, which might be quite expensive.”
Treated, typically, by central banks as tier one capital, hybrids tend to rank “below senior debt but above common equity and maybe preferred shareholders”.
More and more institutions are becoming interested in hybrids, according to Mr Lyster, with insurance companies in particular attracted by spreads of some 50 to 100 basis points over senior debt.
On the downside, investors face the risks associated with ranking lower than senior bond holders, as well as the fear of deferral. However, Mr Lyster adds, in practice this “rarely happens”.
He explains: “If an investment grade company had to stop paying interest on a preferred security if would be shut out of the capital markets. It would be like admitting you are going bankrupt.”
However, this tendency – for issuers to treat hybrids like bonds and never fail to pay – has prompted ratings agency Moody’s to introduce a scale of hybrids, with the existing preferred securities, with effectively zero credit risk, at one end, and “very equity-like instruments” at the other. This is a way, Mr Lyster says, of encouraging investors to “take a bit more risk”.
