JUNK BONDS: THE SUSTAINED APPEAL OF HIGH-YIELD DEBT 8 MARKET LEADER volume of bonds due to mature between 2012 and 2014 by some $79bn. This mitigation of short-term refinancing risk has had a dramatic impact on default rates, which by the end of 2010 had come down to 2.4% from a high in 2008 of 15%. All the rating agencies are now forecasting that defaults will be even lower in 2011. Fitch, for example, is expecting a default rate of between just 1.5% and 2%, assuming that the US economy achieves GDP growth of 3.2% over the year. Furthermore, recovery rates have picked up significantly in instances where companies do default. Whereas in the first quarter of 2009 investors were likely to receive only about 20 cents back on the dollar, the figure had risen to around 60 cents in the first three months of this year. Underpinning the stronger and more secure financial position of most high-yield companies is the promising short-tomedium-term outlook for corporate earnings. Most companies reported improved results in the first quarter of 2011, with the quality of earnings picking up as demand has increased for a wide range of manufactured goods (as opposed to the inventory restocking that boosted sales initially). Macro forecasts <strong>The</strong> macro-economic forecasts that GDP will grow by an average of 1.5% across Europe and by 3% in the US are also favourable for speculative-grade debt. While the figures are obviously a lot lower than those for other regions of the world (notably Asia) these rates of growth will be sufficient to support increases in company earnings without inducing the sort of corporate spending sprees (whether on M&A, expansion of production capacity, share buybacks, or a combination of the three) that inevitably precede a rise in defaults. “Companies remain alert to the risks in their business and look to prefer to pay down debt rather than increase it,” explains Stoter at ING. “This de-risking plays into the hands of high-yield investors. <strong>The</strong>re are still a lot of uncer- Hans Stoter, head of the high yield and investment-grade credit boutique at ING Investment Management. “We expect that trend [to lower-rated issuance] to continue, especially when the number of leveraged buyouts starts to increase,” he says. Photograph kindly supplied by ING Investment Management, April 2011. Arnaud Tresca, head of high-yield capital markets at BNP Paribas in London. “Our guys are simply looking for sufficient cash flows to pay their interest and principal,” he says. Photograph kindly supplied by BNP Paribas, April 2011. tainties out there, which have nothing really to do with high-yield markets, but which will keep management focused on the needs of their bondholders as well as those of their shareholders,” he adds. Arnaud Tresca, head of high-yield capital markets at BNP Paribas in London, made the further point that high rates of GDP growth are not the boon to high-yield investors that they are to the equity markets. “Our guys are simply looking for sufficient cash flows to pay their interest and principal,” he says. On top of the strong current fundamentals of the market, there is also now clear evidence of a structural shift that will be to its long-term benefit, as impending new regulation for the banking sector (led by the Basel III capital accords) will make it increasingly more expensive for banks to lend to subinvestment-grade borrowers. One of the central planks of Basel III will substantially increase the levels of regulatory capital that banks have to assign to riskier assets, which will include such lending. This will not only oblige banks to increase the margins they charge on such debt to compensate for the higher (regulatory capital) cost but it is also likely to lead many to scale back such operations in order to devote more of their resources to less capital-intensive—and potentially more profitable—use. “Companies that have traditionally relied on the bank-loan market are now looking to refinance with a more balanced use of secure debt and highyield securities,” comments Jessop at Pimco. “This has certainly been true for the last 12 months in the US market and we are now starting to see the trend appear in Europe, where there was minimal high-yield bond issuance in 2007 and 2008, as most companies took advantage of the very lenient terms available in the loan market.” <strong>The</strong> shift will be potentially more significant in Europe, where speculative-grade companies have relied on the banking market to a much greater extent than their US counterparts, thereby ensuring that the European high-yield bond market has remained relatively small and illiquid by comparison. “Medium-size corporations are finding banks less willing to provide financing and are being forced M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S
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