The attractiveness of high yield credit has increased in recent months, as the energy-heavy sector was sharply impacted by the disruption in the oil market in the second half of last year. This has resulted in a sharp investor move to the asset class this year, with mutual funds and exchange traded funds investing in high yield corporate debt recording about $11bn of inflows over the first two months of 2015, according to Lipper. This is a sharp reversal from the final two months of 2014, when investors withdrew $4bn.
Tim Beck, Stenham Credit Opportunities Fund
The disruption in the energy space has certainly made the high yield market more appealing for investors, due to lack of discrimination shown in price movements across the asset class late last year. This means high yield has every chance to rally over the next quarter or so. However, while spreads have increased in recent months, we still do not believe this adequately compensates investors for the inherent structural risks that remain in high yield. Excluding energy, high yield spreads are now 482bps over treasuries, compared with 439bps at last year’s tights.
Much of credit is trading at close to all-time tight yields and all-time high prices, but the quality of issuance is deteriorating and the structure of the market is inherently less stable than in the past. The zero interest rate policy adopted by the developed world’s central banks has led driven down yields to historic low levels. At the same time, regulation has restricted the ability of banks to take risk, with the (unintended) consequence of a lack of liquidity in the market. Retail investors, who may be more flighty at times of stress, have also become more prevalent in the market.
If we experienced any shock, be it credit or interest rate related, there is no marginal buyer until yields are substantially higher and prices concomitantly lower. So for traditional investors in credit, the potential returns are constrained and risks elevated. By contrast, this actually creates a compelling case to invest in credit through specialist hedge funds – which can firstly short credit, but also be the provider of liquidity at much lower prices.
These bonds are often call-constrained, in that issuers have the right to buy-back these securities at a price above par at some point in the future. This constrains how high prices can rise in high yield, whereas investment grade bonds for example can regularly trade well above par. We believe returns will be limited to the current yield at best.Spreads not compensating for default risk
Defaults are low and may well remain so for the next couple of years. But spreads, particularly at lower rating levels, are not compensating for average five-year default rates. Defaults may well remain low for an extended period, but given the uncertainties over the global economy, we do not believe this is a good enough reason to own the asset class.Credit quality deteriorating
With the high demand for credit, quality has deteriorated and issuers have been able to dictate terms. Covenant-lite loans, which attracted such bad press in 2008/09, are now significantly higher as a proportion of issuance and the absolute volume is a multiple of that seen pre-crisis.
Lack of liquidity
The high yield market has grown significantly since 2008, with the zero interest rate policy driving demand. However, regulation has at the same time limited the ability for banks to hold risk and inventory. Historically, banks have taken both a principal and agent role in credit markets – helping them function by providing an incremental bid for assets at times of stress. Since the financial crisis, the capacity to hold risk has been much reduced and the role is much more limited to that of an agent. It is unclear who would be the marginal buyer of credit. This could create a gap in pricing, with the potential for strong asymmetric returns from shorting.Less stable investor base
The holders of credit have changed since 2008, with retail investors increasing the proportion they own through both mutual funds and ETFs. Longer-term investors (insurance companies and pension funds) have declined steadily. Retail investors may be more likely to sell at times of stress, which would cause greater price declines.
By Tim Beck, lead manager of the Stenham Credit Opportunities Fund