MUCH attention has been paid in recent months to the sustained recovery in the world’s equity markets.
Rather less attention has been given to the rebound in corporate credit (corporate bonds), although this has been in some ways even more dramatic.
High-yield corporate credit bonds (regarded as relatively risky lower-rated issues, offering potentially higher returns but with a higher risk of default) have risen particularly sharply, with the Barclays Capital European High Yield index up 56% so far this year, albeit after falling by 35% over the course of 2008.
But is this too much, too soon? Possibly yes. One way of approaching this question is to the look at changes in “spreads”, that is the difference between yields on corporate bonds and government bonds with the same time to maturity.
Normalised spreads can be used to indicate the “richness” (i.e. expensiveness) or cheapness of corporate bonds in the context of how spreads have moved over the past 12 months.
These normalised spreads are now close to the bottom of their normal trading range, suggesting that both investment-grade (less risky) and high-yield debt are now expensively valued.
Of course, this does not necessarily mean that corporate bonds are about to retreat again – these apparently expensive valuations can be maintained for some time, especially if the economy is growing.
But current valuations make adding to further corporate bond investments rather less appealing.
Investors also need to be careful about credit selection, as the possibility of widespread defaults remains.
At the peak of the financial crisis last year, corporate bond markets began to price in depression-type scenarios, reckoning that as much as one-third of high-yield bonds might default.
Current spreads now suggest that the market still expects a default rate for high yield debt of around 15-16%. This is a rather higher level than that predicted by the rating agency Moody’s baseline forecasts, but is in line with their pessimistic scenario for the first quarter of 2010.
Default rates tend to lag crises, and it is still possible that we will see rates rising to this level around the beginning of next year, even with economic recovery.
The case of the German luxury goods maker, Escada, which recently filed for insolvency because of dwindling demand for its products and an inability to refinance its debt, serves as a reminder of how things can still go wrong.
Of course, with the average spread for the high-yield index still almost 200 basis points above its historic average, there is some scope for further gains.
But, given the risks outlined above, demand for high-yield corporate bonds is likely to come from those investors with high risk appetite and high composure – and we would emphasise again our belief that credit selection will remain very important.
For those interested in investing in high yield bonds, we would suggest considering diversified, active fund managers with expertise in local markets and sound credit selection processes.
Andrew Miller is regional office head of Barclays Wealth in Newcastle