“Due to the search for yield, a “shut up and take my money” sentiment is starting to emerge in the world of high-yield corporate bonds. Investors would be wise to be more cautious in allocating money to the high-yield markets. It is dangerous to stay in the highest-risk segment with the idea that things will go well for another six months”, according to Sander Bus, managing director and co-head of the credit team at Robeco, speaking in an interview with Fondsnieuws, Investment Officer Luxembourg’s sister publication.
As a long-term investor, Bus is concerned about the exorbitant flow of capital to the riskiest corporate bonds, the so-called junk bonds. In many cases, the yield on government bonds is even negative. In “the search for yield”, bond investors are now turning to high-yield bonds, which are also causing yields to fall.
Last week, the yield on the ICE BofA index of European high-yield bonds fell to 2.34 percent, meaning that buyers have for the first time accepted payments below the inflation level in the eurozone. In August, it peaked at 3 per cent, its highest level in a decade, according to the Financial Times.
Risk premiums too low
According to Bus, the high-yield market is not what it used to be. “In the past you could still achieve 8 to 9 percent returns in this high-risk corner of the market. The yields are now at an all-time low. The spreads of the high-yield segment are about 300 basis points above government bonds. If you zoom in to that three per cent, you see that the dispersion is very low. Most of the bonds are trading within 100 basis points of the index average.”
“Investors are therefore distinguishing less between the level of compensation they demand for bonds with different characteristics.” Bus stated that this is exceptional, as the high-yield segment usually has an increased risk of default.
“For the riskier corporate bonds, there are three credit ratings, BB, B and CCC. On average, 50 per cent of the companies with a CCC credit rating go bankrupt within five years. Yet the average price of that segment now trades above the nominal value (Par value) of the bonds.”
“People know that if the average bankruptcy scenario comes true, then half of those company names will lose money within five years. That need not be a problem for investors as long as the losses can be compensated by the winners. But it is really bad to stay in the highest-risk segment with the idea that things will go well for another six months,” said Bus.
The tipping point
“There will always be a turn in the market”, Bus stated. “A bull market in which credit is granted too easily to weaker companies lays the foundation for a period with more bankruptcies. This scenario is inevitable and should make investors more cautious now.”
“We live in a world of financial repression where central banks are keeping interest rates extremely low to stimulate the economy and aim for full employment. As a fixed income investor, these low interest rates are making it increasingly difficult to offset inflation - which central banks are deliberately trying to lift to higher levels.”
Bus continued: “As an investor, I think you have to think about the tail risks. It is better to play it safe too soon than to stay put for too long. One option is to invest in corporate bonds with a BB-rating. There the failure rate is lower, but the spread is also lower. If you do your job well, as an investor you can still avoid bankruptcies with an average default of 1 to 2 percent per year.”
The end of neoliberalism
A theme that may become relevant for financial markets, according to Bus, is a shift in the dominant political current away from neoliberalism. “For twenty years, the wages of working people in developed countries have barely risen, due to globalisation and cheap labour in countries like China. Shareholders have benefited from this, but now that central banks no longer look only at inflation but also at employment, the labour factor will take a larger share of the cake. That will be at the expense of the capital factor.”
“In China, the “Common Prosperity” policy is now being implemented,” he explained. “Instead of looking only at growth, they are looking at how prosperity should be distributed. The question of the coming period will be: How do we ensure that the low-paid working class can also benefit? You see that President Biden and even our own VVD are doing that. Policymakers want an answer to the question, how do we get the wages up?”
“This is not yet an issue,” he went on, “because demand is so strong that companies can pass on all the rising costs. Labour costs are becoming more expensive, but so are raw materials. There are shortages throughout the supply chain. Companies can now more easily pass on those costs. So at the moment you don’t see margins getting any lower.”