Despite the recent spike in 10-year Bunds to above 1%, the reality is that bond yields across Europe remain historically low. The big picture search for yield hasn’t changed and asset managers will likely need to look wider still.
Whether it is the prospect of continued quantitative easing by the European Central Bank, further economic trouble unfolding in Greece, or the expectation of permanently depressed growth, a prolonged era of low bond yields appears upon us. As longer-dated sovereign bonds remain stubbornly at record lows, this has had a domino effect where even traditional high-yield bonds are offering little more than 3-4%.
For most asset managers (in credit or otherwise) the surge in liquidity from quantitative easing has been welcomed as it has buoyed asset prices.
The flip side of this, however, is that with yields now compressed, maintaining performance – the Barclays euro HY index has generated a total return of circa 30% over the last three years with even the Investment Grade equivalent returning 15% over the same period – is becoming problematic.
Traditionally, credit funds have raised their money from institutional mandates and therefore it has been quite “sticky.” Today this relationship is less certain following substantial retail inflows seeking a yield pick-up. It will certainly be tested in an environment of sub 3.5% yields for High Yield and sub-1.5% yields in Investment Grade. Fund managers face a real risk of retail fund redemption if they are unable to generate sufficient returns. To avoid seeing their funds under management shrink, they need to look further afield for yield.
This means credit fund managers have to move out of their comfort zone.
The natural tendency has been to stick with what is working – typically investing in large-size bond issuances in well-researched and known corporates. This generates efficiency savings as the same diligence is needed on a US$2 billion or US$200 million bond.
At the moment low rates are pretty much a global phenomenon bar some Chinese property developer names, meaning geographic diversification is not a solution. Instead, for more funds, they must move into the unchartered territory of smaller, less liquid credits.
But they will find obstacles ahead. Although demand is a rising tide, there are bottlenecks preventing a matching supply of high-yield bond paper, especially in the secondary market. Part of this is a legacy issue because bond dealers have also focused on the low hanging fruit in large-scale issuance. Research on smaller companies is much more patchy, requiring more independent work on diligence and research.
Another problem, highlighted by fund managers from BlackRock, Pimco and others, is new bank regulation. As Basel III and other post-financial crisis regulatory initiatives (like Dodd-Frank) are increasingly felt, systematically important banks are pulling back from being as active in lower-rated bonds as they once were. This is because new capital requirements mean they could (in theory) tie-up substantial amounts of capital by holding high-yield paper. The result is that a critical cog in the bond market has been impaired, as banks need to be able to hold bonds in order to make tradeable markets in them – when they can’t, liquidity suffers.
This removes a traditional source of liquidity as bulge-bracket banks curb their secondary market activity. Due to these higher-cost compliance structures, commercially motivated organizations are instead directing resources towards activity that generates greater returns on equity like the underwriting of bonds as opposed to the trading of them, a strange state of affairs if ever there was one.
Therein lies the problem: at a time capital is hungry to invest in lower rated bonds due to policy-led quantitative easing, regulation is removing the incentive for larger banks to provide liquidity in those bonds and lessen their ability to provide for that market’s proper functioning.
Investors seeking to move down the credit quality spectrum will find this market underserved.
At the same time, however, this provides an opportunity for new intermediaries, unencumbered by regulation, to fill this gap by trading and researching these less well-known companies. The spoils of this market will go to institutions that can provide good quality research and the ability to commit efficiency capital.
There is plenty scope for growth. Regulators are pushing for more bond supply vis-à-vis bank loans – corporate bonds to bank lending is 20:80 in Europe, which is roughly the opposite proportion of the US.
As new intermediaries enter, this should create a virtuous circle of growth as smaller issues become more mainstream and more investors gain confidence to participate.
As the search for yield extends the frontiers of European high-yield bonds, this opens up a new world of opportunity.
(Hussein Nasser is Head of European High Yield Bond Trading at SC Lowy. Previously, he was Managing Director, Head of European Corporate Credit Trading at Nomura International in London.)