Always consider hidden risks

The Indianapolis 500 of Corporate Bonds Yields
​​US corporate credit market looking extraordinarily rich
( From SoberLook, Reuters )

​​One of the "side effects" of the Fed's monetary expansion is all the capital flowing into spread products, particularly corporate credit. Corporate bond yields are hitting record lows across the ratings spectrum. The low funding costs and plenty of liquidity keep driving high-yield issuance to the roof.

​Issuers have rushed to market this week ahead of year's end, taking advantage of record low funding costs as the yield-to-worst on the Barclays US high-yield index dipped to 6.11%.

Overall, 2012 has been the biggest year on record in terms of volume, with issuance far outpacing previous records. Year to date, the US high-yield market has seen USD321.91bn in issuance, according to Thomson Reuters data. Full-year estimates stand roughly at USD324bn, based on the remaining deals on the calendar.

The previous high-yield record, set in 2010, was only USD264.08bn.

Issuers have had a field day this year, with overwhelming demand for yield in the current low-rates environment forcing more investors into riskier asset classes.

Year to date, inflows in high-yield mutual funds and ETFs have reached USD21.369bn, according to Lipper.

According to the Barclays US high-yield index, the new low 6.115% yield-to-worst beats out the previous record of 6.145% set in mid-September. At the start of the year, the yield-to-worst was some 200bp wider at 8.143%.

"It's been a huge rally both in terms of volume and in terms of performance," said Peter Toal, head of Americas leveraged finance syndicate at Barclays.

"It's been a technically-driven rally. The Fed-induced increase in risk appetite has worked out in spades in high-yield."

Refinancings made up nearly 60% of issuance, as opportunistic issuers tapped the market throughout the year. Another nearly 14% came from corporate M&A activity, with 4.7% seen from LBOs, according to Barclays data. General corporate purposes accounted for 16.7%, with dividends representing 4.4% of volume.

The refinancing trend will likely dominate again in 2013, although a pick-up in M&A and general corporate purposes is expected. But banks don't anticipate the kinds of volumes seen this year.

"It's tough to see how we can repeat this year, because it's just been so robust," Toal said. "I've never seen a year quite like it."

The Barclays high-yield team estimates volume in 2013 to reach USD275m to USD300m.

"As long as underlying rates and equity volatility remain low, and the equity markets stay in a pretty good shape, you'll see continued issuance and continued demand in the form of inflows into the asset class."

The bank expects returns of 4-6% for the asset class, just a bit below coupon given expectations for some price degradation and default loss. This is down from the impressive 15.56% seen year to date, according to the Barclays high-yield index.

JP Morgan predicts 7-8% in returns for next year, saying the extended prices for high-yield bonds this year will limit return opportunities in 2013. The bank expects USD275m in issuance amid robust capital market conditions.

"This reflects the record low financing conditions available to issuers, a broadening of use of proceeds as the new-issue cycle matures (more M&A, general corporate purposes), and the idea that demand for high-yield bonds and leveraged loans will remain strong, as monetary policy remains easy and the economy avoids a contraction," said Peter Acciavatti, high-yield strategist at JP Morgan, in a report.

JP Morgan anticipates that 2013 will end with a yield to worst of 6.50% and high-yield bond spreads of T+560bp, with the default rate to remain below 2%.

For its part, BofA Merrill also estimates USD275m in new issue volume and expects to see returns of around 7%, based on assumptions of low defaults and an improving global macro picture.

"With yields standing at never-before-seen levels in almost every corner of the fixed income universe, it is becoming mathematically impossible to generate capital gains credit investors have enjoyed in the past few years," said Oleg Melentyev, BofA Merrill credit strategist, in a report.

"This is still an interesting proposition in the world of low-single digit return expectations in IG and a decade-long dissatisfaction with equities. HY would remain the right asset class for many investors next year for as long as their expectations are properly adjusted to new realities."

Whether by themselves or within a balanced portfolio, history teaches us that risky bonds are a bad idea, and despite today’s record low interest rates, investors should resist the urge to “reach for yield”.
​​​An average junk bond in the Merrill HY index now yields some 6.3%.

Even emerging markets corporate HY bond yields are near all-time lows.
In fact credit looks highly overpriced relative to US equities. And equities are not exactly cheap at this stage, particularly given some 2% GDP growth expectations in the US. Goldman's relative value model now shows corporate credit at the richest levels in at least three decades.

Central Banks Zero Rate Policy are pushing investors to the Reach for Yield Mentality without measuring the risks associated to it.
Small grab in yield for huge risk involve ; is it a definition of a bubble indeed !​