7 Min Read
* Concerns rise as valuations get stretched
* Loan market and ECB competition compress spreads
* Sell-off trigger difficult to predict
By Helene Durand
LONDON, May 12 (IFR) - Alarm bells have started to ring at the increasingly stretched valuations in the high-yield market, leading some investors to believe that the market could be set for a hard fall.
Spreads on US Double B rated bonds set a new post-crisis low of 231bp this week amid strong demand from investors for higher-yielding debt, while the European iTraxx crossover hit 254.9bp on Friday, close to the post-crisis record low of 2014.
And yet, while many in the market remain confident that very little could get in the way of positive sentiment, investors are increasingly concerned that they are not being adequately compensated for the risk they are being asked to take.
"We think a 450bp spread widening in the next 12 months in high-yield is absolutely possible," said Nannette Hechler-Fayd’herbe, head of investment strategy at Credit Suisse.
"We are seeing that the monetisation of the markets and this liquidity created by the central banks has to go somewhere. Institutional investors are crowded out of the corporate market because of the CSPP [the ECB's corporate sector purchase programme]."
"Private investors who look for yield and cannot find much in investment-grade are turning to high-yield."
While others think 450bp would only come about in a true risk-off environment and is a very bearish outlook, they are nonetheless concerned.
"Looking at global high-yield, we are trading on the edge of the tightest quartile and we have to keep that in mind," said Jeff Mueller, portfolio manager, high-yield/multi-asset credit at Eaton Vance.
"US high-yield is at 370bp and European high-yield at 320bp. If you look back to 1983, when spreads started at 370bp and you look on a 12-months basis, 70% of the time spreads were wider over a 12-month period, with an average 200bp widening. If they went tighter, that was only by 35bp, so there is a skew to the downside."
Concerns about the state of the leveraged finance market were also raised this week in an annexe to the Financial Stability Board's annual global shadow banking monitoring report.
"It appears that many characteristics of a financial cycle are present in this market," wrote Peter Wierts and Rene de Sousa van Stralen at the De Nederlandsche Bank, the authors of the annexe.
"The combination of increasing credit volumes, higher valuations and declining yield spreads could also be interpreted as under-pricing of aggregate risk."
For issuers, the current conditions have been a boon. Grifols priced the tightest Single B issue in European high-yield in April, a €1bn seven-year carrying a 3.25% yield.
"We are in the lower decile in terms of spreads, which may feel like scraping the bottom of the barrel," said Richard Ryan, manager of the M&G Alpha Opportunities Fund.
"Even relatively gentle underperformance can be detrimental to returns and yields and spreads are so low that you don't need to see a dramatic widening of spreads to lead to losses."
According to Ryan, the relationship between Triple Bs and Double Bs has only been tighter than current levels 14% of the time over the past 10 years.
Demand for high-yield has been propelled by competition from the loan market, where issuers have been able to get ultra-cheap financing on more flexible terms than offered by the bond market.
This, added to the ECB's CSPP, which has pushed some investment-grade buyers into Double B territory, means that traditional high-yield investors have had to scramble to get hold of paper.
"There is a narrative to say that some investors have been reaching for yield and willing to take a greater amount of credit risk in order to achieve better returns," said M&G's Ryan.
"If we get a pullback of investment-grade buyers from high-yield, it is difficult to see how the market will be able to withstand that and replace that buyer base."
For all those concerns, market participants are struggling to see what would be the trigger for a widening, especially as a positive outcome in the French elections removed one of 2017's biggest risks.
"Yields remain at historically low levels; however, it's not immediately apparent what the catalyst for widening could be," said Diarmuid Toomey, head of European high-yield capital markets at Deutsche Bank.
"Most leveraged issuers have now refinanced their callable debt and benefit from low interest costs and incurrence rather than maintenance covenants. It would require a relatively significant macro, default, or rate-related event to dramatically change where things are trading in the market."
How and when the ECB begins to taper is likely to play a big part in any correction, as the presence of the central bank has been instrumental in keeping yields low and pushing investors out of the market.
"As we start to hear more about tapering and so on, we will start to see a lot more tension on rates," said Tanneguy de Carne, global head of high-yield capital markets at Societe Generale.
"If we clean all the noise around and narrow it down to a few big macro factors, I think the ECB holds a lot of the answers on future movements and potential corrections."
Investors have already started taking action in preparation for a potential market fall.
"We are underweight Double Bs versus Single Bs where, if you're selective and do your homework, you are getting paid for the risk," said Eaton Vance's Mueller.
"However, overall we are currently underweight risk from both a spread and duration perspective as we are cognisant that we are in the tightest quartile for high-yield in history."
Others have been keeping their powder dry for when a sell-off finally happens, with M&G running a 30%-40% balance in very low-risk assets including cash, ABS, government bonds and covered bonds, according to Ryan.
"The moment people talk about their inability to see what may derail the market is when you need to proceed with caution," said Ryan. "I can't say when we will get a dramatic move but from the current valuation, the upside feels very much capped and any disappointment isn't priced in." (Reporting by Helene Durand, Additional reporting by Yoruk Bahceli, Christopher Spink, Editing by Matthew Davies)