Balance of power
The cause of surging demand for high yield among institutional investors is uncontroversial: investors are hunting yield. “Given rock bottom government bond yields in core Europe and excessive spread compression in the periphery, it is not surprising that higher yielding securities are in demand,” says Tapan Datta, head of global asset allocation at Aon Hewitt.
The scale of demand for high yield bonds, which is being channelled into funds tracking the space, has significantly changed the demand/supply dynamics of the market, shifting the balance of power towards issuers and issuing banks.
Claire McGuckin, who co-manages Kames Capital’s £1.7bn High Yield Bond fund, says: “Unquestionably, the technicals in the European high yield market have moved strongly in favour of issuers and banks rather than investors over the last year. The significant increase in money coming into the asset class has provided strong technical support. New issues are frequently heavily oversubscribed and that has naturally affected prices, taking European high yield to aggressive levels. For some time we have not been comfortable that we are getting enough premum for the types of issuers in the market.
“From a pricing perspective,” McGuckin continues, “there isn’t enough push-back from the markets for certain deals.”
Shorter call periods
As a result of the high inflows and subsequent buying pressure on the primary market for high yield bonds, the rights of bondholders have seen some erosion, which can result in lower returns and weaker protections for investors.
One such erosion has been the shortening of call periods, which allow an issuer to repay the bonds at a given price on a given date in the future. The given price is typically several percent above par, creating potential upside for investors. The longer the period to the next call, the higher the potential capital gain for investors as shorter periods mean an issuer is less likely to be locked into paying a higher coupon.
According to M&G Investments, the price of a seven-year bond, which is not callable for four years, at 6% yield, to call in two years’ time is 109.7. A reduction in the call period of one year reduces the price to call in two years’ time to 107.1, resulting in a cost to investors of 2.6%.
Likewise, another innovation eroding investors’ returns has been the introduction of a call of 10% of the issue size every year within a bond’s ‘non call’ period, typically at 103% of par. This effectively means 30% of an issuers bond could be called at a relatively limited premium to par.
The lack of ‘convexity’ associated with the callability of high yield bonds limits the upside potential available to investors and has become an increasingly significant problem for managers, who are struggling to find positions that materially change the performance of a portfolio. “By virtue,” McGuckin says, “stock selection becomes more challenging in a market that is moving towards smaller issues.”
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