DOWNWARD TRAJECTORY
Despite the supportive picture, however, there can be little doubt that yields on high yield bonds will continue to fall as long as demand remains strong. Apart from anything else, it is the intention of the ECB to push investors into risk assets. And, as investors digest the full impact of the ECB’s action on government bonds, there may yet be a more pronounced decrease in yields on high yield bonds.
Matthieu Guignard, global head of product development and capital markets, Amundi ETF and Indexing, believed in mid-March that the big move had yet to take place as investors were still focused on sovereign rates and demand for high yield would continue to increase and government yields fell even lower. Even if the yield differential remains at its current level and default rates don’t pick up however, other changes in the high yield market are increasing the risks associated with those bonds, which cannot be ignored. In today’s sellers market, the structures underlying many high yield bonds are becoming increasingly flexible, tilted in issuers’ favour with fewer protections for the end investor.
With demand so strong even weaker high yield bonds are being absorbed and the risk associated with high yields bonds has begun to creep up accordingly. There is a danger that weaker bond structures could result in a more pronounced sell off in high yield if a catalyst for a correction occurred. In that case, the true liquidity of the high yield market would be severely tested. In strong contrast to demand for high yield bonds, liquidity is massively down as banks have reduced the amount of inventory they will hold on their balance sheets in the wake of regulatory changes.
This is particularly pertinent for UCITS funds, through which the majority of European high yield is held, where, Chris Redmond, global head of credit at Towers Watson worries there may prove to be a mismatch between the liquidity promised at the fund level and what the underlying market is actually capable of delivering.
Mitch Reznick, co-manager of Hermes Credit says credit management is increasingly about liquidity management. He points to the “profound change in the structure of credit markets. The buy-side has increased massively,” he says, “while banks have severely reduced their inventories. There is effectively around $8bn-10bn on the sell-side supporting $8trn- 10trn on the buy-side.” And, even though the short-term environment remains supportive, the long-term is less promising.
According to Redmond, Towers Watson is taking a cautious approach to credit: “The long-term scenario for European high yield is not particularly good. The compensation for the risk is pretty meagre and economically, Europe is still in a difficult place versus the US as it still hasn’t tackled the problems of debt and competitiveness.”
With demand pressure building as the central bank forces sovereign yields lower and investors move more aggressively into lower credit quality bonds in the hunt for yield, how far will they be willing to go before enough is enough? As yields continue to sink, will investors continue to buy high yield at any cost, or will they realise the dangers associated with going everfurther down the quality curve while the investor protections built into those bonds are increasingly depleted? And what will that mean when the next correction hits for a market that is already massively liquidity constrained?
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