Source: BofA Merrill Lynch Global Research, BofA Merrill Lynch Bond Indices, Janus Henderson Investors, as at 30 October 2017. Driving forces
Explaining the shrinkage in the market is relatively simple; it is due to a number of forces, which are explored below. Before doing so however, it is worth taking a step back to reflect on the fact that eight years into a bull market, with close to record low yield levels, corporates appear to lack the exuberant animal spirits that in the past would have encouraged a leveraging up of balance sheets.
It would appear that the scars of the previous crisis continue to run deep. We have spoken in previous articles and videos about the experience of Japan and the lasting impact of a ‘balance sheet recession’ on both corporate and household attitudes to debt. It is also the case that a low growth and low inflation backdrop makes it hard for companies to envisage ‘growing into’ a highly indebted capital structure. Europe led the way in this regard but it is fascinating to see similar footprints in the US.Changing corporate behaviour
Facing an economic environment with stagnant growth, European corporates have remained relatively conservative in their behaviour. We have commented in the past on the low levels of European merger and acquisition (M&A) activity in this business cycle relative to previous cycles, and the US.
This is particularly noteworthy given how cheaply European corporates can borrow in public bond markets. The European investment grade market currently yields 0.75% and the European high yield market yields 2.12%. The lure of cheap debt seems to exert little force on the European corporate psyche. This has not been the case in the US where investment grade companies have taken full advantage of lower bond yields in this cycle in order to return cash to equity investors.
The US high yield market, however, currently seems to have more in common with Europe, driven by a cautious attitude among private equity sponsors. This is very different to the gung ho attitude exhibited during the 2005-07 private equity boom.Resurgence of rising stars
While the number of credit rating downgrades has exceeded the number of upgrades in the high yield universe, the volume of debt being upgraded to investment grade has far outweighed that being downgraded to the high yield index.
Typically, it is companies with the bigger capital structures (which make up a larger part of high yield indices) that are engaged in improving their credit profile. Not only does this give them access to cheaper and more plentiful funding (should they need it) in the investment grade market, if and when this cycle eventually turns, they will also be in a relatively better position to weather the storm.
The result is — across both US and Europe — a smaller high yield market, as more bonds are upgraded to investment grade.
The upgrade of Anglo American alone earlier this year, resulted in the loss of $9.6bn (par value) of bonds in the US high yield index. Tesco, which makes up 5.7% of the smaller sterling high yield index, has announced it is focusing on a return to investment grade and is buying back debt with that view in mind. In the case of the European high yield market, Barclays estimates €20bn of debt (par value) will migrate from high yield to investment grade in 2018 with only approximately €5bn going in the opposite direction. A newfound affinity with loans
In addition to corporates’ changing business strategies, the high yield bond market has faced cannibalisation from its sister asset class — leveraged loans.
Indeed, possibly the biggest trend in the past two to three years for the high yield market has been the resurgence of loan issuance driven by the continued strong demand for collateralised loan obligations (CLOs) and a sense of protection offered by floating rate notes in a ‘rising rate environment’ (or not, as the case may be).
Borrowers have tended to prefer leveraged loan structures, which typically come with far fewer covenants, allowing more operational flexibility for the issuing firm; over 75% of loans outstanding are classified as ‘cov-lite’. In addition to this, the issuers retain the ability to repay or refinance the terms of these loans at very short notice. A large part of loan activity, particularly this year, has been companies refinancing outstanding loans at lower margins.
There is a lot of overlap in the companies that issue high yield bonds and issue debt (loans), and it is no coincidence that the rapid increase in leveraged loans has coincided with a period of decline for high yield debt. Since the end of 2014, the US high yield market has shrunk by 3.7% while the loan market has grown by 12.7%.
In aggregate, the combined size of the US loan and high yield bond markets has been broadly stable since 2014 (chart 2). Again, this is very different to the wave of mega leveraged buyouts (LBOs), which expanded the high yield and loan markets in the 2005-07 period.Chart 2: combined size of US high yield and loan markets
Source: BofA Merrill Lynch, Janus Henderson Investors, as at 30 September 2017Where do we go from here?
There are many aspects of this credit and business cycle, which continue to surprise investors and differ from the textbook expectations of an aging bull market. Our guidepost for much of the divergence in behaviour between European and US corporations continues to be the experience of Japan in recent decades; erasing the memory of a debt trauma takes more than low interest rates.
In contrast, areas where we have observed a willingness to binge on debt in this business cycle are: emerging market corporates, US investment grade companies and the household sector in Australia and Canada. Each such debt boom presents different investment opportunities and risks to an unconstrained bond fund.
Divergence remains the dominant theme for bond investors. Note: Yields and spreads quoted are correct at the time of writing in late October. Yields may vary and are not guaranteed.