Analysis: Crowded junk bond market faces bumpier 2011

By Natsuko Waki

LONDON (BestGrowthStock) – High-yield corporate bonds are unlikely to repeat this year’s rosy performance in 2011 as inflation threats and a stronger appetite among companies to releverage pose risks to what many see as a crowded market.

The typical underperformance of corporate debt to equities in an expansionary economic cycle, which many investors believe financial markets are in now, and the lingering euro zone debt crisis are also likely to take the shine off these bonds into the new year.

Correlation data shows “junk” bonds — riskier paper rated below investment grade — are now trading like equities, benefiting from demand from investors seeking risky but high-yielding investments.

Contrary to initial expectations, junk debt extended its stellar performance of 2009 into this year as the Federal Reserve embarked on a second round of quantitative easing and the European Central Bank has kept its liquidity operations in place and will do so until at least next March.

But the longer this low-rate environment drags on, the bigger the risk becomes for future inflation and an ensuing monetary policy response.

And unlike equities, high-yield bonds are particularly vulnerable to this looming interest rate threat, known as “duration” risk.

“High-yield debt has begun to behave like high dividend equities, capital guaranteed. There is an unforeseen level of vulnerability from an interest rate shock,” said Bill O’Neill, chief investment officer at Merrill Lynch Asset Management.

“The fun cannot go on forever… There’s no overwhelming comfort blanket for the sector because there’s duration risk.”

Reuters data shows correlations of global high yield bonds and equities have already started to come down after hitting a 7-1/2 year high around 0.8 earlier this year.

Merrill Lynch’s calculations show global high-yield bonds have had an extreme negative correlation to global sovereign bonds since the collapse of Lehman Brothers in September 2008.

The correlation “coefficient” measure of high yield and sovereign bonds stands now at around -0.9, compared with 0.7 before Lehman Brothers collapsed in September 2008.

That means high yields are trading like equities, moving almost exactly the opposite way to government bonds.

OUTFLOWS

Investors may already be sensing a shift.

JP Morgan estimates show retail high-yield funds have seen three consecutive weeks of outflow. In the past few weeks, $1.5 billion has been taken out versus year-to-date inflow of close to $10 billion, representing a 15 percent reversal.

Fund tracker EPFR’s data shows investors pulled $639 million out of high yield bonds in the week ended Dec 3, which was the biggest since early June.

Barclays Capital expects U.S. and euro zone high-yield bonds to give a total return of 5-6 percent and 6.5-8.5 percent respectively next year. That is less than half of this year’s total average return of around 14.5 percent.

This compares with return forecasts for world stocks of many analysts of up to 20 percent.

“We think there is a potential yield curve back up that will damage (corporate bonds) and we will have to try and put some hedging instruments in place against our interest rate exposure of our credit portfolio,” said Percival Stanion, head of asset allocation at Baring Asset Management.

Stanion said hedging ideas included shorting UK government bonds to offset any rise in gilt yields that would be a drag on corporate bond performance.

“The same I think applies in the junk space. It clearly had such a huge move in such a short space of time that we are not going to get anything like that return going forward,” he said.

COMPANIES RELEVERAGING

Corporate bonds in general and high yields in particular could also come under pressure as companies, hoarding record amounts of cash, start to spend the money pile by repairing balance sheets and expanding businesses.

“As long as growth remains at least at trend levels, and we believe that will be the case, corporates should begin to feel comfortable enough to increase leverage. This event risk will mostly be a positive for equities and a negative for credit,” Barclays Capital said in a note to clients.

Thomson Reuters data shows companies globally are hoarding $4.3 trillion in cash and equivalents on their books.

A net 41 percent of fund managers polled by BofA Merrill said corporate balance sheets as underleveraged.

In an expansionary economic cycle, equities perform better than credit. Schroders data going back to 1950 shows equities give excess return of 8.8 percent in an expansionary cycle, compared with 1.8 percent for high yield debt.

The other key risk especially in Europe is the sovereign debt crisis.

“We do not believe that corporates can meaningfully decouple from sovereign spreads. The linkages between corporate borrowing, banks and governments are simply too high,” Morgan Stanley said in a note to clients.

“Our asset class will continue to confront the following puzzle: If one is constructive on European sovereign risk, the best value lies in buying those bonds outright. If one is not, European credit should probably be avoided altogether.”

(Editing by Hugh Lawson)

Analysis: Crowded junk bond market faces bumpier 2011