Investors question value as high-yield spreads narrow

Fri Apr 11, 2014 1:00pm EDT

NEW YORK, April 11 (IFR) - High-yield investors may not have to worry about a sudden spike in defaults but there are growing concerns that valuations are not reflecting risks appropriately, and that the market could be poised for a sharp correction when Treasury yields rise.

A herd-like grab for yield has led to a 100bp tightening of the spread between higher rated Double B and riskier Triple C rated "junk" bonds since June to 253bp. The average yield on US high-yield bonds is now just 5.03% - a smidgen over the record low of 4.95% hit on May 9 last year, according to Barclays data.

That has put valuations at the top of the list of buyside concerns.

"When we talk to clients, it's clear they are thinking about whether the limited remaining upside potential is worth the increasing risks," said Eric Gross, a credit strategist at Barclays.

Although Moody's global speculative grade defaults fell to just 2.3% at the end of the first quarter from 2.9% at the end of last year, some investors said it's time to become more selective in their approach.

"We would love to see a correction to inject some sobriety into the market," said Wes Sparks, head of US fixed income at Schroders.

"For me, as a value investor, it's about whether there is enough risk premium embedded in bond yields. We are selling some bonds that are trading at high dollar prices; it's definitely not a time to be throwing yourself into the market."

Other credit strategists agree with that.

"Like Icarus flying too close to the sun, only to get burned and fall crashing back to earth, high-yield is looking awfully rich to us," said Michael Contopoulos, high-yield credit strategist at Bank of America Merrill Lynch.

His concern is rising rates, and the very real chance that at some point this year, this will prompt a sharp correction.

"Lessons can be taken from 2013's rate driven selloff, even if we don't necessarily believe the widening and flows will be quite as severe this time round."

TIME TO GET PICKY

Few predict a repeat of the four to six point drop in cash bond prices that came in the wake of the Federal Reserve's first hint of tapering last summer.

In fact, over the very near term, conditions will likely remain pretty frothy in high-yield following a rally in Treasuries on the back of underwhelming March payrolls data.

But if and when a correction does happen, it could get messy, and credit selection now is therefore even more vital.

"The cycle is maturing and investors need to be getting more discerning between different credits," said Michael Collins, a credit strategist at Prudential Investments.

"With spreads compressing, they are not getting paid incrementally what they should to buy riskier credits."

Making the right choices is not easy, and the temptation for some accounts is to keep buying as they have so much cash to spend. That has prompted question marks over whether some deals should be getting done at all.

This week's USD10bn-plus supply offered a wide variety of deals, including a USD750m payment-in-kind toggle for BMC Software and a USD300m senior secured bond for previously bankrupt window and door manufacturer Atrium.

The former offered a coupon of 9%, while the latter is expected to come with a yield of about 8% on Friday - very attractive compared to what's on offer elsewhere.

At first glance, the PIK might be considered the riskier of the two because of its deep subordination. It also funded a dividend to private equity owners Bain and Golden Gate that left them with virtually no skin in the game after repaying most of their equity investment in the business.

But while companies have similar high leverage - at more than seven times - some analysts are more confident of the potential earnings improvement at BMC as a cost savings program starts to take effect.

In Atrium's case, however, investors are betting heavily on a very strong housing market recovery and pick up in new home builds - something that was not necessarily reflected in the price, some said.

"To pick up yield, I would prefer to go down the capital structure in a large, higher quality company that we know well and that has a lot of equity beneath it than buy a bond of a small company with limited cash flow," said Sparks.

"We are interested in companies that have positive free cash flow that provides the ability to deleverage."

One thing is certain: this current low interest rate environment will not last.

If earnings and revenue growth do not keep pace with the rise in rates, there will be a tick up in defaults.

As one lawyer put it: "low rates mask defaults, and we're just kicking the can further down the road." (Reporting by Natalie Harrison and Mariana Santibanez; Editing by Shankar Ramakrishnan)