Last year one of the biggest themes was that Europe didn’t get fixed, yet it was provided with so much liquidity that it was inflated out of its existing stress levels,” says Fraser Lundie (pictured), who runs the credit desk at Hermes Fund Managers alongside Mitch Reznick. “The reason that was such a big trade, in particular for high yield, was because it was in no way consensus. At the start of 2012 there wasn’t a single person on the street who had European high yield returning no more than a few per cent at best.
“Because everyone was caught offside, the European high yield market ended up returning in the region of 20 per cent, which is crazy for any type of fixed income asset.”
The Hermes Global High Yield Bond Fund did just that in 2012, returning an impressive 19 per cent with a volatility of 6 per cent. “That’s easily the best risk-adjusted trade across any asset class that I can think of,” opines Lundie.
But 2013 will not be a repeat performance within European high yield. The global high yield market is more fairly priced, the game has moved on. Now, the big problem is cash price and historic low yields because of where underlying government rates are.
The key is to manage that poor convexity, says Lundie: “If the markets climb 20 per cent there’s no way HY could continue to move up like it did last year because there’s an inherent ceiling in the market.”
To understand this upside limitation, if a high yield bond reaches a certain price the company has the discretion to call it back. Last year it wasn’t such a problem because European HY bonds were trading at 95 cents on the dollar. Now, they are trading at 105 on the dollar: they’re at the ceiling.
“From here, all you can expect is income rather than capital appreciation,” explains Lundie.
Then there’s downside risk, specifically negative convexity, which ties in to the call option. At 105, a HY bond trades on the assumption that it could get taken out at any moment by the company. However, if there’s a market dislocation because of a macro shock, these bonds have much further to fall than those without the call option (e.g. any investment grade bond).
“It could theoretically fall very quickly from 105 to 95 because the market re-prices it not on the assumption that it will get called back, but rather than on the assumption that it will trade to maturity.
“We’ve not had this situation for 25 years in HY. If you ask the average bond manager what they are doing about their option pricing risk, they won’t really know what you’re saying. That’s why it’s important, from our viewpoint, to employ credit default swaps (CDS) within the fund. By using CDS you’re not buying things at silly prices, and you avoid the call option (which isn’t available for CDS).”
This negative asymmetry – where the upside is squeezed and the downside is exaggerated – means that performance expectations for European HY are more limited in 2013. Lundie says he cannot see a situation where HY could return more than 10 per cent in the base case scenario, where liquidity from the ECB continues to flood the market.
“Inflows will likely stay sticky in high yield, and probably we’ll do somewhere between 5 and 10 per cent. That’s the realistic level of return. Even if we return 7 or 8 per cent this year with a volatility of 6 per cent, that’s still a really good trade.”
Key to this will be the continued use of CDS, with Lundie noting that “if you’re just buying cash bonds within HY right now, it’s a terrible trade. They can’t go up because of the ceiling and if they do go down they’ll do so twice as much as they would do normally. We think that by using CDS in conjunction with cash bonds you can take out the ceiling and make the fall softer. Instead of buying a bond, therefore, we might sell a five-year CDS and collect the premium.”
A CDS is basically an insurance contract that gives the holder, who pays an annual premium, the right to collect on the face value of the bond should it default.
“We’ve always combined CDS with bonds in our funds, but never within HY has it been more important than it is today because of where valuations are,” says Lundie.
So where are the opportunities within European HY this year?
One important play, according to Lundie, is to focus on companies headquartered within the European periphery, but whose earnings predominantly come from outside of Europe. “A good example would be Fiat Industrial, based in Milan, where 97 per cent of their earnings come from Latin America and North America. The company is doing great, record earnings, yet it trades like Fiat, even though it has nothing to do with cars.
“Another example would be Obrascon Huarte Lain SA, a Spanish-based multinational construction and civil engineering company which is 80 per cent exposed to Latin America infrastructure projects. People see the ticker, they see Spain, and it ends up trading at the wrong level.”
In Greece, the fund portfolio holds a position in OTE, the telecoms company. Its bonds are trading at around 8 per cent for 5-year paper, putting it at the B- rating level for what, says Lundie, is probably more like BB- or B+ rated credit “so you’re getting a couple of ratings’ worth of cushion”.
As for core Europe, Lundie says they favour Peugeot Bank, which has a quasi-government guarantee for the next three years, “so buying a 2016 dated Peugeot Bank bond trading at 4 per cent yield is a good trade.
“If you’re going to play the theme of balance sheet repair, you could choose to play it in terms of peripheral Europe versus the core, or Europe against the US, but we prefer to do it by playing financials against corporates. Banks are going to be forced to reduce their balance sheets.”
In addition to European financials, the fund also has exposure to financial companies in the US such as aircraft leasing companies. “They’ve been through defaults or bailouts in the past and aren’t yet able to participate in equity-friendly activity just yet, which makes for a compelling credit trade.”
In core Europe, currently the main risk when looking for HY opportunities is equity-friendly activity.
If a BB rated company in France, for example, is doing well from a balance sheet perspective, the shareholders will put pressure on the board to seek out acquisitions, which is a credit negative activity. Bond pickers need to try and avoid such companies.
“We’re not seeing that yet in Europe, but we certainly are in the US where companies are starting to look at LBOs again,” says Lundie.
Lundie says that the fund’s best trade last year involved holding a “busted convertible”: this is where a convertible bond does so badly from an equity perspective that the option to convert the bond to shares moves too far out of the money. At this point, it basically behaves like a bond because nobody cares about the equity option.
Tui Plc was an example of a busted convertible. Lundie confirms that they used this successfully in a pair-trade by also holding CDS on the parent company, Tui AG.
“The German holding company owns shipping, hotels etc, and there was a real mispricing to the Tui bonds. The convertible bond space is typically dominated by equity traders so when a convertible bond is busted it tends to fall into no-man’s land. That meant it was trading a lot cheaper, even though its balance sheet was a lot stronger than the parent company. We made around 40 basis points.”
So what is the key takeaway for the high yield market this year?
“If you can’t invest globally and you can’t use CDS then from a valuation and a liquidity perspective there’s no trade left in high yield,” concludes Lundie.
