Analyses and investment views

Bond excesses, Part III. – European “high-yield bonds”

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Bond excesses, Part III. – European “high-yield bonds”

Political correctness has struck even in the bond markets. Bonds issued by low-creditworthiness borrowers were always known as “junk bonds” (JB). The word “junk” clearly expressed that these are bonds with a non-investment rating and everyone understood that they are also associated with above-average credit risk. The same bonds are today euphemistically termed “high-yield bonds”. Unfortunately, this designation confuses the masses of less-experienced investors because not only does it not warn them of the high risk of non-payment but it also gives them the incorrect idea that high yields can be achieved by purchasing these bonds. The reality, however, is completely different.

In fact, the yields of European JB are absurdly low today. They are essentially at the same level as the yields of 10-year US government bonds. There exists, however, an immense difference between these two worlds. When you buy a US government bond, you essentially can be certain that you will get it paid back in due time and in full. When you buy a fund investing into European JB, however, you can be sure that no small part of the bonds in the fund will not be repaid. This is another beautiful example of how deformed bond markets are today and how poorly bond prices value risk.

As an example, take one of the largest funds investing into European JB – iShares Euro High Yield Corp Bond UCITS ETF, managed by BlackRock and traded on the London Stock Exchange with the ticker IHYG. The fund has assets of approximately EUR 5.5 billion and its portfolio contains about 450 bonds of various European corporations.

The yield to maturity for the full portfolio is 2.82%. That is very low. Moreover, this yield will only be achieved if all bonds in the portfolio are duly repaid. This, however, cannot be expected. Let us not forget that these are bonds of low-creditworthiness issuers. Indeed, 4.28% of the portfolio is invested into bonds rated CCC. According to S&P, the long-term average default rate for these bonds is 26.8%. In addition, 28% of the portfolio is in bonds rated B (4.2% of which are not repaid on average), and 67% of the portfolio is in bonds rated BB (0.2% of which are not repaid on average).

If the portfolio behaves according to the long-term averages, it is probable that approximately 2.5% of the bonds will not be repaid (and much more in case of a recession). This means that the average default rate will entirely wipe out the current yield to maturity. The yield will probably be negative, in fact, because it is the lowest-rated bonds which contribute most to the overall yield to maturity and have the highest probability of default. The fund’s costs of 0.5% will just make things that much worse. The term “high-yield bond” is really a misnomer here.

Why are the yields of European junk bonds so low? The main culprit is the European Central Bank. It currently purchases seven times more bonds than there are government bonds issued in the euro zone. It is literally sucking up the government bonds market, doing so with practically no regard for prices. In the US, for example, the Federal Reserve always bought fewer government bonds than were being issued. The ECB is in many cases running out of bonds to buy and it is active even on the corporate bonds market. These massive purchases push bond prices up and their yields down. Investors hungry for at least a minimal yield then buy bonds of increasingly poorer quality for increasingly higher prices.

At just above 2%, the spread between the yields on government bonds and JB is at a record low in Europe. This means that investors regard 2 percentage points of extra yield as sufficient compensation for the risks related to JBs. That is absurdly low. A look back at history shows that this yield spread used to be much greater over the past 20 years, at 6, 9, 15 even 22 percentage points. The 2% we have today is certainly not worth the risk, even glossing over the fact that the difference is calculated in relation to government bonds, the yields of which are themselves at a record low. According to Merrill Lynch, 60% of European bonds rated BB have yields lower than do US government bonds with the same maturity. It is very probable that in future, a short position in European JB will earn more than will a long position.

Invest with care!

Daniel Gladiš, 31 October 2017

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