Corporate Financing Analysis - Bad News Up Ahead For High Yield Bonds - 20 NOV 2017

2017 has been a banner year for activity in the global high-yield (HY) bond market, but a disappointing one for investment grade (IG) bonds. Half way through Q417, however, and with a rise in risk sentiment fast approaching according to BMI's Global Team, the outlook for the two ends of the debt market are about to trade places, with junk bond activity set to endure an abrupt slowdown in sentiment at the expense of an increase in IG issuance.

The Search For Yield
2017 Y-T-D Global High Yield Bond Market Activity By Deal Value, USDbn
Source: Dealogic

From Bull To Bear

As the old adage states, what goes up must come down - and after a bumper run for high yield activity in 2017, a bear market for such debt instruments is fast approaching. Indeed, the relentless rise in the short end of the US yield curve, together with rising inflation expectations, should start to feed through into higher US long-end yields and also add to the upside pressure on interest rate hike expectations across Europe. With little room left for corporate spreads to tighten, high yield bonds in the US and Europe are particularly at risk. Emerging Markets (EMs), meanwhile, should outperform given supportive real yields and rising commodity prices, but will remain at risk from external upside yield pressures.

With upside pressure mounting on government bond yields, and with high yield spreads back to their lowest since 2007, junk bonds in the corporate sector, in particular, face deeply negative risk-reward prospects, particularly in Europe. As BMI highlights, the yield on European investment grade bonds is now below that of 2-year US Treasuries, while European high yield bonds yield only a fraction more than 10-year US Treasuries. This is a clear bubble in our view and reflects the extreme monetary easing policies undertaken by the ECB, which should ultimately weigh on the euro and force the authorities to tighten whether they like it or not.

A Year To Remember For Junk Bonds

2017 has certainly not disappointed either HY issuers or investors ( see ' HY vs IG: Junk Bon d Popularity Continues [For Now] , September 13 2017). According to Dealogic data, global junk bond issuance has tallied USD441.3bn in the y-t-d period, which is up by 45% y-o-y. Conversely, IG bond activity has fallen in value by 3% y-o-y to a level of USD2,947.7bn across the same time period. So, while IG debt activity remains significantly more popular - with the total value of such note sales outpacing HY activity by more than six-fold - both issuers and investors comfortable with the riskier end of the debt spectrum have been enjoying 2017 a lot more than their risk averse peers. Despite this, we note that global debt capital market (dcm) activity has declined by 1% y-o-y to a level of USD6,236.5bn in the y-t-d period.

In terms of the geographical breakdown of junk bond activity in the y-t-d period, the US market has been the most active, chalking up deals worth USD302.5bn, which equates to a 30% y-o-y increase in value from the same stage last year. Similarly, in Europe, the value of junk bond paper sold so in 2017 has risen by 28% y-o-y to a level of USD103.4bn - Dealogic data shows. Asia (excluding Japan) has been the standout region for HY bond activity in 2017, recording USD44.4bn in issuance. This equates to a 256% increase in value y-o-y and serves to illustrate the surge of interest in the region for such fixed-income instruments and follows on from a 44% increase in the value of junk bonds sold in the region across the 2016 full-year period. In BMI's view 2017 was always going to have the potential to be a bumper year for junk bond activity thanks to a combination of the ongoing low interest rate environment and a renewed appetite for risk globally among investors, following on from a year of geopolitical shockwaves in 2016 (with the UK's referendum vote to leave the European Union and Donald Trump's election as US President acting as the main catalysts). As the y-t-d numbers from Dealogic show, the market has not disappointed beneficiaries ( see 'Global Junk Bond Interest To Return To Low Yield Environment', October 12 2016) with the US Federal Reserve's decision to delay raising rates further extending the bull run in note sales at the riskier end of the spectrum across the course of H217. When rates do increase once more, however - as we are expecting them to do in early 2018 - we believe that it will ultimately lead to a rise in defaults and. more broadly, a 'risk off' environment among the debt capital market investment community globally. As a direct result of this, we may well see dcm investors move back toward the relative 'safe haven' of IG bonds once more and, in some cases, focus on so-called 'crossover bonds' - those which straddle the line between HY and IG - especially while the turnaround in risk sentiment is being priced in by investors.