Analysis & Trends:
High-yield
corporate bonds
Higher bond yields with
reasonable credit risk
Understand. Act.
Analysis & Trends
Decisive Insights
for forwardlooking investment
strategies
2
Analysis & Trends
Content
4
High-yield corporate bonds
4
Corporate credit
5
Corporate credit value drivers
6
Managing high-yield bonds
7
Recent developments in the high-yield
bond market offer buy opportunities
12 Decisive Insights
Imprint
Allianz Global Investors
Europe GmbH
Mainzer Landstraße 11–13
60329 Frankfurt am Main
Capital Market Analysis
Hans-Jörg Naumer (hjn)
Dennis Nacken (dn)
Stefan Scheurer (st)
Olivier Gasquet (og)
Richard Wolf (rw)
Jochen Dobler (jd)
3
Analysis & Trends
High-yield corporate bonds
High-yield corporate bonds have suffered from a lack of
liquidity and from investor risk aversion. The higher yields
these bonds offer are linked to the issuers’ creditworthiness.
High-yield corporate bonds
I Corporate credit
1. High-yield bonds and investment-grade
bonds constitute the two segments of bond
debt issued by private companies, known as
corporate bonds.
Here, we will discuss only listed issues of
bonds.
• Investment-grade bonds are issued by
the most creditworthy issuers.
• High-yield bonds are issued by less
creditworthy issuers.
2. In view of the additional risk, corporate
bonds have a higher interest rate than
government bonds. This difference is called
the “spread”: the less creditworthy the
issuer, the higher the spread. The spread
of high-yield bonds is therefore higher than
that of investment-grade bonds.
3. During an economic and stock market
cycle, when the economic situation and
credit risk improve, corporate credit
becomes a real investment opportunity.
When the economic situation and credit
risk worsens, corporate credit has the
greatest risk exposure of the different types
of bonds. High-yield bonds are the most
volatile and most risky of the two types of
corporate bonds.
4
Corporate credit, or corporate bonds, refers to
bond debt issued by private companies. There
are two types of corporate bonds.
• Investment-grade bonds, known as senior
bonds, are issued by the most creditworthy
issuers. They have ratings of between “AAA”
and “BBB-”. Their interest rates are a little
higher than those of government bonds.
• High-yield bonds are those issued by less
creditworthy companies. They have ratings
of less than “BBB-” and their interest rates
are considerably higher than those of government bonds.
The creditworthiness of an issuer is rated by
specialised rating agencies, such as Standard
& Poor’s, Moody’s and Fitch Ratings. Their
ratings are designed to precisely reflect levels
of credit risk: i. e. the risk that an issuer may
default on payments.
Ratings are reviewed at least once a year. They
can be maintained, upgraded or downgraded,
or placed “under review” with “positive” or
“negative” implications, pending completion
of an additional study.
II Corporate credit value drivers
1. Corporate bonds and changes in interest
rates
Like any government bond, corporate bonds
are affected by changes in long-term interest
rates. Their prices thus depend on the level of
economic activity, inflation and key interest
rates.
When interest rates on government bonds
increase, at constant spread, the interest rates
of corporate bonds with the same maturity
also increase. As is the case with all bonds,
their market value will then go down. The
more sensitive (the longer the maturity
and / or the lower the interest rate) the bond,
the greater the drop in price. Conversely,
if the interest rate on government bonds falls,
the rate on corporate bonds will decrease
and their market value will increase. The more
sensitive the bond, the greater the increase in
its market price.
Due to their higher interest rates, high-yield
bonds are less affected by changes in longterm rates than government bonds. There is,
however, another determining factor.
2. Corporate bonds and creditworthiness
The “spread” and thus the interest rate of a
high-yield bond is primarily dependent on the
creditworthiness of the issuer, i. e. its credit
quality.
It is therefore important to hold securities
whose creditworthiness will improve. An
improvement in an issuer’s creditworthiness
warrants a lower spread, which tends to result
in a lower overall interest rate and an increase
in the value of the securities. Conversely, it is
important to avoid bonds whose creditworthiness will deteriorate: a fall in creditworthiness
warrants an increase in the spread, which
tends to result in a higher overall interest rate
and an automatic drop in the value of the
securities.
3. Study of risk
A thorough analysis of a company is needed
to assess its credit quality.
A company’s equity (shares) and mediumand long-term debt (bonds) are what comprise its long-term resources, i.e. an essential
part of the company’s liabilities. An analysis of
the issuer’s sector, market positioning, strategy, balance sheets and financial statements
must verify that the company’s day-to-day
operations will allow it to service its liabilities
adequately over the long term.
A company’s equity analysis and debt analysis
comprise these same steps. Equity analysis
determines the value of the company’s
shares, which represent ownership of a portion of the company. Debt analysis determines the value of the company’s bonds,
which represent ownership of a portion of the
company’s debt.
5
Analysis & Trends
4. Default risk
All issuers have a default risk, i.e. the risk of
being unable to fulfil the terms of issue of
their bonds. The default may result from the
delayed payment or non-payment of interest due, or non-payment of part or all of the
capital. It can also arise from a change in the
terms of issue to accommodate the issuer’s
inability to meet its initial obligations.
The default rate is the percentage of companies having defaulted within a sample defined
either by a given rating, or an economic
sector, or level of debt seniority. It is not the
rate of real capital loss, as it must be supplemented by the recovery rate, i.e. the proportion of the capital affected by the default,
but ultimately recovered by the creditor.
The default rate and the recovery rate
together determine the planned or actual loss
on a portfolio of corporate bonds. Deducting it from the spread gives investors the net
spread, which is the effective remuneration
supplement received compared with government bonds.
III Managing high-yield bonds
The management of a portfolio benefits from
the specific assets it focuses on.
1. Dual nature of high-yield bonds
High-yield bonds have dual share-bond
characteristics.
As a bond or debt, their value is closely
linked to the issuer’s creditworthiness, i. e.
its ability to honour its commitments and
to perform. The market also assesses this
capacity through price of shares in the issuer.
High-yield bonds not only depend on bond
markets, but also on company risk, reflected
in stock markets.
• Verify that a bond’s spread matches the
issuer’s creditworthiness. When they
consider that the spread underestimates
the creditworthiness, they subscribe to
the issue. Conversely, when the spread is
insufficient, they reduce holdings in the
bond.
• Diversify their portfolios between sectors
and companies, as is the practice of all share
investors.
2. High-yield bonds and volatility
Another characteristic of high-yield bonds is
their volatility.
High-yield bonds are more volatile than
government bonds. At constant spread,
high-yield bonds are less susceptible to rises
in long-term interest rates than government
bonds, due to their higher interest rates.
But high-yield bonds are much more affected
by the issuer’s creditworthiness, which is
considerably more uncertain than that of a
country. The impact of creditworthiness
on high-yield bonds’ values and interest rates
is in fact decisive.
Yet high-yield bonds are, in theory, less
volatile than shares, as they are less risky.
In the event of liquidation, creditors are in
fact reimbursed before the shareholders,
so corporate bonds can still be worth something when shares are already worthless.
3. High-yield bonds and liquidity
Another characteristic of high-yield bonds is
their lack of liquidity. A company’s listed debt
often comprises several tranches exhibiting
distinct characteristics, each with a much
smaller capitalisation than that of equity. During stock market turmoil, the lack of liquidity
produces distortions between a bond’s spread
and intrinsic risk. These distortions offer as
many opportunities to buy as to sell.
High-yield bond investors must therefore:
• Be alert to any event likely to affect the
issuer’s trading and creditworthiness.
6
Generally speaking, the lack of liquidity
amplifies the volatility of high-yield bonds.
IV Recent developments in the
high-yield bond market offer buy
opportunities
• the rise in the spread of high-yield bonds,
as shown by the Crossover Index (Xover): a
corporate credit index comprising a mixture
of high yield and higher yielding investment
grade names
Recently, the high-yield bond market has
been characterised by three simultaneous
rises (see Chart 1):
• the rise in the volatility of shares, as shown
by the Standard & Poor’s 500 Volatility Index
(S&P 500 VIX): a popular measure of the
implied volatility of S&P 500 index options.
It is also known as the “fear index”.
• the rise in the spread of eurozone government bonds, as shown by the Markit iTraxx
SovX Index: a family of sovereign CDS indices converting countries.
Chart 1: The strong rise in stock market volatility has impacted the debt markets
(as in May 2010)
in basis points
in basis points
800
350
700
300
250
Xover
500
200
400
150
Sovx
300
SovX generic
Xover generic
600
A correlation can be
observed between
high-yield bond markets
(excluding those issued by
financial companies) and
the sovereign debt crisis,
with stock market volatility
increasing and risk becoming systemic.
100
200
50
100
0
11
7/
20
11
/0
/0
27
/0
28
26
5/
20
3/
1/
/0
27
20
11
11
20
10
20
28
29
/1
1/
20
9/
/0
/0
31
01
10
10
7/
20
/0
6/
4/
/0
02
20
10
10
20
10
20
2/
/0
01
03
/1
2/
20
09
0
VIX
40
20
11
20
29
/0
7/
11
20
30
/0
5/
11
20
31
/0
3/
11
20
30
/0
1/
10
20
01
/1
2/
10
20
02
/1
0/
10
03
/0
8/
20
10
6/
20
/0
04
05
/
04
/2
01
0
10
2/
20
/0
04
04
/1
2/
20
09
0
Past performance is no reliable indicator for future results
Source: Allianz Global Investors Investments Europe (AllianzGI IE) Global Market Analysis, Bloomberg, 29 / 08 / 2011
7
Analysis & Trends
Weekly flows in millions of US $
Chart 2: Strong capital outflows in June, and even stronger in August, from US and
European high-yield bond markets
Net buying flows of US high-yield bonds by mutual funds
800
0
–800
–1,600
–2,400
–3,200
–4,000
02/06/2010
25/08/2010
17/11/2010
09/02/2011
04/05/2011
27/07/2011
Source: EPFR, 30 / 08 / 2011
2,000
10%
1,000
5%
0
0%
–1,000
–5%
–2,000
–10%
–3,000
% of assets under
management
mm
Monthly European High Yield Fund Flows
for last 12 months.
–15%
Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11
Monthly Inflow
(EUR millions)
Monthly Inflow
(% of AUM)
Source: J. P. Morgan as of January 2012
The worsening creditworthiness of governments, whose issues had been deemed
“risk-free”, is affecting the perception of
risk related to listed companies and their
bond issues. For several months, investors
have been massively selling (see Chart 2).
Today, high-yield bonds offer high spreads,
slightly greater than the spreads seen when
Lehman Brothers collapsed, more than three
years ago. They are also characterised by
particularly high volatility, despite the fact
that the default rate remains particularly low,
which is clearly inconsistent.
8
Moody’s and Standard & Poor’s (S&P)
expected default rates over the next 12
months are very low, at 1.9 % and 1.6 %
respectively. Having reached 12 % at the
height of the last financial crisis at the end of
2009, default rates have levelled off at 1.4 % in
the eurozone and 2.1 % in the United States.
Standard & Poor’s specifies that its forecast
of 1.6 % lies on a scale between a best case
scenario of 1.2 % and a worst case scenario of
4 %. In any event, the default rate is expected
to be less than the long-term average of 4.6 %
(see Chart 4).
Chart 3: Low default rate expected by rating agencies
Default rates expected in the Unites States (Bank of America (BofA) and Moody‘s)
Default rate on long-term issues (%)
16
14
12
10
8
6
4
31 %
30 %
21 %
2
0
1985
1988
1991
Actual default rate
1994
1997
Bank of America forecast
2000
2003
2006
2009
2012
Accumulated default rates
Source: Moody’s Investors Service, 2011
Default rates forecast by rating
agencies and banks
Moody‘s
1.9 %
S&P
1.6 % (*)
Source: Allianz Global Investors, 2011
(*) 12-month default rate.
%
Chart 4: Default rates expected by Standard & Poor’s, according to different scenarios
Default rates of US speculative-grade bonds and 12-month forecast
14
13
12
11
10
9
8
7
6
5
4
3
2
1
0
Forecast for June 2012
Pessimistic 4.0 %
(62 defaults)
Long-termaverage 4.59 %
Baseline 1.6 %
(25 defaults)
Optimistic 1.2 %
(18 defaults)
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Recession
Default rates of US speculative-grade bonds
The areas shaded in light blue correspond to the periods of recession defined by the National Bureau of Economic Research
(NBER).
Sources: Standard & Poor‘s Global Fixed Income Research and Standard & Poor‘s CreditPro©.
© Standard & Poor‘s August 2011.
9
Analysis & Trends
In fact, the worst case scenario seems unlikely,
as companies took advantage of the recovery
in 2009 and 2010 to renegotiate their loans
and the dates on which the loans were due.
Of course, a recession could prevent them
from respecting the ratios provided for in
their loan agreements. But the banks are
currently too concerned with their equity to
not be flexible regarding disputes, to avoid
claims and losses.
Nonetheless, market prices can anticipate
an economic crisis. The most representative
issuers of the high-yield sector have a “B”
rating (see Chart 5). In Europe, between 1981
and 2010, this sample’s total default rate over
5 years was 17 %. At 800 basis points – taking
the recovery rate to be the long-term average
of 40 % – the current spread anticipates a total
default rate of 47 %. The market seems thus
substantially overestimating the default risk.
Chart 5: Default rate accumulated over 5 years
Accumulated average default rate of European companies over a several year period,
ranked by rating (1981 – 2010)
25
60
50
*
40
15
30
10
20
5
10
0
0
0
1
AAA
2
AA
3
A
4
5
6
(Time in years)
BBB
BB
B
7
8
9
10
CCC/C (right hand scale)
Sources: Standard & Poor‘s Global Fixed Income Research and Standard & Poor‘s CreditPro©
© Standard & Poor‘s 2011
Implied probability of default accumulated over 5 years
Recovery rate
50 %
40 %
30 %
20 %
10 %
1200
68.2 %
61.5 %
55.9 %
51.1 %
41.7 %
1100
65.0 %
58.3 %
52.8 %
48.1 %
44.2 %
1000
61.5 %
54.9 %
49.4 %
44.9 %
41.2 %
900
57.7 %
51.1 %
45.9 %
41.6 %
38.0 %
800
53.4 %
47.1 %
42.1 %
38.0 %
34.6 %
700
48.8 %
42.7 %
38.0 %
34.2 %
31.0 %
600
43.6 %
38.0 %
33.6 %
30.1 %
27.3 %
5-year spread on the Xover index
500
38.0 %
32.8 %
28.9 %
25.8 %
23.3 %
400
31.8 %
27.3 %
23.9 %
21.2 %
19.1 %
300
24.9 %
21.2 %
18.5 %
16.4 %
14.7 %
Implied default rate = 1 – exp (- Spd / (1 – recovery rate) * Maturity)
Source: Allianz Global Investors, 12 / 09 / 2011
10
%
20
%
* A spread of 800 basis
points for high-yield bonds
implies a default rate accumulated over 5 years of
47 % whereas a long-term
average of Standard &
Poor‘s is of 17 %
Chart 6: Comparison between the default rate and VIX
(measure of implied volatility of Standard & Poor’s 500 index options)
Model of the spread of high-yield corporate bonds, basis points
Default rate
VIX
18 %
20 %
25 %
30 %
35 %
40 %
45 %
50 %
1.0 %
392
424
506
587
668
749
830
911
2.0 %
433
465
546
628
709
790
871
952
3.0 %
474
506
587
669
750
831
912
993
4.0 %
515
547
628
709
791
872
953
1034
5.0 %
556
588
669
750
832
913
994
1075
6.0 %
597
629
710
791
872
954
1035
1116
7.0 %
637
670
751
832
913
995
1076
1157
8.0 %
678
711
792
873
954
1035
1117
1198
9.0 %
719
752
833
914
995
1076
1157
1239
10.0 %
760
793
874
955
1036
1117
1198
1280
The market’s volatility
explains the difference
between the implicit
default rate and the
accumulated historical
default rate
Optimal area
Source: JP Morgan, Moody’s, 12 / 09 / 2011
We have seen that under certain circumstances, the high-yield corporate bond market
lacks liquidity and experiences a rise in its
volatility.
investors that are able to wait for the market’s
return to normal and disappearance of their
capital losses would continue to receive a
particularly attractive return.
According to Moody’s, the default rate of 2 %
it anticipates would justify, with the volatility
range seen in the last four months of between
18 % and 30 %, a spread of between 433 and
628 basis points (see Chart 6). The current
spread is 790 basis points. For a default rate of
2 %, it corresponds to volatility of 40 %; or for
the current volatility of 30 %, it corresponds to
a default rate of 6.3 %, which is considerably
higher than the worst case scenario of 4 %
and long-term average of 4.6 %. We can again
conclude that the market seems overestimating the default risk.
Moreover, a return to equilibrium in public
finances in the medium term, and a return
to slow growth, should mean that the market
price of high-yield bonds gradually aligns
with their true fundamental value. A decrease
in the spread from 790 to 628 basis points,
simply justified by the market’s current
volatility, would generate a capital gain of
16 %. An additional contraction in spreads
towards levels consistent with current
expected default rates would generate substantial additional gains (see Chart 6).
Holding a portfolio of such bonds could provide an attractive annual return. Of course,
a market collapse similar to the one in
2008 / 2009 would trigger a fall in prices. But
11
Analysis & Trends
Decisive Insights
However, companies are in good health and
the default rate is particularly low. Provided
that there is no worsening of the financial
crisis, the high-yield bond market should
gradually return to normal (see Chart 7). In
the medium term, spreads are likely to contract towards levels that are more consistent
with the observed volatility of the market
and the expected default rate. In addition
to high coupons, investors could then enjoy
significant capital gains.
The high-yield bond market is currently suffering from the sovereign debt crisis, investor
risk aversion and a lack of asset liquidity.
Doubts concerning countries’ creditworthiness are undermining the valuing of risky
assets. And the required control of public
spending is casting a shadow on future
growth and issuers’ future financial performance.
Olivier Gasquet
Chart 7: Low valuation
Default rate on European high-yield bonds should remain low in 2011 and 2012
Default rate on all high-yield bonds & Merrill US HY Master II index (spread compared with the
OAS index in basis points)
15
2500
2000
10
1500
1000
5
500
0
Source: Standard & Poor’s, Bloomberg, 15 / 09 / 2011
12
1/
20
/0 04
1/
01 200
/0
5
1/
01 200
/0
6
1/
01 200
/0
7
1/
01 200
/0
8
1/
01 200
/0
9
1/
01 201
/0
0
1/
20
11
2
03
20
01
/0
1/
01
1
00
/0
1
01
/0
/2
00
/0
1
/2
00
Default rate of high-yield bonds (left-hand scale)
01
99
20
1/
/0
01
98
19
1/
01
97
19
1/
/0
/0
01
01
96
19
19
1/
1/
01
/0
4
95
19
1/
/0
/0
01
93
99
/1
/0
1
01
92
19
1/
/0
01
91
19
1/
/0
01
01
90
19
1/
01
/0
1/
19
89
19
01
/0
1/
/0
01
01
/0
1/
19
88
0
Merrill US HY Master II Index
Notes
13
Analysis & Trends
Notes
14
Disclaimer
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