The erosion of call protection may drastically reduce high yield returns and cut into the equity-like yields offered by the asset class, according to Hermes’ co-head of credit Fraser Lundie.
Speaking at a roundtable event, the Citywire A-rated manager said shorter non-call periods, which shield investors from interest rates movements, represent a dramatic change for HY bonds.
‘Recent demand for short-duration debt, combined with an undersupply of new issuance, has allowed companies to bring forward the dates at which they can redeem bonds. Since 2010, non-call periods worldwide have almost halved from 6.8 to 3.6 years,’ he said, who runs the Global High Yield and the Multi Strategy credit funds.
Issuers are winning the power struggle with investors over terms and pricing, according to Lundie. ‘This is particularly evident in Europe, where banks’ retreat from business-lending has fuelled the high yield market but also resulted in companies applying loan features, such as closer call dates, to new bond issues.’
The diminishing non-call periods are not the only threat high yields bonds are facing. Lundie said that a 'special call' feature has been written into new issues allowing a company to redeem 10% of outstanding bonds at 103% of par, meaning that part of the overall issue can be redeemed during the non-call period.
‘This enables companies to redeem debt to their advantage. For the bond investor, it creates a headwind for securities to outperform,’ he added.
According to the Hermes’ credit team, HY bonds are now trading above call prices and valuations reached all-time peak. On the other side, liquidity is now at 2003 levels, which may cause heavy losses for investors who unwind their positions.
‘Last year the US high yield market returned 7.4% as the S&P 500 surged 30%. Achieving long-term, equity-like returns with less volatility through HY bonds will be increasingly difficult,’ he said.
Time to turn the tide
In order to hedge against these risks, Lundie said investors need to reduce their dependence on new bond issues and exploit other sources of liquidity.
‘The first necessary thing is to avoid bonds trading at call prices. Secondly, it’s useful to look at CDS, as they don’t have any interest rates risk or call constraint, and are more liquid as an asset class,’ he said.
‘We also need to invest globally, including emerging markets, and search throughout the capital structure of issuers to determine which instrument offer a better relative value,’ he added.
Lundie is focusing on large-cap issuers as they typically have greater capital structures, therefore proving more relative-value opportunities. ‘Get the right company is not enough, you need to pick the right security and be ready to invest in different instruments, such as CDS and government bond futures.’
Over the past three years, the Hermes Global HY bond fund returned 28.33%, six percentage points more than the BofA Merrill Lynch Global HY index.