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The Three Tenors of the High Yield Bond World

This was a first for IFA Magazine’s Neil Martin – interviewing three senior fund managers in one sitting. And the High Yield team at Aberdeen Asset Management didn’t disappoint in a wide ranging aria which covered some of the top notes of the high yield bond world.

Well, I say three tenors, but Steven Logan, Head of European High Yield at Aberdeen Asset Management (AAM), had to leave after ten minutes explaining, quite understandably I thought, that he was due in a meeting with a client who’s an investor responsible for billions of pounds. And when a client has that much spending power, you don’t say I’ll be there in a moment, once I’ve finished with this journalist!

So I was left in the capable hands of AAM’s Mark Sanders, senior investment manager, and Ben Pakenham, senior investment manager, who took the time and trouble to explain some of the basics of the world in which they operate.

Born Out Of Necessity

High yield bonds were born out of a necessity, when corporates could no longer rely on the banks to provide the funding they needed for expansion. More companies have seen high yield as the ideal, or perhaps the only way, of going forward and this has greatly grown the market.

“I think that’s the key, ten years ago, when people said high yield, there was basically a US market  and not much else…” said Pakenham. “Yet now, European high yield is a market grown from €40 billion to €400 billion  in the last eight years.”

He continued: “It’s an amazing growth rate and part of that is because of fallen angels, but part of it is because of banks who are withdrawing lending to corporates in Europe because they are deleveraging and because they need to shrink their balance sheets and we’re taking their place.”

Fallen angels are those companies which have had their credit rating lowered to below investment grade, but that was only part of the picture which has stimulated the huge growth in the high yield bond market. Demographics have played their part, so has the lack of income elsewhere, but it’s the slowing down of the supply side – the banks – which has been the real catalyst.

Pakenham again: “Companies which have been borrowing from banks for 50 plus years, that have never needed to issue bonds, suddenly found themselves in a situation where bank financing had dried up and you know, once you enter a new funding source, you tend to sort of stick with it, unless something goes horribly wrong,

“I think European high yield, the growth of it, has been astonishing. It’s also interesting that a lot of the money we’ve raised has been from outside Europe, at a time when the European macro has been quite tricky.”

Original Days

Sanders reflected: “It’s strange in a way, because in the UK market when you go back to the original days when it was Aberdeen and M&G, we were the trail finders for sterling high yield in particular. It related to the PEP and ISA  markets, which was a very tax efficient way to hold it.  At one stage there was I think one of our funds we used to run that had one million unit holders, and we used to go out and market a 7% yield.”

Unsurprisingly, given the introduction to the high yield bond market, the AAM team are keen advocates of the asset class.

Pakenham led the charge: “It is just a fantastic product from a long term perspective, I would encourage any kind of pensioner, plus ten-year investor to think about having a significant weighting in high yield, because it does have such great risk adjusted return profiles over the long term, and you know it’s almost regardless of when you buy it.

“The timing is slightly less relevant because our market tends to re-price quite quickly.  Obviously defaults will pick up at some point, but you’ll get higher coupons in the future and whilst you might take a bit of pain in the short term, over the long term it’s not a problem.”

Sanders takes up the running: “When you’re younger, you can buy the accumulation, when you retire you can switch it to distribution, so it works very well. It’s also very robust; equity markets are very high risk; we tend to take the view that high yield is the next step down. Because you have that income, come rain, or shine, the compounding effect of that income is very strong.”

Downsides

As for the downsides, Pakenham believes that people who talk of there being a bubble are wide of the mark. He argues that they don’t think spreads are in ‘bubble territory’ and the team thinks that they are still fairly compensated: “I don’t think there’s a problem, and what’s amazing about this particular credit cycle, is that if you look through history at every other cycle, as yields fall, and company’s cost of debt falls, and people become more bullish about the macro-economic environment, so leverage usually starts to rise , particularly in the new issue market as companies tend to borrow more.  However today, we’re simply not seeing that negative behaviour.”

Sanders said that the main issue they face at the moment, against a backdrop of more demand for the product, is that the banks are starting to come back into the game. He pointed out that over the last five years the banks have been happy to step away, and borrowers have increasingly come to the high yield market, but now they see attractive terms on offer and want back in. The issue is, said Sanders, is that companies have also moved on and see the attractive relationship they have with the bond guys who are locked in for five years. However, banks still want to play on their own terms and company management teams are tired with the covenant waiver and other fees that can be charged.

Sanders added that they are also getting the benefit of a positive equity market, supported by an equally positive IPO scene. He also made the point that even though the lights are also on green, as they say with clients, you always have to take a step back with high yield bonds: “It really does come back to credit, underlying defaults, and what these companies are doing with the money.”

“Over the past ten years  high yield has outperformed  both equities and ‘govvies’. Obviously now and then it has a sell-off, but what we’re finding now is that people are looking for that sell-off as a buying opportunity.”

Batman and Robin

As for how the team originally got together, Sanders explained how he and Pakenham worked together at New Star Asset Management. In 2011 Sanders joined Aberdeen and Pakenham joined shortly afterwards and, in his words, reunited Batman and Robin. At this part of the talk, Pakenham chipped in that he was Batman, whilst Sanders was Robin!

There was a great deal of laughter at that, which seemed to reflect the ease with which the team work. As Sanders said: “We have a mixture of youth and experience, I think it’s a good mix. We have lots of different nationalities and the approach is very much about credit, credit and more credit. And we like doing site visits, we like visiting steel plants, or whatever. We believe in meeting the management, kicking the tyres. You do a lot, credit is like a big jigsaw, you’re always trying to put it together.”

Sanders also said that they had been on some odd site visits, although we’ll keep the details of those for another feature!

The pair also added that the team had no politics, no big egos, and when you hear that, you always assume that the very opposite is true. However, with these three, you kind of believe it.

As to whether you get the message about high yield bonds depends on your position and the clients you might be advising. But, the final point was made with some conviction, that the AAM High Yield team is in a good position to grow globally, and that this is one asset class that is here to stay and make its presence felt.


Postscript

Since this article was written, there has been some concerns about the state of the $10 trillion corporate bond market and how it would cope with a major market event. Much of the debate on the subject has been led by CEO of Aberdeen Asset Management Martin Gilbert who in a recent speech warned about the threat of a run on the corporate bond market. His main assertion is that the Bank of England and other central banks should be considering the option of becoming what’s known as ‘buyers of last resort.’

He told the Financial Times’ City Network: “I think central banks should consider stepping into the corporate bond market and buying corporate bonds in a period of severe market dislocation.”

By doing this, said Gilbert, it would ensure that a run would not take place and that a panic would be avoided. His concerns are borne out of the fact that the corporate bond market has become much less liquid than was previously the case, as regulation has stopped banks from fulfilling their traditional role as providers of abundant liquidity.

The backdrop is of course that when interest rates start to rise, some investors might leave the corporate bond market and go back to more traditional savings plans. The fear is that this would lead to a liquidity crisis.

Gilbert believes that a crisis in the bond market is unlikely, but there will be pressure exerted when interest rates go up and fears of having enough liquidity in the market increases.


 

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