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High yield bonds: junk or opportunity?

Markets are set for a flood of high yield 'junk' bond issues this week, as European companies continue to race into bond markets to raise funds amid fears that interest rates are set to rise.

The trend towards these high-volume junk issues was set in motion towards the end of last year and met with huge investor demand, but this week is set to be one of the busiest in a long time for the issuance of the non-investment grade instruments.

Manchester United Football Club and Heidelberg Cement have been among those firms issuing these high yield bonds this week, with many more set to follow. Indeed, issuance this week is expected to amount to around €3 billion. So, as investors continue to hunt for new sources of yield, is the high yield sector an attractive opportunity or are these bonds dubbed 'junk' for good reason?

Adam Cordery, head of UK and European credit strategies at Schroders thinks the high yield sector's rise is a reason to be positive, if one is able to carry out the necessary analysis.

'A lot of investors will look at high yield this year because they want more income but are worried about interest rate risk. High yield bonds offer one of the best opportunities in the bond market at the moment if you think you can do the credit analysis, along with investment grade bonds in cyclical and subordinated financial sectors. If you think you can do the credit analysis, high yield bonds are attractive as they offer a higher income than investment grade or government bonds, and are much less exposed to the risk of interest rates going up.'

However, as time goes on the attractiveness of the issuances will decline says Cordery, manager of the €2 billion Schroder ISF EURO Corporate Bond fund.

'For now there is plenty to choose from, but over the next couple of years the credit quality of high yield new issues and the yields offered will decline,' he said.

The label 'junk bonds' is often applied because of the higher risk of default, but Cordery thinks this label does not reflect the risk of the high yield sector recently.

'Not all high yield is junk, most high yield bonds didn’t default last year. But quite a bit of investment grade is junk: Lehman defaulted, as did Enron and WorldCom, and they were all investment grade companies,' he said.

Thames River Capital's credit specialist Stephen Drew is also positive about the sector and thinks high yield is the most appealing area of the fixed income market for investors seeking yield currently.

'There is a continuing and insatiable stretch for yield. In this stable interest rate environment, investors have to keep stretching down the credit spectrum or go longer in duration. I think the better of those trades is to go down into lower credit,’ Drew, manager of Thames River's High Income, Global Credit and Credit Select funds, said.

Some have suggested that when the high yield market is in the ascendancy it is a contrarian sell sign for fixed income as a whole, but Drew disagrees. The rules of the game have been changed by the unprecedented stimulus packages, he thinks.

‘Credit will continue to outperform,' he said. 'When interest rates are likely to stay on hold for all or most of 2010, people look at the incremental yield they can get from investment grade and high yield. Leverage is on the mend and corporates are in the sweet spot.’

‘In a traditional market where the transmission mechanism for capital is working, one should maybe move into more riskier assets such as equities. But this is not a traditional credit cycle, we probably haven’t even hit the true credit cycle yet, which will probably be in 2011-2013. This credit cycle will be more elongated than usual, due to the massive stimulus. At the moment there is a huge amount of liquidity washing through the system, which trumps all.’

In addition, Drew thinks defaults in the corporate sector peaked in December 2008 and also that, although companies are keen to issue this new debt before rates rise again, when they do go up they will not return to normal levels.

'Interest rates can not go up meaningfully until countries can pay back their debts. When rates do rise I think we will have a new normal for rates. They won’t go to cyclical highs of 5.5%, they will more likely be 2.5%-3%,' he said.

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