Europe's high yield market could be turned on its head by further sovereign downgrades to Italy and Spain with as much as €106 billion worth of previously investment grade debt entering the sector, according to leading bond managers.
These comments were made by both Citywire A-rated manager Stefan Isaacs, who runs the €1.57 billion M&G European Corporate Bond fund and the €1.45 billion M&G High Yield Corporate Bond fund, and Muzinich’s high yield expert Tatjana Greil-Castro.
Isaacs said the ‘potentially significant relationship’ between corporate credit and sovereign debt in both Italy and Spain, meant a number of non-financial corporate debt issuers are under considerable pressure.
'The current ratings for the largest Spanish and Italian non-financial issuers suggest that the market is right to be nervous,' said Isaacs.
'On average, the four largest Spanish issuers are only two notches above high yield status; for Italy’s five largest issuers it’s about three notches.’
Spanish and Italian corporates both received negative rating actions as a consequence of ratings downgrades, which have seen Moody’s drop Spain from Aa2 in July 2011 to Baa3 at present .
This stark drop in credit ratings was also instigated by S&P, which over the past year has slashed both Italy and Spain’s ratings from A+ to BBB+ and from AA- to BBB+, respectively. Isaacs warned further downgrades could see a huge re-rating of previously investment grade debt.
‘If all Spanish and Italian non-financial paper were eventually to lose its investment grade status, we calculate that €47 billion nominal of Spanish paper and €59 billion nominal of Italian paper could fall into high yield territory.’
‘That would be a massive €106 billion worth of paper – or 80% of the existing non-financial Euro High Yield index – heading into the high yield market. That’s a lot of paper to swallow.’
Time to strike?
Another manager who is keeping an eye on potential downgrades is Tatjana Greil-Castro of Muzinich & Co., who has been working with one unnamed institutional investor to buy up Spanish investment grade names should they be re-rated following another sovereign downgrade.
She said: ‘The yield available on some of these more highly-rated names, such as Telefónica, would spike if Spain’s sovereign debt was downgraded.’
‘This would create a very attractive opportunity to selectively pick up companies with considerably stronger balance sheets and credit positions than you typically find in the high yield space.’
Echoing Isaac’s point about the potential shake-up for the high yield market, Greil-Castro said fund managers and investors whose mandate forbids the holding of high yield debt would become forced sellers if there a large portion of investment grade debt was downgraded.
‘The high yield market could be much larger as a result of numerous investment grade names dropping into high yield indices. This means there could be a sell-off in some existing high yield names as investors seek to replace them with more creditworthy new entrants.’
The M&G European Corporate Bond has returned 26.16% over the past three years. Over the same time period, its Citywire benchmark, the BofA Merrill Lynch EMU Corporate Bond TR, rose 24.35%.
Meanwhile, Isaac’s M&G High Yield Corporate Bond fund has returned 37.26% in three years, while its Citywire benchmark, the BofA Merrill Lynch Eur Currency HY Const Hdg, rose 68.61%.
Greil-Castro’s Muzinich EuropeYield EUR fund rose 45.46% over the past three years compared to its Citywire benchmark, the BofA Merrill Lynch Euro High Yield, rose 60.03%.