The slew of Asian high-yield paper sold during the first few weeks of 2013 suggests investors are on a junk bond binge.
With bank deposits paying almost nothing, investors are searching for better returns — and junk bonds fit the description. Unfortunately, the enthusiasm brings to mind some of the irrational exuberance witnessed back in 2000, when investors piled into dotcom stocks.
According to Dealogic, Asian high-yield borrowers have raised $6 billion so far in 2013, a record start to the year. This is a remarkable sum for just three weeks of business, representing nearly 40% of the $15.3 billion raised from Asia ex-Japan during the whole of 2012.
Worldwide, total high-yield issuance stands at $22.3 billion, more than double the $10 billion raised during 2012, also the highest year-to-date volume on record, according to Dealogic.
There are some signs of a pushback from investors — with KWG Property being the first borrower to pull a deal this year. But issuance has clearly surprised on the upside.
“Some of the initial at-any-price enthusiasm towards high-yield new issues has waned, but our expectations for a strong start to the year for both primary and secondary have still been exceeded,” said Owen Gallimore, head of credit strategy in Asia for ANZ.
But even as Asia’s high-yield market continues to churn out deals, fund managers are cautioning that last year’s returns are unlikely to be repeated as high-yield spreads have tightened dramatically.
According to Threadneedle Investment, the spread pick-up that Asian high-yield corporates offer over Asian high-grade corporates compressed from 623bp to just 270bp during the course of 2012, while the J.P. Morgan Asian credit high-yield corporate index posted returns of 25.4%.
“It would require investors to take a leap of faith to believe the Asian high-yield market can deliver the kind of exceptional returns seen in 2012,” wrote Clifford Lau, Asia-Pacific head of fixed income at Threadneedle Investment, in his investment update for 2013.
“The very strong performance of high quality high-yield credits last year has now made them as sensitive to treasury risk as investment-grade credits.”
Investors that bought high-yield bonds last year were rewarded handsomely, as they saw many of those bonds recover from battered down levels. But now, as companies are pushing bonds out the door, the downside risk has increased.
“I think that the capital upside for high-yield bonds is capped, especially after the strong returns we saw last year,” said Bryan Collins, fixed-income portfolio manager at Fidelity. “In fact, we believe that there is more downside risk, albeit modest, particularly in light of increased supply. As always, income will drive total returns for high-yield bonds over the longer term and more so for the year ahead.”
Increasingly, fund managers are asking whether investors are being properly paid for the risk they are taking. Rates are now at the lowest they have been, which explains why companies are keen to lock in long-term funding, in some instances, forever.
“The risk and return for high yield is getting ahead of fundamentals,” said Arthur Lau, head of fixed income Asia ex-Japan at Pinebridge Investment. “We do not expect a surge in default scenarios in China as the economic situation has improved. But taking into account the near-term volatility, we feel that investors are not sufficiently compensated for especially with regard of some bond structures.”
In particular, perpetual bonds — or bonds that have no maturity — are risky products. Private banks have been big buyers of these products. Institutional investors, on the other hand, have kept a wide berth and caution that retail investors need to look at them more closely.
“Investors are not looking at the structure of perpetuals closely and carefully enough,” said Pinebridge’s Lau. “Some of these perpetuals are potentially subject to a high non-call risk,” said Lau. “If down the road economies improve and the US starts to raise rates, an investor could be sitting on a low-yielding bond that is very difficult to get rid of. Investors need to look beyond the near term.”
Junk bonds from China have dominated supply this year, making up 64% of high-yield issuance. Chinese borrowers now constitute about 18% to 19% of the J.P. Morgan Asia Credit Index — and there is a threat of more supply.
“We expect supply from China to grow,” said Pinebridge’s Lau. “That is the risk we face and a problem for every fund manager. Part of this is due to the dynamics between the onshore and offshore market. We do not believe that there will be a reserve ratio requirement cut and liquidity onshore will remain tight, so we expect to see more Chinese names including new and repeat issuers tapping the offshore bond market.”
It is ironic that the flood of supply is coming — and investors piling in — just as concerns over returns emerge. Markets have a strange tendency to move from feast to famine. Back in May last year, when two automakers — Baoxin Auto and China Zhengtong Auto — were forced to pull deals, it seemed as though no investors would touch junk bonds with a barge pole.
That now seems like a distant memory. Today, junk has become the new staple diet for investors. One can’t help but wonder when the indigestion will kick in.