Fri Jul 30, 2010 2:16pm IST
By Natsuko Waki
LONDON (Reuters) - Investors wary of investment grade corporate bonds because of a heavy presence of banks in them may have a rethink thanks to greater clarity surrounding European banks, prompting a switch back from high-yield debt.
High-yield bonds -- typically riskier paper rated below investment grade -- have been a hot credit asset over the past year as it was an "ex-banks" trade for those who were worried about the fallout from Europe's sovereign debt crisis.
This resulted in a rush of funds into the so-called junk space, with fund tracker EPFR estimating nearly $6 billion had flown into a broader high-yield bond universe since January.
However, the tide may be turning in favour of higher-quality investment grade after last week's European bank stress tests were conducted without incident and banking regulators scaled back proposals to beef up global bank capital and liquidity rules.
"High yield has outperformed basically because it was not banks. That was pretty much the best thing you could say about the asset class," said Christian Dinesen, head of international corporate credit research at Bank of America Merrill Lynch.
"But for the rest of the year, senior financials should, particularly after this benign result of the stress test, have a pretty good run. High-yield is okay but ... risk-return wise investment grade is probably better."
A Reuters poll of global asset managers published on Thursday showed exposure to investment grade bonds rose to 22.6 percent in July from 19.7 percent in June. High yield debt was less popular.
Until now, investment grade bonds have struggled this year, especially in Europe, where more than one in two issues come from banks.
European high-grade corporate issues, which have sovereign-like ratings in the investment grade space, returned 0.7 percent less than benchmark governments this year, BofA Merrill estimated.
In contrast, junk debt gave an excess return over government bonds of 0.94 percent in the same period.
Based on prices, global junk debt rose 22.7 percent over the past year while top-rated corporates gained 7.3 percent.
BofA Merrill forecasts spreads of high grade European debt to tighten 27 basis points from current levels to 202 bps towards the year end, giving an excess return over government bonds of 1.5 percent.
Goldman Sachs expects spreads of triple-B issues -- the riskiest segment within the investment grade space -- to hit 175 bps this year, their lowest since late 2007.
The positive performance outlook comes against a backdrop of falling default rates. According to Standard & Poor's, the 12-month rolling default rate for global investment grade paper stands at just 0.21 percent, down from 0.41 percent in 2008.
"We remain confident in investment grade, this is one of our clear risk trades. The risk rewards are clearly tilted towards the positive side. On HY, valuation is a little bit too stressed," said Franz Wenzel, senior strategist at AXA Investment Partners in Paris.
A Fitch survey of 85 asset management houses showed investment grade financials moved to the top slot for most favoured credit investment choice, with 21 percent of investors picking them, versus 14 percent for emerging market firms.
HIGH YIELD RISKS
High-yield debt by definition gives a higher return than investment grade bonds, but it carries a bigger risk of default and loss on principal and interest.
Furthermore, supply risk appears to be higher in the junk universe. Citi expects high yield to be the only key market where issuance is likely to be higher than 2009 and to be one of the highest in the past 10 years, at over $200 billion.
Investment grade bonds can also be appealing when compared with equities, especially for those who are looking to increase exposure in the banking sector. Apart from its intrinsic structure that is safer than equity, valuation is one reason.
Generally speaking, investment grade credit has lagged equities in recovering from a May sell-off.
The credit derivatives swap index for most-liquid investment grade issues in Europe, measured by the iTraxx , fell 26.4 percent since its May risk aversion peak. The VIX that measures equity option volatility more than halved.
"When you're investing in credit, all you care about is to get your money paid back," Dinesen said.
"When it comes to comparing banks in terms of equity and credit, in a scenario like this, you're likely to get the performance first in credit, then in equities."
(Additional reporting by Jeremy Gaunt, editing by Mike Peacock)
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From Reuters published on Fri Jul 30, 2010 2:16pm IST