Analysis - Top-grade corporates pricey, investors move to junk

LONDON Mon Oct 1, 2012 10:56am BST

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LONDON (Reuters) - Top-grade corporate bonds - an investor bulwark in the financial and the euro zone crises - have become too expensive for some investors after a more than three-year bull run, and the focus will shift more to junk bonds for their fatter yields.

European high-yield bond funds, which offer a higher return for more risky debt, posted the biggest weekly inflow on record at $2.1 billion (1.2 billion pounds) in the week ended September 19, nearly 20 times more than the first week of the year, data from fund-tracker EPFR shows.

In the same week, European investment-grade bond funds took in less than $90 million, and their cumulative inflow for the year so far lags the high-yield total by about $2 billion, Bank of America Merrill Lynch said in a research note.

"Investment grade corporate bonds were interesting. It's the longest trade in the investment management community since the beginning of the crisis and it's our longest trade - we have been running this trade for five years," said Didier Duret, chief investment officer at ABN-AMRO Private Banking, which manages more than $200 billion.

"But the good time has rolled, the juice is gone. Simply look at the yield."

The yield on AAA-rated corporates has fallen to about 1.5 percent on average from 2.5 percent at the beginning of the year and nearly 5 percent four years before, according to Bank Of America Merrill Lynch's AAA global corporate index. BofA's global indexes include all bonds issued in major markets that still have at least one year remaining to maturity.

Its global high-yield bond index shows a yield of over 7 percent. That's down from 9.6 percent at the beginning of the 2008, but total return is still over 14 percent year-to-date, while it is at just over 5 percent for the AAA index.

AAA-rated corporate debt now pays only 20 basis points more on average than investment-grade government bonds, according to BofA, after investors piled up corporate credit at a time the euro zone crisis has eroded their confidence and the ratings of in sovereign bonds.

"For the absolute yield that you get, it's very expensive ... It makes more sense to invest in the lower investment grade, the high-yield sector and the emerging market bond corporate names," ABN-AMRO's Duret said.

Fund managers' shift to high yield became more pronounced during the summer, with inflows into more risky paper increasing substantially since June, EPFR data shows.

Issuance of high-yield bonds reached an all-time monthly record surpassing $50 billion in September, Thomson Reuters data showed.

RISKS

The latest monthly Reuters poll of leading investment houses last week showed that a majority of investors - 28 versus six - still saw value in investment-grade corporate bonds.

But the share of investment grade corporates in bond portfolios fell, and several respondents gave qualified answers, such as Elke Speidel-Walz, chief investment strategist for Germany at Deutsche Bank Private Wealth Management, who pointed to a "visibly lower scope compared to the past".

For Bank of America Merrill Lynch, the move to high yield in September showed the European Central Bank's sovereign bond-buying plans were encouraging investors to take on more risk.

"The Draghi (and Bernanke) medicine is starting to work. Suppressed fixed income yields are simply pushing more money into higher-yielding credit markets," the bank said in the research note.

Andrew Milligan, head of global strategy at Standard Life Investments, however, said part of the appeal of high-yield bonds is that they are less exposed to potential sovereign problems.

"People have been shifting more out of investment grade into high yield, partly because investment grade isn't giving much of a return ... and partly because if government bonds did sell off, to a certain extent you are a little more protected by buying high yield, because the impact on your final return wouldn't be so great," he said.

High yield credit entails risks of its own, however, with some analysts worrying that defaults could rise with the recession, while a load of vulnerable high-yield debt from leveraged buyouts is approaching maturity.

Ratings firm Standard & Poor's forecast in a report last week that corporate defaults in Europe would rise further because of a deteriorating growth outlook.

But for Standard Life's Milligan, the current environment means it's worth betting on high yield for the time being.

"You ask yourself: is there a recession risk in 2013? No, I'll stay with high yield. Is there going to be a recession in the second half of 2013? No, I'll stay with high yield."

He added, however, "You're constantly hoping you're not going to see some default or some break in the debt servicing, which drastically reduces your final return."

(Additional reporting by Joel Dimmock and Scott Barber; Graphics by Scott Barber; editing by Jane Baird)

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