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The music kept playing in credit markets in 2015, but the tune definitely changed.
The return of corporate credit shocks jolted bond investors over the past 12 months, with portfolio managers in both European high-grade and US junk and investment-grade debt nursing considerable losses for 2015. A surge of defaults, led by oil and gas drillers duly arrived as high leverage in the sector left companies exposed to the relentless decline in commodity prices.
What has surprised investors this year is how specific companies — rated among the least risky by the major rating agencies — found themselves in unexpected territory, testing the resolve of investors.
Volkswagen admitted it had cheated on emissions tests. Anglo American slashed dividends and announced a slew of asset disposals. Petrobras was engulfed in a Brazilian political scandal as the price of crude slid. Yum Brands levered up and said it would split off its Chinese operations.
Investors, faced with sudden paper losses as bond prices fell rapidly and pushed up yields, have become more risk averse as debt across at least half a dozen subsectors — including energy, materials, retail, media, pharmaceuticals and telecoms — weakened.
“The extent to which investors are shunning the riskiest part of the investment-grade and high-yield space is more extreme than most of us thought at the beginning of the year,” says Tom Stolberg, a portfolio manager with Loomis Sayles. “The aversion to risk is greater than an investor survey in January would have led you to believe.”
Investors have pulled more than $36bn from US junk and investment-grade bond funds since the start of June — when oil prices last eclipsed $60 a barrel —, according to figures from Lipper. With Brent crude plumbing its lowest level in 11 years this month, pressure on the energy sector shows little sign of easing as 2016 dawns.
The Barclays US high-yield index is set to post its first negative return in seven years, sliding more than 5 per cent. The European corporate aggregate has declined roughly 0.4 per cent, in contrast to its 8.4 per cent return in 2014.
This month, Yum was added to the list of so-called fallen angels — investment-grade companies that have had their debt downgraded into junk territory — after Moody’s and Standard & Poor’s cut their ratings on the company’s spin-off plans.
Another prime candidate that triggered ructions in credit markets, was Valeant. After it obscured its relationship with a specialty pharmacy group, the company’s bonds maturing in 2025 slumped by more than a fifth before rebounding.
Fears surrounding Valeant reverberated through to other junk-rated healthcare companies, including Endo International and Mallinckrodt. That left fixed income investors across the junk space, regardless of sector, asking: what is the risk of contagion?
The risks have indeed been digested, as yields have climbed. Rating agencies project a jump in defaults over the coming 12 months, although they are thought to remain broadly centred in the oil and gas and materials sectors.
“The one-offs did not help but there were a couple seismic events,” says Bob Michele, chief investment officer for JPMorgan Asset Management. “When it became clear that energy prices would continue to fall, everyone became concerned.”
Credit shocks in Europe were more contained. Most energy companies raise finance in dollars and so shocks were limited to individual companies.
Volkswagen bonds had several years of income wiped out in the aftermath of the emissions scandal while commodity company Glencore’s bonds were briefly quoted in cash terms rather than yield, as investors worried about the company’s financial health.
Later in the year Spanish construction companies Abengoa and Isolux suffered from the slowdown in Latin America where they had exposure. The read across to the rest of the market was limited.
“Certainly with Isolux and Abengoa they were fairly well telegraphed,” says Chris Munro, co-head of leveraged finance in Europe, the Middle East and Africa at Bank of America Merrill Lynch. “You had people pre-positioning or taking the view that they were idiosyncratic.”
Perhaps the biggest shocks for credit investors was the movement in the interest rate paid to holders of German Bunds. As the European Central Bank’s quantitative easing programme pushed down the risk-free interest rate, coupons on investment-grade bonds also fell.
So when the yield on German Bunds rose rapidly during April and May, credit investors saw big losses on supposedly very safe corporate bonds that track government paper.
“There are a number of AA-rated US names whose 2015 bonds are trading at 85 [cents to the dollar in] cash and these bonds are six to nine months old. That’s a 20 to 25 per cent annualised loss: that’s not why you buy investment-grade credit,” says Frazer Ross, a managing director on the debt syndicate desk at Deutsche Bank.
This has underlined the anxiety heading into the final days of the year, with many investors still on edge as high-yield bond markets deteriorate in the US.
“The sensitivity to these sort of moves is heightened,” says one portfolio manager. After the Bund sell-off it led to “that mental situation when people step back and say ‘why do I have paper with a 1 per cent coupon’.”
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