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Secondary market becomes primary priority

20 Mar 2006

With investors taking on riskier assets to hit their spread targets, many of them have moved down into the primary high yield bond market. And with more demand than supply, prices in the secondary market have inevitably tightened to record levels. Many hope that the emergence of the synthetic market for both high yield bonds and loans will relieve some of the pressure.

Following two years of solid gains, the European high yield market turned in another sound performance in 2005, with the Credit Suisse European High Yield Index rising by close to 6%, although last year was also a highly volatile one for the asset class. The first half was particularly unstable with concerns over GM and Ford pushing the Itraxx Crossover index from a low of 151bps in the first quarter of 2005 to as high as 435bp by May.

A return to stability brought the spread in high yield back down to 267bp in July, before the US hurricanes, rising oil and commodity prices and higher interest rates pushed the index back over 300bp in September. The roller-coaster year for high yield ended a strong fourth quarter at 275bp.

The spread tightening that took place in the second half of 2005 created a challenging environment for investors looking for value in the secondary market in the early weeks of 2006. As HVB noted at the end of 2005, "while our base-case scenario is that strong technicals and weaker fundamentals will remain well balanced, the risk is clearly skewed towards wider spreads."

"High yield is very expensive at the moment," says Jochen Felsenheimer, head of credit derivatives strategy at HVB in Munich. "We are currently trading at 265bp on the i-Traxx index where a fair level based on default probability and recovery rates is between 350bp and 400bp. That has been driven simply by the fact that we still have a very big global liquidity overhang. We have a very subdued yield environment in which investors looking to meet their spread targets only have two alternatives. They can either move down the credit quality curve by buying high yield bonds, or they can leverage their higher quality names through instruments such as CDOs. At the moment we are seeing a combination of both strategies."

In this environment of tight spreads in the secondary market, investors say that over the coming few months they expect to see much more differentiation between credits, and between different ratings in the high yield market.

"Following the recent compression in spreads in the high yield market we are quite cautious," says Chris Brils, portfolio manager at ABN Amro Asset Management in London. "We think there will be decent returns to be made in the double-B segment which has historically been the most attractive area of the market on a Sharpe ratio basis. But we would be less comfortable about the single-B and triple-C names going forward."

But Brils says that even within the universe of double-B names investors need to differentiate between contrasting types of credits, with fallen angels generally very different animals from other companies in the high yield market. "We take the view that the cross-over universe almost needs to be seen as a separate asset class," says Brils. "For example, outstanding bonds from companies such as GM, Fiat and Ahold don't have the covenants that investors are used to in the high yield market, which can mean that there are more risks inherent in the market for fallen angel credits."

Others agree that with spreads as tight as they are, credit analysis and stock picking will come into its own for investors in the high yield market in 2006 and beyond. "Investors... have to split up the high yield market into the 'good names', which still offer fair value despite the subdued spread valuation, and the 'bad boys', which should be avoided," advised HVB in a research bulletin published in December. "Alpha picking remains the name of the game in 2006."

CDS to the fore

In tandem with a much more intensive focus on research and alpha picking, high yield investors are increasingly being urged to use the credit derivatives market as a means of unlocking value against the backdrop of an expensive looking secondary market.

"Because liquidity in the credit default swap (CDS) market even for high yield names is constantly improving it is becoming increasingly simple to set up long-short strategies using the credit derivatives market," says HVB's Felsenheimer. "Investors can also build up portfolios of names they favour and hedge those positions efficiently with the CDS index."

Investors say that they are becoming more active in the credit derivatives market. "We use CDS for efficient portfolio purposes," says Brils at ABN Amro Investment Management, "and CDS can be a good way of protecting your position against negative credit events. But the CDS market is still less developed and less liquid in high yield than in the investment grade market."

Others agree that the CDS market has become an increasingly efficient and cost-effective means of managing high yield portfolios. HVB notes in its most recent quarterly report on European high yield, "buying protection in the iTraxx Europe Crossover has... become very popular in the context of hedging against systematic spread movements due to [the] outstanding liquidity and low transaction costs."

But some bankers say that many of Europe's smaller and more conservative investors have yet to explore the opportunities in the credit derivatives market — leaving them in the vulnerable position of being long-only players in the high yield market. "It is true that many European investors are still plain vanilla cash only players," says one banker. "It is important that they build up their expertise in the derivatives market, because with spreads so tight, it will be difficult for long-only players to perform well in the high yield market."

The opportunity for investors to buy protection on their exposure to the broader speculative market is no longer restricted to CDS on bonds. An embryonic market has also started to develop for CDS of leveraged loans, with Dresdner Kleinwort Wasserstein (DrKW) and Morgan Stanley pioneering the development of this market by quoting CDS prices on the Wind leveraged loan.

Morgan Stanley describes CDS on leveraged loans in a recent research bulletin as "the final piece of the jigsaw". "As a CDS market for senior, secured loans develops, the entire capital structure of a European corporate is now tradable synthetically," notes the Morgan Stanley briefing.

In the first instance, the opportunity to trade leveraged loans synthetically will, inevitably, appeal principally to banks, given how unattractive Basle II will make it for them to hold lesser-rated credits from a capital regulatory perspective. "Fees and ancillary business may still compel banks to lend, but the return on capital will be lower," explains Morgan Stanley. "This creates a big incentive to hedge the exposures using CDS — if a bank buys protection from a well rated counterparty, the risk-weighting on a generic single-B loan could fall to just under 10%, from 187%."

Looking to the longer term, however, bankers say there is no reason why an increasingly liquid market for CDS of leveraged loans should not attract institutional investors as well as banks. "In developing the CDS we aimed to replicate the underlying product in a synthetic way as closely as possible, allowing for participation in the market by investors who are unable to become lenders of record," says Tom Johannessen, senior loan trader at DrKW in London.

The evolution of a market for CDS of leveraged loans is one of a number of reasons why private equity sponsors who have been calling for a curb on trading of loans may be wasting their time. Fitch notes in a recent report that "financial sponsors have recently attempted to insert transfer restrictions in the loan documentation of certain deals to curb the activity of event-driven distressed investors. The agency does not believe such restrictions will become widely accepted by the new breed of hedge fund investors who have contributed decisively to the current liquidity." 

20 Mar 2006