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Strong performance of high yield bonds to continue, says Newton’s Chadha

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Parmeshwar Chadha, manager of the Newton Global High Yield Bond Fund, expects to see strong returns from high yield corporate bonds over the coming year.

“The high yield asset class has performed very strongly so far this year, and we expect to see spreads tightening by around 200 basis points over the next year,” says Chadha. “Financial results of high yield corporates continue to be very strong; US high yield issuers enjoyed a vigorous second quarter of 2010, announcing much improved financial performance as well as decreasing levels of leverage.”

Meanwhile, default rates are rapidly declining. Over the first half of the year, global default rates declined from 11.1 per cent in the previous year, to 6.1 per cent, while the credit rating agency Moody’s expects this rate to fall below two per cent over the next 12 months.

“We tend to agree with this prediction, given the strong financial results seen in the first half of the year, coupled with companies’ improved access to capital markets. At the same time, the re-financing of debt has continued steadily over the past nine months and this has pushed back the ‘wall of maturity’ – the vast corporate debt which needs to be paid off or refinanced over the next few years – from 2012 to 2014. Furthermore, the longer capital markets remain open, the more staggered the debt maturity schedules of corporates will become, and this in turn should help keep future default rates lower,” says Chadha.
 
Another positive development for the high yield market is the continued issuance to investors of first lien debt by issuers, as relationship banks trim the size of their lending books.

Chadha says this is attractive for high yield bond investors for two reasons. First, investors get a first lien pledge on a company’s physical assets, so if there is a default then recovery rates will be a lot higher, as first lien bank loans have historical recovery rates of around 90 per cent.

Second, as most issuers will be trying to access the capital markets at the same time, they will need to pay an attractive coupon in order to be able to issue successfully.

“However, it must be noted that these developments are negative for the equity of such companies as the substantially higher cost of interest tends to have an adverse impact on the future earnings per share of the company,” adds Chadha.

“While we remain bullish on the asset class given the generally benign environment, we are happy to avoid overweight positions in CCC-rated or low single B-rated corporates,” says Chadha. “Our primary concern with CCC- and CC-rated issues is that in this low/zero growth environment, we believe the risk premium for these assets should be materially greater than prior to the credit crunch. As such, even at their current attractive spreads, for the most part, these spreads are in fact wholly justified.”
 
Newton’s preference remains for high single B- and BB-rated issues, as they tend to have a strong physical asset base, ample liquidity, no material short-term re-financing requirements, and most importantly, do not require top line growth in order to meet their obligations.

Moreover, as financial markets are likely to remain volatile for the foreseeable future, Chadha believes low beta (BB) corporates will outperform their high beta (CCC) peers.

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