Bond Markets – A Brief History of Time

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As of 2020, the European High Yield Corporate Bond Market was worth €508 Billion. 

In just 10 years the large and well-established asset class continued to develop with the value of outstanding bonds growing more than 370%!

When compared to the US High Yield Market, however, the European and Sterling High Yield markets are relatively young.

The US High Yield Market has its roots in the 1980s and was a product of the growth in leveraged buyouts in corporate America.

How much are they worth?

Worth around $1.67 trillion, the US High Yield Market is roughly 50% of the Global High Yield Market – which itself is worth approximately $2.8 trillion.

It was almost two decades later before Europe and the UK saw the high yield market develop.

In comparison, the European market is approximately 18% of the global market.

How much has the market grown?

Whilst relatively small when compared to the US, annualised growth has been 24.6% and 12.19% since 1999, for the European and Sterling markets, respectively.

Not only have the markets been growing, but they have also seen an increase in diversity which is great for investors trying to achieve a diversified portfolio.

For example, there are now more issuers, more industries, different rating spectrums, and different types of bonds.

What has caused this?

The key growth driver has definitely been globalisation.

The expansion of the European and UK markets means companies have been able to develop in other parts of the world.

Global issuers tend to be at the higher end of the ratings range – BB – and have relatively large capital structures.

Origins of high yield bonds

As mentioned earlier, the US High Yield Market began in the 1980s.

Until then, high yield bonds were actually just the outstanding bonds of fallen angels.

What’s a fallen angel?

Remember there are two main types of bonds you can invest in: investment grade bonds and high yield bonds.

Investment grade bonds are issued by investment grade companies – they are rated AAA to BBB-.

High yield bonds are issued by high yield companies – they are rated BB to D.

Fallen angels are issuers that have been downgraded from investment grade to high yield by rating agencies.

This usually means that they had the lowest investment grade rating of BBB-.

Subsequently, they were relegated and were rated high yield with a rating of BB+.

How does a fallen angel become a fallen angel?

Firstly, there is a collective name for the ratings of BBB / BBB- / BB+ / BB – it’s called the “crossover space”.

As the name suggests, it’s the space where an issuer can crossover from an investment grade company to a high yield company, and vice versa.

An issuer will usually enter a high yield index if the average rating is BB+ or lower – this can differ slightly between index providers.

You should also know that the European and Sterling Investment Grade Markets are much larger than their high yield siblings at $2.45 trillion and $776 billion.

What does this mean?

Well, due to this fact, fallen angels tend to be relatively larger in size.

This also means they are more liquid.

But – this can be a problem if there is no initial demand.

Fallen angels will see demand from investors who are measured against a benchmark, especially if the issuer becomes relatively large in the index.

Are fallen angels a good investment opportunity?

Like all bond investments – it depends.

Are there economic factors that cause the market conditions to change?

With economic growth comes a decrease in an investor’s risk-averse characteristics.

With economic recessions comes an increase in an investors risk-aversion.

You should be wary of fallen angels when they move from investment grade to high yield suddenly.

Sometimes, they entail a “multi-notch” – where the company’s credit rating is downgraded by several levels.

It’s important to understand the drivers of the rating action as this helps you make a better investment choice.

Case Study

An infamous example is Steinhoff – a retail conglomerate which went from BBB- to CCC after undergoing restructuring in the space of 6 months.

Rising Stars

Issuers that have been upgraded from high yield to investment grade are known as rising stars.

Investment grade investors sell their bonds when a fallen angel is formed – the opposite is true for rising stars.

There is real value in identifying a rising star because their credit momentum drives positive price performance.

Not only this, but they will also now have a lower correlation with the market.

Sounds good – any drawbacks?

Although a rising star has a lot going for it, the restrictions on bond documentation for high yield bonds tends to loosen.

What do you mean?

For rising stars, the restrictions or covenants that were in place when the issuer first joined simply fall away.

In other words, they no longer apply.

For example, there is a commitment to maintain leverage below a certain level.

What’s leverage again?

It is the use of borrowed capital for investments – expecting the profits made to be greater than the interest payable.

Simpler please…

Essentially you are using debt to try to make a profit, in order to pay back the debt.

Are there any more pros?

Sure – another example could be the obligation to buy back bonds with Initial Public Offering (IPO) proceeds.

This makes sense and rewards an issuer attaining investment grade status with more financial flexibility.

Falling angels on the other hand arrive with very little in the way of protection.

When they were issued, they were investment grade companies so they have very few restrictions on what they can and can’t do.

They also tend to be unsecured – not back by assets should they default.

Using the Steinhoff example, where a company is distressed, weak documentation is a real disadvantage.

Our next blog post…

We will take a look at the different types of Yield that you will encounter and how to measure them.

As usual, all of this content can be found on our free Bond Academy, a CPD accredited course that offers 5 hours of CPD activity.

If you have any ideas on topics that you’d like for us to talk about, please email me: anil@wisealpha.com.