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Increasing disconnect between risk-reward profile of high yield corporate bonds and investor behaviour, warns S&P Capital IQ

Investor behaviour does not reflect the declining yields of European high yield debt and the weakening outlook for this investment, according to a report by S&P Capital IQ entitled “High Yield Corporate Bonds: Still a Risk Worth Taking?”.

S&P Capital IQ found that yields on European high yield debt have been decreasing by an average of 5% over the last year. Furthermore European high-yield bond spreads against 10 year German government bonds have tightened by an average of 4.7% over the same period. Nevertheless, the European high-yield bond market has had an exceptional start to the year, with issuance volumes of €15.5 billion through 8 March 2013, according to S&P Capital IQ’s Leveraged Commentary & Data.

Despite the UK heading for another possible recession and many European economies still struggling, demand for European high-yield corporate bonds is soaring,” comments Claudia Holm, Director at S&P Capital IQ. “Moreover, there has been an increase in issuance in every non-investment grade rating category from 2010 to the latest figures in 2013. As long as these bonds do not default, investors may expect higher yields compared to investments in corporate bonds with lower risk profiles, given the implied increase in risk associated with speculative grade investments. However, this subsequent exceptional rise in demand for high-yield debt instruments has decreased yields for these bonds.”

Even though global and European default rates have been on a downward trend from the peak of the crisis in 2009, S&P Capital IQ observes that there has been an increase across most non-investment grade rating categories from 2011 to 2012. Furthermore, the number of S&P Ratings Service rating downgrades of non-investment grade corporate debt increased relative to the number of upgrades in the last quarter of 2012.

As yield on Euro-denominated bonds have decreased to an average of 6% in January 2013, S&P Capital IQ examined the risk reward profile of these bonds as measured by its Risk‐to‐Price® (R2P) methodology.  “The probability of default, calculated using Merton’s structural approach, points to a sharp increase in Europe’s high yield universe,” highlights Gustavo Tella, Application Specialist at S&P Capital IQ. “The average estimated one-year forward looking probability of default – excluding financial institutions – has nearly doubled in the last year from 18.7% at the end of January 2012 to 32.2% as of 31 January 2013. Meanwhile, Utilities, Energy and Consumer discretionary are the sectors with the biggest increase over the past twelve months.”

S&P Capital IQ observes that, despite the above fundamentals, the risk appetite remained strong in 2012 with the number of high-yield bonds issued rising for another year, confirming the past on-going trend over the past four years.

The indicators for European speculative grade debt are negative but it is worth remembering that these securities still provide investors with higher yield when compared to government and investment grade corporate bonds,” concludes Holm. “We will continue to monitor the decreasing returns to identify if there is enough momentum or if a reversal is expected.”

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