Short view By Philip Coggan - Financial Times
Short view
By Philip Coggan
Published: March 14 2006 02:00 | Last updated: March 14 2006 02:00. Copyright by The Financial Times
Corporate bond investors are getting worried. It is not just that yield spreads over government bonds are low by historical standards. The phrase of the moment is "event risk", the danger that corporate action will result in a sudden downgrading of bonds.
With Europe awash with takeovers, both real and rumoured, event risk is all-pervasive. If a large company is taken over in a debt-financed deal, shareholders may rejoice. But bondholders see the value of their securities fall sharply, as the likelihood of repayment declines.
Gary Jenkins and Jim Reid of Deutsche Bank point out that event risk creates a paradox. When investors start to get nervous about corporate debt, it is normally the weakest credit (high-yield, or junk, bonds) that suffers most. But there is no point in making a leveraged takeover of a company that already has a lot of debt. Such deals tend to be aimed at more conservatively financed companies, so event risk hits those investors who thought they were being cautious.
Investment grade investors can suffer a "double whammy" in current market conditions. "If a single-A rated company turns into a single-B overnight through event risk, not only do investors lose out by spread widening on day one, they are likely at this stage of the cycle to see bonds trade at a spread that does not statistically compensate them for holding the bond until maturity," say Jenkins and Reid.
Deutsche Bank calculates that high-yield spreads would outperform government bonds over the next five years if the cumulative proportion of bond defaults is less than 22-23 per cent. Over the past 12 months, the default rate in Europe has been zero but historically, the average default rate over five years has been 21.3 per cent.
That suggests high-yield bonds are just about fairly priced in Europe. The problem has been the recent surge in issuance by poor credits, with CCC-rated bonds rising as a proportion of the market from 2 per cent in 2003 to 30 per cent last year. Given that around one-third of CCC-bonds default within two years, that suggests the default rate should start to rise next year. Something else for bond investors to worry about.
By Philip Coggan
Published: March 14 2006 02:00 | Last updated: March 14 2006 02:00. Copyright by The Financial Times
Corporate bond investors are getting worried. It is not just that yield spreads over government bonds are low by historical standards. The phrase of the moment is "event risk", the danger that corporate action will result in a sudden downgrading of bonds.
With Europe awash with takeovers, both real and rumoured, event risk is all-pervasive. If a large company is taken over in a debt-financed deal, shareholders may rejoice. But bondholders see the value of their securities fall sharply, as the likelihood of repayment declines.
Gary Jenkins and Jim Reid of Deutsche Bank point out that event risk creates a paradox. When investors start to get nervous about corporate debt, it is normally the weakest credit (high-yield, or junk, bonds) that suffers most. But there is no point in making a leveraged takeover of a company that already has a lot of debt. Such deals tend to be aimed at more conservatively financed companies, so event risk hits those investors who thought they were being cautious.
Investment grade investors can suffer a "double whammy" in current market conditions. "If a single-A rated company turns into a single-B overnight through event risk, not only do investors lose out by spread widening on day one, they are likely at this stage of the cycle to see bonds trade at a spread that does not statistically compensate them for holding the bond until maturity," say Jenkins and Reid.
Deutsche Bank calculates that high-yield spreads would outperform government bonds over the next five years if the cumulative proportion of bond defaults is less than 22-23 per cent. Over the past 12 months, the default rate in Europe has been zero but historically, the average default rate over five years has been 21.3 per cent.
That suggests high-yield bonds are just about fairly priced in Europe. The problem has been the recent surge in issuance by poor credits, with CCC-rated bonds rising as a proportion of the market from 2 per cent in 2003 to 30 per cent last year. Given that around one-third of CCC-bonds default within two years, that suggests the default rate should start to rise next year. Something else for bond investors to worry about.
posted by Carlos T Mock at 4:19 PM
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