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High yield value trap: party over for high yield bonds as risk no longer rewarded

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High yield value trap: party over for high yield bonds as risk no longer rewarded 1

High yield bonds are no longer rewarding duration and credit risk correctly, argues RWC Partners’ Justin Craib-Cox, and investors should consider using convertible bonds to earn equity-like returns as volatility continues to affect markets.

Following an initial widening, high yield bond spreads quickly tightened in the wake of the initial coronavirus crisis, despite signs that economies have a long way to go and there may be more stress to follow.

With high yield bonds offering under-appreciated risks in the current environment, investors should look elsewhere for debt that has equity-like returns according to Craib-Cox.

“Bond markets are at a turning point, where taking credit and duration risk will not be rewarded as it was in the past,” says Craib-Cox.

“High yield bonds have enjoyed very strong risk-adjusted returns in recent years. That is because the environment has been broadly supportive, thanks to low rates, minimal interest burdens and muted volatility of outcomes. And with investors in need of income and having to allocate more to high yield, it becomes a sort of circular arrangement.

“So why was this period so good for high yield? Simply put, massive monetary support from central banks pushed interest rates lower and dampened volatility, and those conditions helped to limit defaults in high yields while pushing bond prices higher.

“Plus, risk preferences and an aging global demographic created more demand for bonds, providing a steady bid for more speculative credit. In other words, the bet of loaning money to shaky companies worked fine in this period, given that high yield issuers were largely able to repay or refinance their debts.”

But where the market stands today in the ‘New Normal’ is clearly different, Craib-Cox believes.

“Asset price volatility has increased with the more uncertain future following the Covid-19 pandemic, even with rates staying low and governments pledging fiscal support. Corporate defaults, particularly in the US, have crept up even before the coronavirus crisis began.”

Speculative-grade corporate default rates

Source: Moody’s Investors Services, 31st August 2020.

Source: Moody’s Investors Services, 31st August 2020.

“The rapid spread of the pandemic caused a massive widening in credit spreads in March and April 2020, and a subsequent loss of capital for the sub-investment-grade bond market. As such, high yield does not look like a bargain anymore, with spreads recovering to pre-lockdown levels while the probability of defaults has plainly increased.”

“In a world of low rates and low volatility, issuers used the high yield markets with carefree abandon and no concern for extra leverage. Now that volatility and uncertainty have returned, simply adding another layer of debt to get through a rough patch doesn’t make as much sense.

“Overleveraged issuers are facing conditions vastly different to those they assumed when taking on debt, and investors accustomed to low defaults from this market are thinking again about exposure to this asset class.”

Craib-Cox argues investors in high yield bonds that have the flexibility to earn return through embedded equity options should consider convertibles, which have outperformed high yield this year.

Convertibles vs High Yield

1-year performance

Source: RWC Partners, 30th September 2020.

Source: RWC Partners, 30th September 2020.

“While high-yield bonds are a one-way bet that a speculative issuer will not default, the embedded option to convert gives positive returns if stocks rally, but limited downside thanks to a bond floor.

“These structural features helped convertibles to outperform high yield, both when markets sold off in early 2020, and during the rally that began in April 2020.”

“In fact, from the year’s lows, convertibles recovered to pre-lockdown levels more quickly than high yield, and as of the end of September, convertibles are positive for the year while high yield remains negative.

“Issuers too are now choosing to use convertibles, with a record amount of issuance in 2020. Convertibles are being issued by companies that may be the stronger operators in a temporarily challenged sector, or looking to finance growth prospects, particularly in sectors such as IT where the pandemic has created opportunities in areas such as distance working and learning.

“With less representation from highly leveraged or cyclical sectors, many investment grade or equivalent convertible bonds, and a growth aspect to many issuers, the sector composition of the convertible market is also quite different to high yield, with potential diversification for credit.”

Investing

Stocks slip from highs; investors wait on Fed

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Stocks slip from highs; investors wait on Fed 2

By Matt Scuffham

NEW YORK (Reuters) – Global stocks slipped from record levels on Tuesday, with investors cautious as the Federal Reserve kicked off its two-day policy meeting and U.S. lawmakers continued to debate a new stimulus plan.

Those concerns overshadowed impressive results from a slew of companies, including from General Electric and Johnson & Johnson, which had earlier pushed the S&P 500 to a record high.

“Investors don’t expect the Fed to give any reason to think they are getting closer to talking about when they will consider scaling back QE, but nervousness is brewing on Wall Street,” said Edward Moya, senior market analyst at OANDA in New York.

Wall Street’s main indexes closed lower.

The Dow Jones Industrial Average fell 22.96 points, or 0.07%, to 30,937.04, the S&P 500 lost 5.74 points, or 0.15%, to 3,849.62 and the Nasdaq Composite dropped 9.93 points, or 0.07%, to 13,626.07.

The MSCI world equity index, which tracks shares in 49 nations, fell 1.99 points or 0.3%, to 666.09.

After a “buy everything” rally over several months supported by money-printing pandemic stimulus packages, near-zero interest rates and the start of COVID-19 vaccination programs, some investors are worried markets may be near “bubble” territory.

They point to rocketing prices of assets such as bitcoin or the soaring stock of short-squeezed videogame retailer GameStop.

“There is room for some consolidation,” said Francois Savary, chief investment officer at Swiss wealth manager Prime Partners.

Uncertainty over the timing and size of fiscal stimulus also tempered sentiment.

Disagreements have meant months of indecision in the United States, where new coronavirus cases have been above 175,000 a day and millions of people are out of work.

Democrats in the U.S. Senate will act alone to approve a fresh round of stimulus if Republicans do not support the measure, Majority Leader Chuck Schumer said.

U.S. Treasury yields were narrowly mixed in choppy trading, after hitting three-week lows on the long end of the curve, as investors remained cautious about the stimulus and the slow global roll-out of coronavirus vaccines.

Benchmark 10-year notes last rose 2/32 in price to yield 1.0347%.

The U.S. dollar edged lower across the board as traders showed a preference for riskier currencies.

The dollar index fell 0.2%, with the euro up 0.21% to $1.2162.

European stocks advanced, shrugging off political upheaval in Italy, as strong earnings from wealth manager UBS and auto parts maker Autoliv added to a string of upbeat corporate updates.

The pan-European STOXX 600 index closed up 0.6%, with a rally in automakers, industrial companies and SAP helping the German DAX outperform.

Europe’s broad FTSEurofirst 300 index added 0.64%, at 1,573.47.

The IMF raised its forecast for global economic growth in 2021 and said the coronavirus-triggered downturn in 2020 would be nearly a full percentage point less severe than expected.

Italy’s FTSE MIB rose 1.2% after Prime Minister Giuseppe Conte handed in his resignation to the head of state, hoping he would be given an opportunity to put together a new coalition and rebuild his parliamentary majority.1.2163

MSCI’s broadest index of Asia-Pacific shares outside Japan fell 11.47 points or 1.58% in Asia overnight. South Korea and Hong Kong topped losers, each falling more than 2%. The sell-off also caused Japanese stocks to slip 1% and Chinese blue-chips to tumble 2%, their biggest one-day loss since Sept. 9.

All had touched milestone highs earlier this month.

Gold prices edged lower. Spot gold dropped 0.2% to $1,850.63 an ounce. U.S. gold futures settled down 0.2% at $1,850.90.

U.S. crude oil futures settled at $52.61 a barrel, down 16 cents or 0.30%. Brent crude futures settled at $55.91 a barrel, up 3 cents or 0.05%.

(Reporting by Matt Scuffham; Editing by Dan Grebler, Mark Heinrich and Sonya Hepinstall)

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Current cryptocurrencies unlikely to last, Bank of England governor says

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Current cryptocurrencies unlikely to last, Bank of England governor says 3

By David Milliken

LONDON (Reuters) – No existing cryptocurrency has a structure that is likely to allow it to work as a means of payment over the long term, Bank of England Governor Andrew Bailey told an online forum hosted by the Davos-based World Economic Forum on Monday.

“Have we landed on what I would call the design, governance and arrangements for what I might call a lasting digital currency? No, I don’t think we’re there yet, honestly. I don’t think cryptocurrencies as originally formulated are it,” he said.

Bitcoin, the best-known cryptocurrency, hit a record high of $42,000 on Jan. 8 and sank as low as $28,800 last week, far greater volatility than is found with normal currencies.

“The whole question of people having assurance that their payments will be made in something with stable value … ultimately links bank to what we call fiat currency, which has a link to the state,” Bailey said.

The BoE, like the European Central Bank, is looking at the feasibility of issuing its own digital currency. This would allow people to make sterling electronic payments without involving banks, as is currently possible with banknotes, and would in theory help avoid the volatility that renders bitcoin impractical for commerce.

Bailey said the appropriate level of privacy for digital currencies was likely to be hotly debated and was potentially underrated as a challenge in setting one up.

“This is a big one that is coming on to the landscape, the whole question of a privacy standard for transactions made in any form of digital currency, and where the public interest lies,” he said.

(Reporting by David Milliken, editing by Tom Wilson and Alistair Smout)

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EU sustainable investment rules need better corporate data – banking report

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EU sustainable investment rules need better corporate data - banking report 4

By Simon Jessop and Kate Abnett

LONDON (Reuters) – European Union rules aimed at defining sustainable investments should help reduce “greenwashing” by businesses, but better quality corporate data is needed to ensure they work effectively, a banking report said on Tuesday.

The sustainable finance rules will classify investments that can be marketed as sustainable, a move aimed at steering much-needed cash into low-carbon projects to deliver the bloc’s climate goals.

From January to August 2020, 26 of the region’s biggest lenders tested the EU framework across a range of core banking processes, including retail banking, trade finance and lending to smaller companies.

As the main providers of finance to companies across the EU, the ability of the banking system to track and report on whether corporate activities are sustainable or not could prove crucial in assessing the rules’ success or otherwise.

The lenders broadly welcomed the regulations as they seek to align their businesses with the transition to a low-carbon economy, the report by the United Nations Environment Programme Finance Initiative and the European Banking Federation found.

However, they also raised a number of issues, many of which were data-related and could require a phasing in of reporting requirements.

While many large companies are already required to disclose certain environmental and social information by law, the bulk of smaller and mid-sized banking clients are not, hampering banks’ assessment of their alignment with the rules.

Concerns over the quality, detail and standardisation of data is also an issue when looking at banks’ lending overseas, something that would be made more complex as other regions launch their own regulations.

The banks who tested the EU rules called on regulators to seek global alignment of regulations, and for better tools to manage data from clients, such as a centralised EU database.

While under no compulsion to lend to activities that can be classed as sustainable, banks see sustainable finance as a growth area that is likely to take on more importance in coming years should policymakers tighten environmental legislation.

With more investors globally looking to become shareholders of companies with a good record on managing environmental risk, banks are also likely to look to reduce their exposure to environmentally or socially harmful activities over time.

The European Commission is expected to finish the section of the rules covering climate change in the coming months, before they take effect in 2022.

(Reporting by Simon Jessop and Kate Abnett; Editing by Pravin Char)

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