‘Junk’ returns to Europe

As sub-investment grade bonds regain popularity on European markets, many analysts have pointed to warnings from recent history

 

Other analysts see it as a good profit opportunity in a market where interest rates continue to hover near zero. One anonymous fund manager has said that “short-duration, high-yield paper with a reasonable credit quality that matures or is callable very soon is attractive.” As with other indexes, high-yield indexes dropped in value initially, but are now rebounding. That means, at least for the time being, hedge funds are being rewarded for investing in these high-yield bonds. Longer-term bonds are at increased interest rate risk and also trade at a tighter spread, providing little upside payout.

The high-yield option is becoming available to new markets, like the one in China. The Shanghai stock exchange is opening up these new investments initially to institutions as a means to deepen investment options in the country. Assuming the investments work out and issues of transparency, liquidity and regulation are ironed out, the market may expand later to private equity funds.

The ability for smaller, private companies to issue bonds will add a new dimension to Shanghai’s exchange which has previously been almost exclusively limited to large, state-owned enterprises. Many analysts and traders believe that the trial period will run six months to a year before potentially branching out into even more investment options.

China’s corporate financing history has been nearly opposite that of other mature economies. In the US and Europe, corporate debt financing typically accounts for 60 to 70 percent of total financing, while in China, it averages around only 10 percent. Once the market is opened to these high-risk bonds, China’s balance may begin to ease toward that of other countries.

Of course, risk is inherent in these types of vehicles, and especially during the trial period, underwriters and buyers will end up negotiating with sellers to set final prices.

Underwriting fees and a higher negotiated interest rate may well mean a higher cost to the issuer, but the pay-off for both parties could be very good. Investors will need to educate themselves regarding the investment and the seller, and use appropriate measurement criteria. Investors used to measuring large corporations may find that tools with more finesse are needed to critically evaluate the health and profit prospects of a smaller company.

China’s move toward including high-yield bonds may herald a broadening of the market for these products, though, and the inclusion of these in hedge fund portfolios may only be beginning.