ECB QE alchemy transforms junk bonds

Higher yield equals greater risk, a maxim that eurozone investors appear increasingly willing to ignore.

For investors reluctant to pay for the privilege of lending at negative yields to sovereigns or earn microscopic returns lending to highly rated corporates, one solution is a trip down the risk spectrum.

High yield bonds or junk rated debt, in common with the eurozone fixed income market, are being distorted as the European Central Bank undertakes massive monetary stimulus and suppresses interest rates.

While junk has generally been considered highly speculative in nature, investors are willing to look beyond such risk, flocking to bonds still sporting a yield well above zero when a quarter - some €1.4tn - of sovereign debt has a negative yield and more than two-thirds of investment grade debt yields less than 1 per cent.

"There's a huge amount of moral hazard created by the ECB," says Christopher Iggo, senior manager at Axa Investment Managers. "People are taking on more credit and duration risk than would have been the case otherwise."

The rush into junk has duly pushed up prices and lowered yields across the sector, altering risk perceptions and the returns on offer so that "high yield" has been redefined.

"In a way, the HY [high yield] frontier has been redrawn from between BBB and BB to between BB and B," says Thibault Colle, a strategist at UBS.

The first tier of junk bonds rated BB has seen heightened investor demand compress spreads to the extent they now move more in unison with investment grade BBB rated bonds than with other strata of junk.

"The de facto boundary between investment grade and high yield has quite honestly moved in this new world that we're in," says Mike Kessler, a European credit strategist at Barclays. "Many investors believe it is inevitable that lower rated high yield has to follow suit and join the rally."

And join the rally it has.

Half of euro BB rated bonds - assets classed as high risk by rating agencies - now yield less than 2 per cent, according to Markit and UBS, illustrating how the hunt for returns has slashed the yields of even the riskiest assets.

"This market distortion represented by QE is a gift from heaven given to investors by the ECB. It's difficult to tell your clients you're not accepting this gift," says Didier Saint-Georges of Carmignac.

For many investors, the boundary shift is justified.

While 15 per cent of the US junk bond universe consists of debt sold by energy companies, thus seen being vulnerable after the recent slide in oil prices, the sector reflects just 1 per cent of the eurozone high yield market.

Iain Stealey, a fund manager at JPMorgan Asset Management, says: "We see European high yield as a constructive place to be, given default rates are very low and earnings and economic growth are just starting to pick up.

"There are lots of tailwinds - lower costs, the falling euro, lower refinancing costs and a larger equity cushion below debt."

But some fund managers warn that investors may be overlooking the fact that junk is fraught with very real risks.

"We see the yields on offer as not adequately compensating investors for either the far higher level of default risk or the poor secondary liquidity in this part of the market," says David Ennett, head of European high yield at Standard Life, in reference to CCC rated bonds.

Relentless QE-fuelled appetite for junk has now swelled the euro market to roughly $365bn, with the average yield at issue falling to 4.35 per cent, according to Dealogic.

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Standard & Poor's, the rating agency, has warned that the leverage of new high yield issuers has jumped to five times this year, up from 4.5 times a year ago.

Fund managers also warn that while QE fuels demand for junk bonds and drives up prices, it does not enhance liquidity, a problem that many investors have overlooked.

"Liquidity in this market is just not what it was pre-financial crisis. It's just not the same world - the asset classes are bigger, the banks are smaller and cannot take on more risk," says Mr Moini.

Mr Saint-Georges of Carmignac warns: "One of the issues in Europe is that QE is coming too late, and for that reason it's coming too big. The main difficulty for bond investors will be liquidity when the trend reverses, and then high yield will become a big issue. You'll have everyone rushing to the door."

Mr Iggo says: "It's like the big bad train coming down the track but nobody knows when it's coming or how fast it's going."

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