European Bond Traders Suffer High-Yield Anxiety on Losses

Warning signals are starting to flash for Europe’s biggest money managers as a selloff in the U.S. high-yield bond market shows signs of crossing the Atlantic.

Investors in London and Edinburgh say they’re either cutting holdings of junk notes, buying credit derivatives to insure against losses or moving into high-yielding debt backed by collateral, such as oil rigs and cable networks.

“We are treading very carefully in the high yield space,” said Ariel Bezalel, who oversees the $3.8 billion Jupiter Strategic Bond fund in London. “We have had to say no to the vast majority of transactions this year.”

While the change in sentiment isn’t as marked as in the U.S., where a record $7.1 billion was pulled out of funds buying junk bonds in the week ended Aug. 6, bondholders that snapped up a record $115 billion of high-yield securities in Europe this year are growing wary. The region’s junk investors lost 0.3 percent in July after 12 straights months of gains, while in the U.S. speculative-grade debt forfeited 1.3 percent.

Borrowing costs for Europe’s riskiest companies, which have been suppressed by six years of central bank policy, are starting to climb. The average yield investors demand to hold junk bonds in euros has jumped 0.5 percentage points since the beginning of July to 4.15 percent, according to Bank of America Merrill Lynch index data. That’s the highest since February and up from a record low of 3.46 percent in May.

Push Back

Bondholders are also starting to push back against the erosion of safeguards, with representatives from at least six firms meeting in London last month with the Association for Financial Markets to discuss reinforcing language in documents governing bond sales that protect investors.

“We are approaching an inflection point,” said Jon Mawby who helps manage a 755 million-pound ($1.3 billion) strategic bond fund at GLG Partners LP that has cut its holdings of junk bonds to 15 percent from a record high of 45 percent last year. “When investors get more complacent, as deal structures become egregiously skewed against the investor and as yields compress we should be seeing warning signs.”

Demand waned in July as investors withdrew $259.7 million from western European high-yield credit funds, the most since June 2013, reducing year-to-date inflows to $9.3 billion as of Aug. 1, according to EPFR Global data. Redemptions outweigh inflows in the U.S. with net flows for the year of negative $8.47 billion, the data show.

Market Indigestion

Regina Borromeo cut the holdings of global high-yield bonds in the strategic fund she manages at Brandywine Global Investment Management LLC to 58 percent of the total from 74 percent. At the same time the fund’s allocation to emerging market bonds has almost doubled to 15.4 percent because the debt offers better value, she said. Philadelphia-based Brandywine oversees $58 billion globally.

“There has been some indigestion in the market in July,” said Borromeo. “Considering the performance we have had across high yield in both the U.S. and Europe it shouldn’t be surprising to see a bit of a pullback.”

Buyers of junk bonds are still ahead on the year with the securities handing investors total returns of 4.98 percent in Europe and 4.23 percent in the U.S., according to Bank of America Merrill Lynch index data,

Chris Higham, who manages the Aviva Investors Strategic Bond Fund, cut the fund’s holdings of junk bonds to 30 percent from about 40 percent because a decline in yields has made the notes less appealing, he said.

Even so, value can still be found provided investors take account of credit risk, according to Eve Tournier who manages the $11.8 billion PIMCO Funds Global Investors Series - Diversified Income Fund. She is focusing on established companies rather than the wave of new issuers that are typically smaller, lower-rated and may be highly leveraged.

“In this current low-yield environment, higher yielding assets can present opportunities if you stay focused on risk,” Tournier said.

Awakened Investors

Fund managers will seek to walk a fine line between selling debt too early and avoiding being crushed in a stampede for the exit, according to Luke Hickmore, an investment director at Scottish Widows Investment Partnership in Edinburgh.

Instead of selling bonds in the SWIP Strategic Bond Fund Fund he co-manages, Hickmore sought protection against losses by buying credit-default swaps. The derivatives now account for about five percent of the fund, which increased its holdings of junk bonds to a record 45 percent earlier this year.

“You have got to be careful not to be too negative too soon,” said Hickmore. “But we are increasingly wary that the rally we have seen is running out of steam.”

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