Fund managers face shortage of European junk bonds

A blockbuster bond buyback by Tesco comes at a pivotal moment for fund managers owning European high-yield debt, with more cash chasing fewer bonds as bellwether companies vacate the speculative-rated debt universe.

The shrinking of the European junk bond market reflects an increase in groups reclaiming a stronger credit rating, with their outstanding bonds leaving junk bond indexes and entering high-grade baskets.

Anglo American exited Bank of America Merrill Lynch’s widely followed euro high-yield bond index at the end of August. Telecom Italia is just on the cusp of becoming another “rising star”, a term used for companies that return to investment grade.

“As much as 8 to 10 per cent of the benchmark could leave us in the next six months and it’s hard to see a similar amount of fallen angel candidates compensating for the loss,” said Peter Aspbury, a portfolio manager at JPMorgan Asset Management.

Tesco’s impact on the UK junk bond market is set to be even greater, as it is the second largest constituent of Merrill Lynch’s sterling high-yield bond index, making up more than 5.5 per cent of the benchmark.

The UK supermarket chain announced this week that it would pay down as much as £700m of its outstanding bond debt as it looks to strengthen its balance sheet and regain investment-grade status. Tesco’s debt was downgraded to the high-yield bond market in 2015.

Telecom Italia’s bonds comprise 4.25 per cent of the euro high-yield index. Fitch already classes the company as investment grade, which has allowed the European Central Bank to purchase its debt under its bond-buying programme. Telecom Italia carries the highest subinvestment grade ratings from Moody’s and S&P, with both agencies upgrading its outlook earlier this year.

When combined with bonds from Tesco, ArcelorMittal, Leonardo-Finmeccanica and ThyssenKrupp — which have all been flagged as potential rising stars — this climbs to more than 9 per cent.

In contrast, there are very few large fallen angel candidates on the horizon, with the notable exception of Syngenta, whose investment grade rating hangs in the balance due confusion over its support from the Chinese state.

“I’m therefore reluctant to predict that index spreads would widen as a result of these higher quality, lower spread credits leaving the benchmark, because fund managers will be re-investing the proceeds in a shrinking market,” Mr Aspbury added.

High-yield bond fund managers are already under pressure to reinvest cash due to the swell of companies turning to the leveraged loan market for funding. Loans have seen red-hot demand this year, due in part to record sales of collateralised loan obligations.

“The thing that is really thinning out the high-yield market is all the bond-to-loan refinancings,” said Azhar Hussain, Royal London Asset Management’s head of global high yield.

Private equity firms have long favoured leveraged loans in Europe, but now traditional bond market stalwarts in the telecoms and cable sectors are also being swayed by the increasingly longer-dated funding loans can offer.

Wind Tre announced on Wednesday the largest European junk bond sale of the year — a jumbo €7.3bn refinancing deal — but is shifting more of its debt into the loan market. The Italian telecoms firm is raising €3bn of new loans, which is more than four times the size of its existing €700m loan facility.

“This year the loan market has competed with bonds on a scale we haven’t really seen before,” Mr Hussain said.