Amid growing confidence in euro-area authorities’ response to the regional debt crisis, yield-hungry investors have been returning to the riskier categories of corporate debt, including the peripherals: Portugal, Italy, Ireland, Greece and Spain. Is it safe to go back into the market?
Investors are stuck between the need for yield and the fear of “tail risk”—the risk of outsized losses triggered by a market shock. The challenge is to find assets that generate yield, but that are not going to suffer heavy losses in a bad-news scenario.
In the peripheral countries, we’d be wary of being overweight in government bonds, which are still overshadowed by debt problems. The same goes for financial-sector corporate bonds, which are closely linked to sovereigns. But among the nonfinancial corporates, we think that the balance of upside and downside is looking quite attractive.
We looked at nonfinancial corporates in the peripheral countries, making a simple calculation to give a rough idea of the 12-month excess return in different market scenarios.
As shown in the chart below, at the end of September, peripheral corporates (both investment grade and high yield), were trading at an average spread of about 400 basis points (4%) over Bunds—well above historical average. If bond prices just moved sideways, the expected excess return over governments would be about 4.8% for the year—quite attractive under current market conditions. And if spreads reverted to their historical average, the excess return would be a very attractive 8.7%.
In a bad-news scenario, if spreads went all the way back to their 2011 highs, the expected excess return would still be positive, at about 1.8%. As shown in the chart, it would take a much worse market selloff to wipe out all excess returns.
For investors looking for yield, another choice would be euro high-yield corporates, excluding the peripheral countries. We did the same exercise, shown in the chart below.
At the end of September, the average spread over Bunds was about 5.8%—slightly below historical average. If prices moved sideways, the excess return over governments would be about 6.5% a year. Both of these are higher than the return on the peripherals.
But the downside scenarios look different. If high-yield spreads reverted to their historical average, the excess return would be a more modest 2.8%. A 270 basis point widening—which would have been the zero-excess-return point for the peripherals— would result in losses of about 4.4%.At the extremes, if spreads returned halfway to their 2008 peak, investors would suffer a loss of around 22%, while a 1000bp move would result in a loss of as much as 42%.
In short, the peripherals seem to offer an acceptable yield under most scenarios, with a more moderate downside than nonperipheral high yield corporates.
What does this imply for investors? The nonperipheral high-yield market has already rallied a long way. We do think opportunities remain, but it’s more a case of careful case-by-case security selection than just buying the broad market.
Passive index exposure is looking like a risky strategy at the moment, as it’s essential to weed out the weak government-related names.
In the peripherals, we’re not necessarily recommending a headlong dash into the market, but the opportunities are certainly interesting. Of course, some issuers are riskier than others, but not all peripheral corporates have deteriorating balance sheets. There are stable companies out there with strong global business models. Some have pre-funded themselves well into 2014 and 2015, and this lack of reliance on the capital markets is likely to make them more resilient than sovereigns or financials.
The BBB/Baa-rated peripheral issuers are an interesting case in that they are, theoretically, most at risk of falling into high-yield territory if there are further sovereign downgrades. But we think this risk has been priced in by the market, and some companies are trading at too much of a risk premium—potentially creating attractive buying opportunities.
Particularly for investors who are thinking of a longer time frame (say three to five years), we think the peripherals can be a robust addition to the portfolio. And it’s going to be one to watch in the coming year.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not
necessarily represent the views of all AllianceBernstein portfolio-management teams.
© 2012 AllianceBernstein