Lavish yields are credit market investor magnet

Euro corporate funds are up an aggregate 12.91 percent and euro high-yield funds up 50.23 percent to Oct. 16, according to data from Thomson Reuters fund research firm Lipper: a bonanza compared to paltry yields in other asset classes.

The last 12 months have been a once-in-a-77-year opportunity, said Schroders' head of pan-European fixed income Jamie Stuttard, referring to the yield spike during the Great Depression.

It almost didn't matter what you bought in investment-grade bonds; nearly all have gone up in price.

Europe's credit investors still see room for additional profits even after a seven-month rally. The picture is changing for the primary market, which was open only for the strongest borrowers at the start of the year.

The flavour right now is for lower credit ratings, said Mark Lewellen, head of European corporate origination at Barclays Capital. There are a lot ... more challenging credits in the market right now.

Investors are moving down the rating curve into junk bonds. Europe's high-yield market has gone from 18 months of dormancy to 17 billion euros of new issues - all since May with the exception of Fresenius, which came in January.

A lot of juice has already been squeezed out of euro-denominated investment-grade corporate bonds, which have outperformed government bonds by 1,070 basis points, according to Andrew Sheets, credit strategist at Morgan Stanley.

TOO HOT?

It's a question of pull and push, said Chris Marks, head of debt capital markets at BNP Paribas.

The paucity of yields from cash and government bonds will persist until the end of the year and probably some time beyond that, he said, while companies face uncertainty about their ability to raise bank loans in the future.

(This) has prompted a great range of European corporates to use the bond market like never before, said Marks.

Some market observers have now started saying the rally could go too far and repeat recent history. Standard & Poor's said last week junk bond buyers may not be exercising enough discipline.

Investors may not fully be factoring credit risk into their investment decisions, given the tight pricing of new issuance and the re-emergence of creditor-unfriendly transaction terms.

Investors now need to be more selective, Schroder's Stuttard said. He focuses on the centre of investment grade ratings, avoiding borrowers at the tight end with dull, Treasury-like performance and at the wide end, which includes some mis-rated credit at risk of ratings downgrades.

Money going into credit has had the right results thus far, but some is going in now for the wrong reasons, said Gary Jenkins at Evolution Securities.

If people think they are going to get the same returns as earlier this year, they are going to be sorely disappointed.

There may be considerable danger, say investors and analysts, in buying high-yielding credits when they lack ratings or provide no detailed assessments of future cashflows and leverage.

Chris Marks, head of debt capital markets at BNP Paribas, said investors are using proxy characteristics to anchor the buying decision.

Before the end of the year, you'll see a lot of lower credit quality, compared to the first half of the year. The pipeline is skewed towards crossover credits and toward emerging markets, Barclays' Lewellen said.

Stuttard - who took part in the rally from the start - still sees a good cyclical opportunity in investment-grade credit.

Investment-grade spreads are still wider than the wides of 187 basis points seen in the last credit downcycle in 2002, and factors pushing spreads tighter are not likely to let up anytime soon, the optimist camp says.