25 Jun 2018 3 min read

The barbarians are NOT at the gate

By Martin Reeves

Concerns that rising leveraged buy-out (LBO) activity is bad news for high yield bonds are misplaced. Credit quality is improving, indicating lower default rates, which is good news for investors as spreads have further room to tighten.


When journalists Bryan Burrough and John Helyar wrote Barbarians at the Gate in 1989, they described a world where the rise of the leveraged buyout was leading to a corresponding decline in the credit quality of high yield bonds.

Not today.

The credit quality of high yields bonds is improving, with a higher proportion of BB rated issues indicating lower default rates in future

Financing costs have been falling, which helps to improve company cashflows and hence the quality of the high yield market. What’s more, today’s coupon rates are typically 2% higher above the market yield amongst European BB-rated issuers, further reducing their borrowing costs. This means there is more headroom for global interest rates to rise before higher financing costs have a negative impact on corporate cashflows.

Nowadays, there are other options on the table to meet corporate financing needs.

Leveraged companies increasingly prefer loan issuance and private credit, rather than high yield bonds, to finance themselves

This is good news for the high yield market, for as leveraged issuers are turning away from bonds likely future credit concerns, and particularly default risk, are being transferred from the high yield bond market to the covenant light loan and private credit arenas.

So, while overall demand for higher yielding assets has never been greater, this shift to loans has led to outflows from the high yield bond market. Most significantly though, this has not hurt the performance of high yield bonds. Quite the reverse; during 2017 there was a negative correlation between capital flows and total returns from high yield bonds.

In the leveraged loan market, where covenants are typically short-term, one could argue credit risk is rapidly growing, removing some of the riskier debt that otherwise would have been parked in the high yield bond market.

If we are expecting a decline in default rates amongst high yield bonds, investors would intuitively expect compression in credit spreads (measuring the return over the risk-free rate) to continue.

Although credit spreads have compressed, we believe that high yield bonds still offer sufficient compensation for credit risk

Based on the average experience in BB rated bonds and quite possibly B rated issues as well, there is still sufficient compensation for credit risk. Amongst riskier CCC rated paper though, this might well not be the case.

Some have argued that the improvement in credit rating within the index could be a product of the rating agencies changing their methodology. However our experience when we are reviewing the many issuers that pass our desk is that this is not the case.

So on that basis, the next time we hit a major economic slowdown, the high yield bond market could actually experience a lower level of defaults.

This is good news for investors, as the market has yet to discount potential for lower default rates

Martin Reeves

Global Head of High Yield

Martin runs a team of high-yield professionals focused on global opportunities. He joined LGIM in September 2011 from AllianceBernstein, where he worked for 13 years. Martin was a founding director of the European High Yield Association and was Co-Vice Chair of the Association for Financial Markets in Europe’s High Yield Board. He qualified as a chartered accountant with Ernst & Young and gained a MA from St Catharine’s College at the University of Cambridge, where he read Economics.

Martin Reeves