Upgrades out of European high-yield could balance outflows

By Yoruk Bahceli

LONDON, Feb 16 (IFR) - The possibility of several ratings upgrades could see several billion euros of bonds leave the European high-yield sector and provide some technical support for the market after fund outflows reached record levels this week.

Data released on Friday showed €2.8bn has left European high-yield funds tracked by JP Morgan since the start of the year, compared to €6bn for the whole of 2017, with €1.4bn of the outflows taking place for the week ending on Wednesday. Retail funds flows account for around a quarter of demand for the asset class, bankers estimate.

The outflows are the largest ever on record for European high-yield bond funds, according to EPFR, which said this was due to eroded investor protections drawing increased scrutiny.

But while money is leaving high-yield so, potentially, are several of its leading issuers. ArcelorMittal (LSE: 0NSF.L - news) was the first fallen angel to see an upgrade this year, when S&P assigned it an investment-grade rating earlier this month.

Other names include Telecom Italia (Amsterdam: TI6.AS - news) , aerospace and defence company Leonardo, Tesco (Frankfurt: 852647 - news) and ThyssenKrupp (IOB: 0O1C.IL - news) . In total this could take some €24bn out of Bank of America Merrill Lynch's euro high-yield index, which amounts to around 8% of its total, according to IFR calculations.

This would also cut the share of Double Bs in the asset class, which have played a key role in compressing yields in 2017 as they attracted significant demand from investment-grade "tourist" accounts.

But a syndicate banker said he expects cash returning from the sale of upgraded issuers' bonds by high-yield funds to balance out with cash leaving high-yield.

FUNDAMENTALS VS TECHNICALS

While a deterioration in the quality of high-yield indices due to a decline in the share of Double Bs would be expected to push the market wider, the actual impact will depend on how crossover and investment-grade buyers look at the asset class going forward.

"The unconstrained funds want the carry and the lower duration, but they don't want the defaults, so they have a bias towards Double Bs," said one portfolio manager.

"Where will an investor who wakes up and finds Telecom Italia upgraded to investment-grade go to fill the Double B space in his basket? It's a good question that could mean there is a prolonged period of really strong demand for Double B risk," he added.

But the potential for further moves in rates complicates that picture, possibly reducing investment-grade appetite for high-yield paper. Many high-grade and high-yield investors are fearful of 10-year Bunds breaching 1%, according to a BAML investor survey released on Friday.

"Many say that at these levels 'tourist' investors in credit might begin selling corporate bonds, particularly Double Bs, and flock back to government debt," BAML analysts wrote. That could create further prospects for widening by removing a key source of demand for the asset class while it deteriorates in quality.

One syndicate banker said dealers had not observed a shift by investment-grade funds away from high-yield since the start of the year. Despite the impact of the global equity sell-off on high-yield, Double B rated French laundry services company Elis managed to price a five-year inside 2% last week.

"The only thing that would change [crossover demand] is markets becoming more risk averse. Then, you will see a flight to quality," said a DCM (KSE: 024090.KS - news) head.

LIMITED DOWNGRADE PROSPECTS

The asset class is unlikely to be bolstered by new fallen angels with only a handful of European companies on rating agencies' negative watch lists.

Israeli pharmaceutical company Teva has been this year's key downgrade, now carrying junk ratings from all three agencies. It has brought €7bn into BAML's index, though, given its listing, its debt isn't included in European benchmarks based on geography.

TDC (LSE: 0MOP.L - news) was put on review for downgrades into junk territory by Moody's and S&P on Wednesday after the Danish telecom company backed a €5.4bn-equivalent buyout offer from Macquarie and a consortium of local pension funds, but it has a mere €3.5bn outstanding in bonds, according to Thomson Reuters (Dusseldorf: TOC.DU - news) data. That is a very small number in comparison to the bonds that could leave high-yield indices. (Reporting by Yoruk Bahceli, editing by Alex Chambers, Alice Gledhill)