The boom in high yield markets has continued into 2011 and money continues to flow into emerging market debt - leading some to talk about bubbles and a return to bad habits. Elsewhere in the debt markets, the financial crisis and its aftermath are still being felt.

The first quarter of 2011 has been one of mixed messages in the debt markets. Defaults are falling and corporate bonds began the year with record volumes in the US. Rising risk appetite saw high-yield debt have a brisk start to the year, and volumes are rising in emerging markets. But fear about bail-in proposals in Europe has led to record volumes in the covered bond markets as investors look for assets that will not be subject to new rules. The US municipal market, too, saw record outflows - with more than $20bn withdrawn from muni funds in the 10 weeks to the end of January.

Emerging markets up

In emerging markets, volumes are growing and new issuers are coming to market. In Asia, local currency markets continue to deepen - with 24.6% growth in Indonesia and 29.4% in Malaysia. African markets have been hit by the rolling unrest across the north of the continent - Nigeria's debut Eurobond in January suffered a little in the after market  - and Côte d'Ivoire defaulted on last year's restructured bond, but the damage to the broader markets has been surprisingly limited.

Deals are getting done and there is growing optimism about the continent's prospects. At the end of January, Afren’s $450m five-year secured bond, the first high-yield bond from an exploration and production company with assets in sub-Saharan countries, was over-subscribed in the midst of the unrest.

“There is a certain level of decoupling of concern about bond issuance from some of the recent social and political unrest that would not have been the case a few years ago,” says Alex von Sponeck, head of debt origination for central and eastern Europe, the Middle East and Africa at Goldman Sachs. “Issuers may now pay a slightly higher premium, but most deals will get done. Investors continue to search for yield and there is clearly a lot of liquidity, but it is also a sign that investors are increasingly differentiating between markets in Africa, rather than treating them as a homogenous block. This is a tribute to the slow but growing set of issuers from across the continent.”

Defaults down

At the beginning of February, Moody's reported that there had not been one default in all the global companies that it tracks in January - the first month to claim a clean sheet since June 2007. It is perhaps no coincidence that in the first two weeks of January, banks and companies borrowed $67bn in the US market, the busiest start to the year on record, according to Thomson Reuters.

While long-term rates have risen recently, companies have jumped at the chance to lock-in funding at rates that are still lower than they were a year ago. Then the average yield paid by investment grade non-financial companies on dollar bonds was 4.43%, compared to February's average of 3.94%. For financial companies included in Barclays Capital’s index, the average yield is now 4.02%, down from 4.84% a year ago.

And with growing evidence of a US recovery and near-zero official rates in the US and Europe, investors have turned to riskier assets. As a result, the boom enjoyed by high-yield bonds in 2010 has continued with a lively start to the year. Last year, the market raised a record amount of debt - more than $300bn - and saw returns of almost 15%. This was second only to gold in terms of price performance by asset class.

With one banker estimating that more than $15bn of high-yield debt had been sold in less than a week in January, yields on junk bonds were pushed down to a record low of 6.8% in the third week of February.

“There is tremendous liquidity coming into high-yield asset managers,” says Michael Moravec, head of high-yield and leveraged loan markets at Barclays Capital. “The rate environment is low and credit spreads are continuing to compress. A record number of European companies are coming to market.”

Europe's bail-in

But in Europe, the outlook is more mixed. The second week of February brought a growing prospect of haircuts for Irish bondholders and Danish Amergerbanken's bankruptcy. Coming hot on the heels of the bail-in plans for banks, it suggested a tougher future for bank finance.

Last October, a client survey by JPMorgan revealed that European banks could lose more than a quarter of their senior bondholders and face higher funding costs if bail-in plans were passed (see this month's cover story). While the biggest banks are able to sell bonds, smaller institutions and those from weaker economies such as Spain and Portugal will likely struggle to raise funding at economical rates – and many of these weaker institutions are still largely reliant on the European Central Bank for funding.

When Brussels unveiled its bail-in plans in early January, bond markets virtually froze. While the markets have calmed, it is clear that financial investment group investors are increasingly looking to protected instruments - such as covered bonds - that would be exempt from bail-in rules.

In 2010, worldwide issuance of covered bonds reached $356.5bn - up 20% on the previous year. By mid-February, covered bond sales had reached $89bn. Typically, senior debt accounts for about half of all bonds issued, and covered bonds about three-fifths of that. By the same date, senior bond issuance had reached $97bn.

Eurozone worries

Concern about the fiscal health of the eurozone periphery also resurfaced. After a successful bond sale had boosted confidence over Portugal in January, renewed concern about the country's ability to raise funds in the capital market pushed yields on the country's five-year debt to their highest level since the formation of the euro. In mid-February, the yield on Lisbon's 10-year debt hit 7.43%, rising above levels seen last November and increasing the spread over German government debt yields to 415 basis points.

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