To understand where you are in the high yield market, it is helpful to take a look at where we have been. People talk about how we are 8+ years into this “cycle” and are express concerns about valuations. We believe this is a valid concern for certain market sectors, primarily equities. From early 2009 through mid-2017 we have seen a virtual straight line up in equity prices with only minor corrections along the way.1
We are sitting at record price levels in the S&P 500, DOW, and Nasdaq, with many questioning investor complacency and valuations.
While these concerns have spread across a variety of financial sectors beyond just these equity indexes, we view the high yield market a bit differently. Yes, there are credits that are overvalued within this market, but there are still some bonds and loans that we see as fairly and even undervalued. Yes, yields are low relative to historic levels, but this is in a context of persistently low rates around the world. Spread levels are still well above historical lows.
Looking at recent history, we don’t believe we can say that high yield investors are complacent. It hasn’t been a straight upward move over this market “cycle” as we have seen with equities. In fact, if you look at the chart of spreads within the high yield market, we have seen this market go through its own cycle of sorts.2
Almost a year and a half ago we saw spreads widen to over 900bps, hitting 919 bps on February 11, 2016.3 While this is nowhere near the spread widening we saw in 2008/2009, which is certainly the outlier as reflected in the chart above, the spread highs that we saw in early 2016 were near the spread highs that we saw during the prior spread peak during the Telecom, Media, and Technology (TMT) collapse of 2001/2002, when spreads topped out right around 1,000bps. There is even high yield data going back to the early 1990’s, when the country was in the midst of the recession, and we saw spreads peak then again right around that 1,000bps level.4
It is important to understand some of the factors that were present going into the declines at the turn of the century, 2008, and even 2015/2016 as we evaluate where we are today. As we closed out the 1990s, we were in the midst of the internet/technology bubble. Telecom, media, and technology were going to revolutionize the world and financial markets were wide open to these companies seeking money to establish their businesses, with investors hoping to grab a piece of the pie. Just as we were seeing companies with little the way of actual revenues, much less profits, able to generate equity proceeds via IPOs, we were seeing similarly relaxed issuance standards during this time in the high yield market. Media and Telecom (Broadcasting, Cable/Wireless, and Wireline and Wireless telecommunications) accounted for 45% of all high yield bond new issuance in 1999 and 57% in 2000.5 Telecom alone was 20% of the high yield market by August 20006, and add media and technology and these three high flying areas were a significant piece of the high yield market.
As the internet bubble burst, and the events of September 11th hit in the midst of this, we started seeing default rates accelerate. Total default rates moved up from about 4-5% in the years prior to 9-10% in 2001 to mid-2002.7 Media and telecom defaults accounted for 44% of all defaults in 2001 and 65% in 2002.8
The issues that preceded the decline early 2008, before the full scope of the financial crisis hit, were also related to relaxed issuance standards. But here it wasn’t a specific industry that caused the problem; but rather three letters—LBO. Leveraged buyouts have always been part of the high yield market and in many cases have created value for investors along the way. LBOs in and of themselves weren’t the problem; rather, it was a massive wave of LBOs that hit during 2005-2007 and were being done at high multiples with very thin equity allocations committed to the deal. This meant these new structures were left to be heavily financed with debt. Acquisition financing in the high yield bond market grew from 13% of total new issuance volumes in 2003 to 51% in 2007.9 Higher leverage multiples were widely accepted as leverage on the index grew from an average of 4.5x in 2003 to 5.4x at the end of 2007.10
High multiples and heavy debt loads proved to be a toxic mix as the financial crisis hit in the latter part of 2008. The premise of the elevated multiples and large debt financing was that these companies would grow into their capital structures. But as the “Great Recession” hit, those hopes for growth evaporated in many cases. Default rates across the high yield market spiked in late 2008 and early 2009, and these highly levered LBOs weighted on the market and default rates for years to come.
Moving to the more recent history, the market disruption in 2015-early 2016 was similar to what we saw in 2001/2012, where specific industries were of issue. This time it was energy and commodities (metals and mining), which by mid-2014 were about 23% of the high yield index.11 We saw the “contagion” spread to the broader high yield market as investors became concerned about high yield in general given the energy concentration, which lead to selling and pricing pressure and spread widening across the high yield market. Default rates did accelerate, but it was contained to the problem industries of energy and commodities. In 2016, these two industries accounted for a staggering 81% of all default volume.12
But this cycle it was much shorter lived as those problem industries were a smaller portion of the high yield market than the telecom, media and technologies companies were back in 2000. Additionally, we saw commodity and energy prices move up from the bottom and largely stabilize, easing much of the market overhang and uncertainty.
So as we circle back to today, where does that leave us? Defaults are the major risk for high yield investors and on that front, we have seen the weaker energy and commodity players largely already dealt with and restructured (cleaned up their balance sheets and eliminated debt), and given we haven’t seen a rapid rise in energy prices (oil is still half of where is was in the summer of 2014), we don’t see another collapse brewing. We also aren’t seeing aggressive issuance in the energy space, with energy at 14.7% of YTD issuance, exactly in line with the sector’s weight within the high yield index.13 But just because the energy concerns have moderated, are there any other problem industries on the horizon? We’d certainly argue that retail has clearly become a challenged space, but this sector only accounts for under 4% of the high yield bond index.14 Of note, other than energy, no other industry comprises more than 10% of the high yield index. Default rate expectations remain below historical levels for the foreseeable future.15
Looking at the broader high yield market fundamentals, aggressive issuance has gotten this market in trouble before, but YTD issuance has been well disciplined. While issuance proceeds are up 8% versus last year, non-refinancing volume is at its lightest pace since 2011, with refinancing dominating the primary market at 64% of total YTD issuance, with merger and acquisition issuance at just 17%.16 Investors certainly don’t seem to be complacently just waiving in the deals. Leverage statistics within the market are reasonable and still well below what we saw in 2007, currently at 4.4x, and interest coverage is strong at 4.1x17 indicating to us that management teams are continuing to exert caution as they look at empire building and growth opportunities (or lack thereof) going forward.
So again, while some may argue investor complacency in other markets, we don’t feel the same holds true for high yield. Investors haven’t fallen asleep at the wheel over this cycle, as evidenced by the spread widening we saw just a year and a half ago. Market technicals remain disciplined, as we see issuance dominated by refinancing and two way fund flows within the market. Credit fundamentals remain reasonable, as evidenced by the leverage and coverage stats. Moody’s recently reported their measure of liquidity stress was at a record low, as corporate liquidity has improved. Defaults are tame and expected to remain so for the next couple years.
As we look at today’s high yield market caution is warranted, yes, but we certainly don’t believe it is time to run for the exits as investors may well miss out on valuable yield by doing so. There are overvalued and very low yielding securities within the high yield market, or certain cases where we believe investors are overlooking key risks for specific credits. For instance, over 30% of the high yield index trades at a YTW of 4% and under18, which certainly doesn’t indicate value to us. We believe investors should exercise caution by actively not passively participating in the high yield market—putting together an active portfolio versus buying a passive, index-based product—rather than avoiding the high yield market altogether. Relative to the other fixed income options or equity valuations, we believe there is still attractive yield to be had by in investing in high yield bonds, but that value has certainly become less pervasive over the last year requiring investors to avoid aggressively stretching into credits we would classify as overly risky or to accept the very low yields offered by a notable portion of the market, which can create risks of their own via pricing risk if the security is trading above call prices or higher interest rate risk. There is value but we believe investors should actively search for that value on a credit by credit basis.