During October, we saw the general high yield market hit multi-year lows on spreads; however, in the first part of November, we have seen that reverse. Over the first half of November, some softness has emerged in the high yield market, as money has flowed out of the space and spreads and yields have moved higher, and with it discussion in the financial media as to whether there are real issues within the high yield market, positioning it for a sustained fall, and if this is a precursor to an equity decline (as high yield is often seen as a leading indicator).
We have seen these periods of high yield market weakness and the same sort of discussion several times already this year—first this past March and again in August. The stories were the same, outflows, followed by a back-up in spreads/yields, and financial commentators worrying “the end” is near, only to have the weakness be met with buying after a few weeks and the high yield market resume its move up. Will this time be the same and we’ll see a fairly quick reversal with buyers coming back in, or are there real, fundamental issues within the high yield market?
Ironically, I think our answer is yes to both questions. As active player in the market, we see that the general fundamentals remain solid and we don’t see any pervasive cracks emerging within the broad high yield market. However, there are problems in specific industries and companies. The recent weakness we have seen has been largely centered in certain industries, namely healthcare and telecom. Over the past few weeks we have seen weak earnings reports from a few large high yield debt issuers in these industries, as well as company specific news such as a failed merger in one high profile issuer. The market is punishing companies for weak results or unfavorable news, which we believe makes active investing all the more important. But it is important to note that we are NOT seeing widespread fundamental cracks in the high yield market or systemic overhangs as we have seen in prior cycles (such as the massive deals getting done and levering up of companies as we saw prior to the 2008 crash).
Overall, we see the recent weakness in the high yield market as an indication of a healthy market. Yes over the past few years, spreads and yields in the high yield market have been run up as investors search for yield, creating overvalued situations in many cases, but the last few weeks have demonstrated that we are still seeing some of the ups and downs that you’d expect in a market where investors are rationally making decisions. Below we outline some of the relevant considerations that we believe are significant for investors as they look at the high yield market—from market technicals, such as money flows and new issue activity, to market fundamentals, including default rates/outlooks, credit metrics, and credit liquidity:
- Money Flows: We have seen weeks when money has flowed into the market and weeks when money has flowed out, and in total, the market has seen outflows of over $8bn so far this year from mutual and exchange traded funds, which would indicate to us that this isn’t a market that is being blindly “chased.” Investors are not just throwing money at the asset class.
- New Issue Activity: Even in the midst of the recent weakness in the high yield market and outflows, we are not seeing new issue activity abate. Deals across the credit spectrum and for various use of proceeds are getting done. A couple companies pulled deals because the market was demanding too high of an interest rate for their liking, but this indicates to us that the market is acting rational and not just waiving in deals at any price. On the flip side, the strength of the new issue market indicates that there is still demand for these deals by investors, at the right price, and that companies still have access to capital to address a variety of needs, including refinancing, mergers and acquisitions, and investments in growth.
- Default Environment: Default risk is one of the most important risks for high yield bond investors. Default rates are well below historical average and are expected to remain low in the year ahead. According to JP Morgan, the trailing 12 month default rate is 1.3% and is expected to remain low, around 2%, in the year ahead versus a historical average over nearly twenty years of 3.7%.1 Notably, nearly half of the defaults over the past year have come from three sectors: energy, retail, and healthcare.
- Credit Metrics: Credit metrics as a whole are solid, with EBITDA and margins improving and coverage (EBITDA/Interest expense) and leverage (debt/EBITDA) reasonable. For instance, the average quarterly leverage multiple over the last 10 years has been 4.3x, and currently we are at 4.1x.2 Again, we are not seeing the massive multiples being paid for deals or companies levering up as we saw prior to the 2008 credit crisis.
- Liquidity/Maturities: As noted above, we have seen solid market technicals in terms of new issues, which is important in how it translates to individual company fundamentals. Access to capital is essential in providing company’s liquidity and allowing them to address maturities. With the persistent low rate environment and open new issue market, we have seen companies proactively addressing their maturities coming up in the next few years. We are now left with a “manageable” 15.8% of the high yield bond and loans maturing in the next three years3—certainly not any sort of “maturity wall” that is of concern. Notably the Liquidity Stress Index, as measured by Moody’s, continues to trend downward, indicating liquidity strength among issuers. A lack of liquidity and/or an upcoming maturity being unable to be refinanced can trigger a default in a security in many cases, thus we feel our current positioning bodes well for the continued low default rates.
Yields and spreads are widening. In some cases, rightfully so. We are seeing the market punish credits for bad numbers. We are seeing prices fall in some of the more challenged industries. But largely speaking, we believe the fundamentals within the high yield market remain intact. The last couple weeks have proved to investors that fundamentals do matter and, accordingly, we see that as proving that active management is critical in the high yield market.
We believe that an active portfolio within the high yield market can offer investors attractive yield. Additionally, we believe it pays for investors to be invested to continue to generate this yield—no matter what the price movement is for a security, corporate bonds are accruing interest/yield daily. Timing the market has proven to be difficult, and this income can help offset price declines, and if we see a repeat of what we saw in March and August, we may well see the market quickly rebound and resume its upward move.
1 Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 11/3/17, https://markets.jpmorgan.com. Current default rate as of October 2017. Historical default rate for the period December 1998 to October 2017. Default rates include distressed exchanges.
2 Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 9/26/17, https://markets.jpmorgan.com. Based on quarterly leverage multiples for the period Q1 2008 to Q2 2017, and current leverage as of Q2 2017.
3 Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 11/14/17, https://markets.jpmorgan.com.