We have had the benefit of living through every cycle in the high yield market since inception in 1984.  Extremely large moves to the downside occurred in 1990, 2002 and 2008.  All of these periods were preceded by a very significant collapse in spreads over Treasuries and most importantly, a dramatically over-levered credit market.  In 1989 and 2007, massive LBOs dominated the high yield financing game and the leverage multiples were obscene.  Prior to 2002, it was the TMT sector (telecom, media and technology) that was printing billions of dollars of air (think CLECs which never even produced any EBITDA).  We have seen no such silliness up to this point, so to say the high yield market is a bubble is wrong.  We believe that there is no imminent collapse coming.  Spreads for the high yield market (as indicated by the J.P. Morgan High Yield Index) over the 5 year Treasury are within range of the historical median levels¹, so by no means in bubble territory.

The primary enemy is default for high yield investors.  At Peritus, we address this by the disciplined credit process that we undertake, in which highly levered credits by our standards are avoided.  In addition, we focus on companies that we believe are producing a consumer essential and generating free cash flow.  Importantly, we analyze whether this cash flow will continue regardless of how weak the economy gets.

We are always looking at the macro environment and if there is one area investors might consider for their overall portfolio it is interest rate risk.  The good news is that the high yield market has a substantially shorter duration than other fixed income products (see our blog, “Options for Yield”).  It is my concern that interest rates will rise for the wrong reasons not for the right ones (the right reason being stronger economic growth).  My worst case scenario would be that that Japanese have to repatriate their money (they own over $1 trillion of the US Treasury market)³, and the Chinese begin to focus on their domestic economy and say good bye to the US dollar and hello to letting the Yuan rise dramatically.  That could leave the Fed as the only bid for the Treasury market and could provide a major issue for rates.  However, we believe that if this scenario was to come to pass, high yield’s low/negative correlation² to rate increases would be a major benefit.  Stay tuned for our piece analyzing how high yield bonds respond in a rising rate environment, to be posted in the coming days.

¹  Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, and Rahul Sharma.  “Credit Strategy Weekly Update,” J.P. Morgan, February 8, 2013, p. 47.  Current spread to worst of 539bps versus a 20-year median of 538bps.

² Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, and Rahul Sharma.  “2012 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 2012, p. 26, 97.

³ Based on U.S. Department of Treasury data, as of November 2012.