We see default risk as the most prominent risk for credit investors.  As we look forward, a benign default environment is projected over the next few years.¹

Broadly speaking, this projection does make sense to us.  Some of the triggers for default include an inability to continue servicing debt by paying the semi-annual interest on the bonds, as well as an inability to repay or refinance the bonds upon maturity.  As J.P. Morgan recently noted²:

Combined, high-yield bond and loan issuance totaled $1.9trn over the last two years, with the emphasis of this on refinancing. As a result, maturities between now and 2017 remain low and are lower than where they stood several years ago. As it stands, only $31bn of high-yield bonds and loans come due between now and yearend, while only $85bn in debt comes due in 2016, making the total amount of debt set to mature in the next two years a mere $116bn, an amount equal to roughly four-and-a-half months refinancing volume based on last year’s run rate. Further, over the next two and three years a mere 4.5% and 10.9% of the $2.6trn leveraged credit market will mature. By comparison, at year end 2010, 10.1% and 21.2% of the market was coming due in two and three years, double today’s levels.

The low interest rate environment and wide open refinancing market have allowed companies to push out their maturities and add liquidity to their balance sheets, positioning them well for the years ahead.  And as noted, this new issuance activity has largely been for refinancings, not massive acquisitions or LBOs, indicating that companies are not levering up their balance sheets as we have seen in past cycles.³

Looking at the default outlook another way, as we begin 2015, the projected default rates are well below what the spread level would imply as the future default rate:⁴

So based on spread levels, we are looking at an implied default rate of about 4.3%, right near the historical averages.  But over the next couple years, the projected default rates are expected to be about half of that.  Given the high yield market is generating a spread level around historical averages, yet default rates are projected to be well below average, we believe this translates to attractive value in today’s markets.  However, investors must make sure that they still understand what they own and the prospects for their individual holdings.  A benign default environment is a definite positive, but it must not lead to investor complacency.

We believe the broader high yield market is positioned well for the years ahead, but that outlook has been dramatically altered for the energy sector given the huge fall in oil prices that we have seen.  The energy market makes up about 17% of the high yield index⁵ and this industry has been strong issuer over the past couple years.  While we certainly do see value in certain energy production and services companies that will be survivors at current oil prices, we believe that others are poised for a very rough road ahead.  Projections are for the default rates within the energy sector to massively spike once oil hits $65 or below on a sustained basis (currently, we are right about $50/barrel).⁶

We see those most at risk are domestic shale producers, which have been bond issuers as they have tapped markets for capital to sustain their production.  As we have noted in our prior writings (see our piece, “The Year Ahead: High Yield, Energy, and Interest Rates”), many U.S. shale producers weren’t generating cash flow even with oil at $100 and face rapid well decline rates, requiring heavy capital reinvestment to sustain production.⁷  So as we sit today, the cash flow usage situation has gotten much worse with oil prices cut in half and the access to new capital has significantly dried up, so those companies needing new capital to sustain production may likely be out of luck.  We believe this may well lead to a downward spiral of production dramatically falling off and cash not being there to service the existing debt load, thus defaults may occur for many involved.

Again, we don’t want to paint the energy sector as all the same—there is what we see as attractive value at current price points in certain credits, as bond and loan pricing has been taken down in some cases as an over-reaction, but there are also value traps of which investors must beware.  Investors need to be actively doing the credit work to determine the individual company’s liquidity, their cash needs to continue production, and stress test the companies under current oil prices.  Investors need to further assess where in the capital structure it is best to be positioned.

Investors are searching for yield, and we believe there is attractive yield to be had in the high yield market, especially considering the benign default outlook for the vast majority of the market.  But we are ardent believers that investing in the high yield market does take active credit selection and thorough fundamental analysis, rather than just modeling an index without attention paid to the viability of the credit or where in the capital structure to be positioned.

1 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. 115.

2 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update.” J.P. Morgan, North American High Yield and Leveraged Loan Research. February 20, 2015, p. 1.

3 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. 28.

4 Spread to worst level as of February 5, 2015. Other data from Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “Credit Strategy Weekly Update,” J.P. Morgan, North American High Yield and Leveraged Loan Research, January 16, 2015, p. 6. As determined by J.P. Morgan: Excess spread equals the monthly median of the difference between actual spreads and default loss during the last 25 years for bonds. Excess spread tends to rise and fall with shifts in the default cycle, as higher defaults eventually meet “reflective” spreads, causing a compression in excess levels. We like to think of excess spreads as the premium an investor requires to be paid above the expected default loss.

5 Energy is 17% of the JP Morgan USD US High Yield Index. Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. 7.

6 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. 54.

7 See our piece, “The Year Ahead: High Yield, Energy, and Interest Rates,” information on well decline rates on p. 14.