Over the last 20 years, there have been two major default cycles. One in 2001/2002 and another in 2009.1
There have been apprehensions that today’s energy market issues will cause another major default cycle for the broad high yield market, putting us back to periods like 2001/2001 or 2008/2009 when we saw a huge spike in defaults and a blow out in spreads. We don’t expect this to happen as today’s high yield market is very different from the market conditions that we saw during each of those periods.
2001/2002
During the late ‘90s and into turn of the century, markets were in the midst of the “dot.com” bubble. Telecom, media, and technology were going to revolutionize the world and businesses were getting both debt and equity financing based on business plans, with little in the way of revenue, let alone profits or cash flow to actually service the debt. As noted in the chart below, issuance in the media and telecom industry in the years leading up to the crash was around 40 to over 50% of all high yield bonds issued.2
By the end of 2000, the media and telecom industry comprised about 35% of the total high yield index.3
As the bubble burst, defaults did spike, with defaults related to media and telecom alone over 44% of total defaults in 2001 and over 64% in 2002.4
Similar to the 2001 period, today we face a problem industry: energy. In today’s high yield bond market, the energy industry currently comprises about 15-17%5 of the total high yield market, depending on the index referenced. So, this puts today’s problem industry less than half of what the problem industry was in 2001. Looking at a similar chart to the one above, let’s look at recent new issuance by industry.6
While the energy industry has been the industry with the most new issuance over the past few years, it has only ranged from 14-18% versus the 40-57% of issuance we saw in media and telecom in the years leading up to its collapse, and we argue here that recent issuance has been largely for real businesses, not business plans (except in certain cases of shale producers) as we saw in the telecom bubble.
As we look at today’s high yield market, certainly the energy industry is a much lower portion of the total market than we saw media and telecom representing in the 2001/2002 period; thus, we believe issues in the energy space will be much more contained relative to what we saw in 2001/2002. Additionally we believe that the 85% of the high yield market not related to energy is largely positioned well from a leverage metric and liquidity perspective, as we have not seen aggressive financing or companies levering up their balance sheets, and near-term maturities are fairly minimal, so we’d expect non-energy defaults to be well below historical averages, as we have seen for the past few years. As we noted in one of our recent writings, J.P. Morgan provided the following detail on their default forecast, and we agree with their take:7
While maintaining a benign 1.5% 2015 default forecast for high-yield bonds and loans, we recently made adjustments to our 2016 default outlook due to the Energy sector. Specifically, we forecast the high-yield default rate to rise to 3.0% in 2016, based on an approximate 10% default rate in Energy (15% Energy market weight adds 1.5% to the default rate).
Importantly, they are projecting continued benign default rates excluding energy of 1.5%. With a 10% default in the energy sector in 2016, the default rate moves up to 3% for the total market. Even if JPM is being too conservative and we actually see a higher default rate in energy in the latter part of 2015 and 2016, we’d still expect the non-energy defaults to remain subdued.
2008/2009
Let’s turn our attention to the other default spike that we saw in 2008. In that case, it wasn’t a problem industry or even issues specific to the high yield market. The problems leading up to the 2008 crash were systemic through all financial markets and had to do with easy credit and massive leverage. This isn’t to say that the high yield market didn’t participate in the over-levering—it certainly did—but the problems in the high yield market weren’t what lead to the collapse.
Looking back at the 2006/2007 period, we are seeing a massive LBO (leverage buyout) wave, with acquisitions being done at massive multiples and being financed with huge amounts of debt and little in the way of equity, leading to high leverage levels for these companies and capital structures the companies need to grow into. During this time, high yield spreads, a measure of how we assess value within the high yield market, hit all-time lows of around 270bps.8 Then, we saw what many thought at the time was the world ending in late 2008 and it permeated through every industry, causing all-time highs for default rates in 2009.
Again, these were systemic issues pervasive though all financial markets and hitting a high yield market that was recently at all-time lows in terms of valuation. We don’t see the same conditions today. First, yes there are challenges in today’s market, be it slowing demand in China, falling oil prices, concerns about rising rates, or the Greek debt crisis, among others. These challenges have caused investors to be more cautious and more risk adverse, which is a healthy response. However, we don’t see any of these as catastrophic to bring the entire market into freefall and lead to the collapse in many businesses across the board. Yes, China is slowing down, and this will hit the profits of multinational companies and may likely hinder equity valuations, but it is important to note that the high yield market tends to be more focused on North America. If and when the Fed does ultimately act on rates, again, this may have a temporary impact on markets, but we certainly don’t see them taking aggressive action given the current economic environment and we wouldn’t expect them to do anything that would severely hamper markets, given how conservative and aware of market reactions/perception they have proven themselves to be.
It is also important to keep in mind all of the regulations put in place post the financial crisis and scrutiny given to leverage have left us in an environment of much less leverage system-wide. Even here in the high yield market, leverage multiples have remained relatively moderate and interest coverage multiples improving, as much of the new issuance done has been for refinancing and has been done at lower interest rates, improving cash flow generation potential for issuers. Additionally, high yield valuations (as measured by the spread-to-worst) are currently above historical median levels and never got near historical lows during this most recent cycle, such as we saw proceeding past default spikes.9
This is not 2001/2002 or 2008/2009. The energy industry is a much lower portion of the high yield market than we saw with the media and telecom space at the turn of the century and we don’t see a massive systemic issue on the horizon to bring the market down. We’d expect defaults to be contained largely to the energy market, with the rest of the high yield market positioned well. There are certain areas of the energy space that we caution investors to avoid, namely many of the shale producers and energy service providers. Yet the recent repricing of risk and the widening of high yield spreads offers investors what we see as attractive value for many of the non-energy names in this market. The high yield market lends itself to active investing, especially in times like this where investors can capitalize on the opportunities and avoid the problem areas.
As active managers, that is just what we are doing now and have done through our history. Back in 2000, we weren’t sold on the media and telecom hype, as we focused on real business that we could understand with real cash flow prospects. We largely avoided the space going into the meltdown, and were able to buy at huge discounts telecom related securities that we saw as ultimate survivors and expected to profit at the demise of others. Earlier this year we reduced our energy exposure well under the levels held by the indexes, and we may look to selectively increase our exposure to the space and capitalize on opportunities at deep discounts when the timing is right—but for now, there is much to avoid in this space, and plenty of opportunities in non-energy related high yield names providing what we see as attractive yields and a moderate default environment for active investors.
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