There has been a lot of recent talk about risks within the high yield market, much of them we believe are exaggerated, as we discuss in our piece, “Making Sense of Markets.” One area of concern that has been raised is the state of high yield issuers. For instance, a Bank of America report concluding that the high yield market is laden with highly levered companies that are struggling to grow has recently been making the rounds. This report also discusses how the decline in refinancings as a percentage of total issuance can be a signal that the cycle is turning. We believe that both of these points are a bit misleading and don’t accurately characterize today’s high yield market.
First off on the leverage and growth front, we have been in a very slow growth environment for the extent of this entire “recovery” and high yield default rates have remained subdued the entire time, and are expected to remain we below historical average excluding energy.1
In fact, recent default rates of 1.5% are less than half of historical averages, and rates are expected to remain around this level excluding energy. Additionally, leverage has remained fairly stable (and is actually projected to decline excluding energy as indicated below) and interest coverage (cash flow relative to interest expense) has actually improved.2
So the situation certainly doesn’t seem to be as dire as is being painted; rather in actuality it looks to be improving for the majority of the high yield market.
On the new issue front, we too pay close attention to “use of proceeds.” Generally speaking, the use of proceeds that concerns us most is when bonds are issued to fund mergers and acquisitions/LBOs and dividends. We certainly are not near this level of what we would characterize as “bad behavior” that we saw back in 2006/2007, prior to the 2008 collapse.3
Year to date, we have seen an increase in the reported acquisition financing and decrease in refinancings relative to the last couple years, but we believe these numbers at face value are misleading. In fact, this year we have seen a small number of very large M&A deals occur that have skewed the numbers. If you were to exclude the top five new deals this year4, all of which were for M&A, we get a total M&A use of proceeds of only about 23.5% of remaining deals and refinancings 53%…both of these virtually unchanged from 2014.
Having participated in this market for decades, we don’t see the current use of proceeds as something to be concerned about or a signal that the cycle is turning—rather we see the current new issue activity as good support for our belief that markets have generally been tame and well behaved. There are always companies that add leverage at the wrong time through dividend payments to the private equity sponsor, LBOs at high valuations, or merger and acquisition (M&A) transactions, but we are certainly not seeing this at the same level as we saw heading into the 2008 collapse, after the massive leverage binge in 2006 and 2007. Currently there are selective, company specific issues with leverage, which active managers can work to avoid, but this is simply not a widespread asset class issue.
As we look at today’s high yield market, not only are we seeing great value from a spread/yield perspective on much of the market, but it is important to point out that this is in the face of well below average default rates, bond maturities pushed out for several years, and improving cash flow coverage relative to interest (meaning more room for potential cash generation at the corporate level). While there are certainly names to avoid in the energy and commodity space—areas where we do expect default rates to meaningfully tick up—we believe the fundamentals are relatively tame for much the rest of the high yield market. We don’t expect that we are on the verge of the credit cycle going bust; thus, we see the current environment as a terrific opportunity for active investors in the high yield debt markets. Read more on our thoughts in our piece, “Making Sense of Markets.”
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