As an interest rate increase seems to be in the cards for December, so many people seem quick to point out the problems this can present for the high yield market. However we don’t believe that these potential “problems” are completely grounded in fact. We’ve talked at length about how historically high yield bonds have performed well during periods of rising rates, not only due to their low duration and higher starting yields, but also because for rates to rise, it is usually is in the face of an improving economy, which would be a benefit for the companies issuing the debt (see our pieces, “Strategies for Investing in a Rising Rate Environment,” “Making Sense of Markets,” and “Duration-based Investing in the High Yield Market”).
Another topic that often comes up as people discuss a rate increase is the perception that these last seven years of “easy money” has led to a bunch of fundamentally weak companies getting bond deals done that wouldn’t be able to get them done in normal circumstances, resulting in lots of weak and vulnerable issuers out there and likely a big spike in defaults as rates rise. We question the facts and logic of this argument.
First and foremost rising rates do not trigger a credit event for issuers. Keep in mind the entire point of companies issuing bonds versus other forms of financing is to lock in their borrowing costs. The vast majority of bonds have a fixed rate of interest over their time outstanding. So the interest rate on this debt remains the same no matter what Yellen or the various Treasury rates are doing. Rates become relevant when a company has to refinance their debt and face the interest rate environment at that time. However, with the vast refinancing effort we have seen over the past several years, the actual amount of near-term debt maturities is minimal, meaning few companies will have to face this refinancing trigger over the next few years.1
Not to mention the fact that we don’t expect the Fed to be aggressive in rising rates, thus we don’t expect a massive spike in rates. So even for the few that do have to refinance over the next couple years, for a company to have to pay an incremental let’s say 100bps or so on their debt is unfortunate, but certainly not what we would see as a death nail in their ability to survive. (And as we have pointed out time and again, the Federal Reserve controls the Fed Funds Rate, an interbank lending rate, while for the high yield bond market, it is the 5- and 10-year Treasury rates that are more relevant, and those rates have been relatively range-bound as of late).
Turning to what has been issued over the past few years, you can see from the chart below that based on credit quality (ratings) of the newly issued bonds, the credit quality does not appear out line with history. Looking at every year since the quantitative easing began the top tier ratings category (split BB to split BBB) has been at or above the 19-year average, and thus the lower ratings category (B and under, and not-rated) is at or below the 19-year average. Specifically looking more recently, this year only 40% of issuance has fallen in that lower ratings category and in the prior two years 45-49%, versus the 19-year average of 58%.2 It doesn’t appear that this period of “easy money” has led to significant stretching on the credit quality of newly issued bonds.
Finally, we’ll look at the leverage (debt level relative to cash flow/EBITDA) and coverage (cash flow relative to interest costs) ratios as important metrics in assessing a company’s ability to service their debt. Looking at the leverage metrics for the high yield market, they have been pretty stable, and by some accounts are expected to decline excluding the energy industry.3
Additionally, coverage ratios have actually been improving, meaning companies have more cash flow available to service their debt.3
This isn’t to say all companies are in solid financial position and you should just buy the broad high yield index. There are credits to avoid from a fundamental basis as we do believe that the default cycle in the high yield market will heat up, but expect that will be driven by commodity prices, hitting the energy and commodity sectors specifically, not primarily interest-rate driven. We expect defaults to remain well below average in the rest of the high yield market and a moderate increase in interest rates will not impact that. Active management is important in the high yield market as you choose what industries and specific companies to allocate your investment dollars to based on fundamentals; however, we don’t expect the Fed moving rates at a moderate pace over the next year will have a meaningful impact on high yield issuers. For all the fears that seem to exist relative to an interest rate move, it is important to remember historically this market has performed well during years that we have seen rates rise, and the arguments that “easy money” has led to weak issuers in the high yield market appear unfounded. Instead, as we now sit at multi-year highs on spread levels, we believe that the high yield market is currently offering very attractive value for selective, active managers.
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