Hold on to high yield

Fredrik Wilander
08-06-15 14:39 | Markets and investments | Fredrik Wilander

As I have written before, it is clear that we are in a prolonged credit cycle. It is now six and a half years since global high yield credit spreads peaked in December 2008. After such a strong run as we have witnessed, it would not be surprising to see markets getting a bit overheated with spreads becoming very tight, and the credit fundamentals of new deals getting worse. However, when digging into the data, we still see few of the excesses that characterized credit markets in 2007. 

Starting with spreads, for the Merrill Lynch Global High Yield Index they hit a bottom of 243 bps in the early summer of 2007. While spreads have tightened year to date, they still stand at a quite respectable 480bps, about twice as high as at the peak of the 2007 market. 

The canaries in the coal shaft

Another area to keep track of is the characteristics of new high yield issuers. If things are starting to overheat, it should be visible first in the quality of new issues/issuers. Here we do not see any clear warnings signs, more of a marginal deterioration. Based on data from JP Morgan, the share of issuance going to fund acquisitions (a bond investor’s worst enemy in a close race with dividend deals) is marginally up in 2015 compared to last year, but still low. Refinancing (good for bond holders) remains high. The quality of new issuers, as measured by the still low share of issuers rated B- or below, remains high. And the share of Toggle notes and Payment in Kind notes, where companies do not have to pay cash coupons, is very low. None of these “canaries in a coal shaft” have fallen of the perch. Especially comparing to the levels in 2007, the high yield market still looks substantially healthier. 

When and how much to pay?

Companies typically fall in trouble with their debt when it is time to pay back/refinance (although lately we have seen a few highly levered energy deals having trouble paying coupons). For any particular issuer, it is clearly more uncertainty around the possibility to repay a loan 10 years from now than next year. That is why credit spreads typically rise with maturity. However, for the market as a whole, there is another factor to consider. If the maturity structure is very short it also means more companies seeking refinancing at the same time. For example, if all companies borrow at 1-year maturities, the entire market needs to refinance every year instead of refinancing being spread out over many years.  Therefore, another metric to keep track of is the maturity structure of the entire market. In general, average maturities have trended lower the last decade. Currently, some 28% of the market (Merrill Lynch Global High Yield Index) is to refinance in the next four years. While not alarmingly high, it is also not particularly low by historical standards and slightly higher than at the start of the rally in 2009. 

There is also a clustering 3-5 years out, often called a “maturity wall”. The situation with a looming wall we have had for many years, and the wall has always been pushed out through refinancing. And that has been easy given the improving health of corporates and the search for yield by investors. However, investors should of course keep in mind that things may not look so bright a few years from now. 

A somewhat better picture is painted by the leverage (debt to earnings before interest) of new issuers. If new deals coming to market are highly levered, this raises the risk that these companies will have problems paying back a few years down the road. It could also be a sign of markets getting overheated and investors accepting deals they shouldn’t. That was clearly the case in the years before the financial crisis, where leverage was increasing driven in part by LBO deals which tend to be more highly levered. So far in this cycle, we have not seen leverage picking up in any meaningful way. For the US market new issue leverage, according to JP Morgan data, was 4.6 times earnings before interest, right below the average since 1995 of 4.7 times. 

Bottom line: Global High Yield is the best performing fixed income asset class in our portfolio recommendations year to date. High yield has also held up better over the past few weeks when government bond yields have been spiking, due to shorter maturity and the “cushion” against rising rates provided by the credit spread. From a credit risk perspective, most metrics still look quite healthy. The maturity structure of the market is probably the least favorable (coupled with liquidity risk, which is a blog post of its own), although not alarming. Spreads have narrowed and defaults we expect are marginally on the rise, but at a yield to worst of right above 6% and spreads at 480-490bps, we still deem the asset class as fundamentally attractive. We hold on to our overweight in high yield.  

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