This post was written for CFA Institute and coauthored with Marty Fridson, who is one of the most perceptive analysts I have ever met. It was first published on the Enterprising Investor.
The standard joke about high-yield bonds is that they’re not high yield any longer.
People started to tell that joke when the high-yield index fell below 10%. They’ve continued revising it as the index has moved steadily downward to its present 6%.
So let’s replace it with a much better joke: A bond manager has to appear in traffic court for a moving violation. The judge asks, “Don’t you know what ‘yield’ means?” The bond manager replies, “It’s been so long since there’s been any, I’ve forgotten.”
The judge begins to lecture him: “It’s every citizen’s duty in our society to understand the laws and obey them. It’s a sacred covenant.” The bond manager interjects, “I didn’t understand that last part.”
This joke evoked a chuckle from the audience at CFA Society New York’s 28th Annual High Yield Bond Conference. Martin Fridson, CFA, has been organizing and moderating the event for its entire history, starting back “when government bonds were yielding 9% and a respectable high yield credit could be found yielding around 14%.” Attendees have come to expect a mix of quirky humor, tactical insight, and portfolio management wisdom.
Enterprising Investor and CFA Society New York hope to transmit healthy doses of each through this experimental format.
What follows are 13 charts interspersed with related commentary from panelists throughout the event. To be clear: These quotes are from 13 and 14 June 2018 at the CFA Society of New York. In most cases, the charts and commentary were offered at different times. Participants’ remarks have been edited for clarity, and many rich veins of discussion could not be included due to length considerations.
CFA Society New York has made videos and copies of the presentations available, but the best way not to miss out next year is to attend in person. CFA Society New York puts on many insightful programs and offers many opportunities to get involved.
- “The ability of companies to access the market [since the crisis] led to a large spike in B issuers. There are also a lot more rated issuers in total than 2009.” — Robert Schulz, CFA, managing director, corporate ratings, S&P Global Ratings
- “The investment grade market has grown 40% over the last four years. The HY market has shrunk since 2015, and its overall credit quality has improved.” — Riz Hussain, director, US high-yield credit strategy, Barclays Capital
- “Usually, things are never at the average. When defaults start spiking, they spike to double digits. A ‘non-recessionary’ average default rate for bonds is 2.3%. We don’t see anything at Fitch that leads us to believe the cycle is going to turn into a spike over the next year.” (Editor: Fitch’s work put the high-yield default rate at 1.8% in 2017.) — Sharon Bonelli, managing director, Fitch Ratings
- “There’s no question [default rates] are very low. People talk about this as ‘We’re in the 13th inning of a credit cycle.'” — George Varughese, managing director, Alvarez & Marsal
- “Our view is that money will be shifting from US to a more global situation over the next few years. Right now we’re getting to the unusual position where you don’t have a pickup from local EM into high yield. There’s an embedded view on the dollar, but that opportunity to swap into EM is a pretty compelling one from a total return standpoint.” — Henry Peabody, CFA, vice president, multi-sector portfolio manager, Eaton Vance Management
- “Almost one third of the market was expected to default during the credit crisis because of their near-term maturities. Most companies now want to extend their runways. [They] are going out five, six, seven years. When rates start rising, you wind up getting more tenders. High-yield companies withstand rising rates better than expected because of that.” — Anne Yobage, CFA, director/co-founder, SKY Harbor Capital Management
- “If you think about the financing cycle we’ve had this last few years, high-yield companies have built this incredible runway which means it will take some time for issuers to pay higher coupons. . . . I think the loan index coupon actually fell by 40 basis points this year. . . . [Rising interest rates] will certainly affect lower-quality issuers the most because they have more floating rate notes.” — Martha Metcalf, CFA, senior portfolio manager, Schroders Investment Management
- “The shift we’ve seen over the past year to the Fed not giving you a get-out-of-jail-free card, the ECB not backing down as Italy gets volatility. We’re more nervous about rates than others. We don’t see a 10-year Treasury north of 5% as crazy, and people are asking if there’s value in the front end, if a 2.5% two year is sucking attention away from other credits.” — Henry Peabody, CFA
- “If rates are going up because earnings are going up, most of the market will be just fine. From a total return basis, it gets back to bonds and what’s investable. High yield has a strong record of outperformance when interest rates are rising. Over the past 20 years, there have been 16 50 basis point hike cycles.” — Kevin Lorenz, CFA, managing director/portfolio manager, TIAA
- “This late in the cycle, you’re really down to the relative value argument. The opportunistic buyer has definitely stepped back. Fundamentals are supportive, technicals are in balance, but valuations are stretched here.” — Martha Metcalf, CFA
- What does a flattening yield curve mean? “The strongest relationship is between 2s10s and the 3yr forward default rate. So the oft-forecast crisis via rates is likely to happen in 2021.” — Riz Hussain
- “Right now, we have to defend the asset category. We’re at historical tights, so a lot of clients think there’s nowhere good to go from here.” — Anne Yobage, CFA
- “We like the B part of the market probably the most. Five to 6%, two- to five-year maturity is our sweet spot.” — Anne Yobage, CFA
- “We’re more focused on B and CCC, but partially offset with investment-grade exposures, because we found that we could find large-cap BBB entities with higher yields than BB. Subordinated paper from [for instance] JP Morgan has more liquidity, plus a [yield] pickup. And in contrast to what we’ve said about high yield, supply in investment grade has been quite good this year.” — Martha Metcalf, CFA
- “You don’t get paid two or three times the Treasury base rate for absolute certainty.” — Wayne Plewniak, managing director/portfolio manager, Gabelli & Company.
- “It used to be that credit had a very tight correlation with rates.” — Sam Derosa-Farag, market strategist
- “We’re quite positive on the credit cycle. We think it still has long legs here. We are very comfortable moving down in credit quality for that reason: We think we’ve experienced much of the major headwinds already in the high-yield market. We are looking for a 5% year for both full duration and short duration products.” — Anne Yobage, CFA
- “We are constructive on high yield overall. From a strategic vantage point, spreads are top-decile narrow, top 30% over the last 20 years. Put those two together and look at it by credit rating. If you back out credit-risk premia, historically BB has provided very strong risk-adjusted returns. We think they will continue to do so.” — Kevin Lorenz, CFA
- “It’s hard to be enthusiastic about valuations. Leverage is extended, even though backward-looking interest coverage is solid. Technicals have been very strong. We do get the sense, at least in the near term, that foreign participation is backing away.” — Henry Peabody, CFA
- “Maybe equity valuations are too high, and if they are, that’s going to be felt across all asset classes.” — Kevin Lorenz, CFA
- “The average high-yield new issue is worse than average because companies come to market opportunistically.” — Martin Fridson, CFA, chief investment officer, Lehmann Livian Fridson Advisors
- “You should be willing to move between acting as an owner and acting as a creditor if you are buying these assets.” — George Varughese
- “We cut our forecast for new issue supply by $40B, which puts it as low as it was in 2009–10.” — Riz Hussain
- “We tend to think there’s a pretty good correlation between volatility spikes and slowdowns in the new issuance calendar.” — Jarrod Kaplan, director, Credit Agricole Securities CIB
- “Seventy percent or so of high-yield proceeds has been used for refinancing . . . that’s the highest since 2007.” — Riz Hussain
- “We have the luxury of avoiding the new issue market . . . . Generally what’s new issue today is what you want to buy in one or two years. Bankers aren’t in the business of enriching investors, they work for their clients.” — Henry Peabody, CFA
- “Seventy-seven percent of the floating-rate loan market is considered ‘covenant lite.’ Leverage through the first lien part of the capital structure is about as high as it’s ever been. Relative to high yield, there are some concerns about credit quality. We’ve seen a 20% increase in capital structures that are loan only, and 58% of loan issuers are loans only. That means a majority of loan issuers today don’t have bonds below them.” — Riz Hussain
- “When [abuses of covenants] happen, the company is simply doing what the documents allow them to do. And shame on us, shame on the investment community, for letting that happen.” — George Varughese
- “The recovery experience will be much different than it’s been historically.” — Martha Metcalf, CFA
- “Back in the mid 2000s, the structures got very esoteric. Each deal was unique. It still worked out in the end. Contrast that to today, where every deal is pretty much boilerplate. But the point that keeps getting made is that cov-lite is going to hurt.” — Kevin Lorenz, CFA
- “You have to really trust that management teams have your interests at heart . . . ” — Anne Yobage, CFA
- “And they don’t.” — Kevin Lorenz, CFA
- “We invest across bonds and loans. In our mutual fund, loan exposure has ranged from 0 to 20%, and today it’s at 7%. Everything we buy is based on bottom-up credit views. The problem we’ve had in the loan market is one of repricing. It is just getting too rich for us.” — Kevin Lorenz, CFA
- “You’re seeing the most late-cycle behavior in the loan market. It won’t be a catalyst for defaults but it will affect the recovery experience . . . . I heard a CLO manager say that covenants don’t pay coupon, cash flow does.” — Martha Metcalf, CFA
- “Now is an excellent time to be in active management . . . you need to treat the market with caution and go in with a deep fundamental view.” — Henry Peabody, CFA
- “Dispersion is sitting at the lows. Positioning suggests caution. Dealer inventories are basically flat. High-yield CDX positioning is basically flat. Mutual fund manager performance this year is really narrowly distributed.” — Riz Hussain
- “We’ve seen deals in 2018 with a seven-plus year maturity, though still no longer than eight. For instance: Iron Mountain, Vista Energy, Telenet. There’s a continued loosening of terms. The market is getting more aggressive. The depth of the second lien loan market is increasing with large ‘bond-size’ placements readily achievable. Two to $5 billion enterprise value LBOs, where you would tend to need a junior piece to be a high-yield bond, [can now be funded with] first and second lien loans.” — Jarrod Kaplan
- “HYG and JNK have much higher flow volatility than what the price volatility would suggest. Managers have increasingly been using ETFs to take tactical views, but also to manage liquidity overall. That means you can’t look at ETF flows as additive to mutual fund flows.” — Riz Hussain
- “ETFs are 3.4% of the US HY market. All 45 high-yield ETFs trade 15.7% of 3m average daily volume in total market. The largest premium/discount to underlying was ~.3%/-~.4% on the five most stressed days.” — Bradley Kotler, vice president, SPDR Fixed Income Group, State Street Global Advisors
- “We see ETFs as enhancing the liquidity process. As a seller, you’re getting the greater of the liquidity in the underlying or the ETF.” — Sal Bruno, chief investment officer, IndexIQ
- “On Columbus Day, there was $1 billion in volume for JNK even though the bond market wasn’t open.” — Bradley Kotler
- “We are very underweight retail. We like the telecom space a lot. Basic industries and housing are very strong areas too.” — Anne Yobage, CFA
- “Retail bankruptcies, most of the time, end up in liquidations. Most of the lending to a retail company is typically done on an asset-based basis on inventory and receivables. Because of Amazon and many other things, brick-and-mortar business models are under attack. So when a bankruptcy happens, a secured lender is best able to get a recovery by liquidating the receivables and inventory instead of assuming the business risk. Most of the time the secured creditor wins because they have a lien to the assets. Not true in all cases: Many retail companies have emerged from bankruptcy and continued to be companies afterward.” — George Varughese
- Retail is “the most active in terms of defaults these days, the total 12-month default rate for retail is about 9% on the high-yield side.” — Sharon Bonelli
- “Individual sectors have been strained, but it hasn’t spilled over to the broader market.” — George Varughese
- “I don’t believe we’ve taken many ratings actions based on tax reform.” — Robert Schulz, CFA
- “About 40% of public high-yield issuers have interest coverage below 3.3x. Tax reform means that interest above 30% of EBITDA is no longer deductible. So, some portion of their interest bill will no longer be deductible. But there will be an offsetting effect in the form of a lower tax rate, which means their tax expense will also fall.” — Riz Hussain
- “The most mentioned use of tax saving proceeds [on company earnings calls] was M&A/asset purchases.” — Riz Hussain
- “There has never been a three-year period where the high-yield market has exceeded its beginning carry. Previously, when we had sub-carry years, CCC meaningfully underperformed while BB outperformed. This year, that’s inverted and CCC has outperformed.” — Riz Hussain
- “CCC also offers a nice premium but is the most volatile and most subject to volatility, so we are less excited about CCC given the run.” — Kevin Lorenz, CFA
- “We want to like the CCC space but you really have to look at the companies there. We find CCC attractive as a ratings category, but don’t like the names.” — Anne Yobage, CFA
- “From 1984 to 1999, CCC bonds were badly behaving citizens. Lots of institutional investors wanted indices that excluded CCC.” — Sam Derosa-Farag
- “Energy rising stars (Editor’s note: that’s the opposite of a fallen angel) are particularly strong. They were 60% of rising star volume in 2017.” — Riz Hussain
- “If a company goes bust, the short-term bond and the long-term bond are both going to default. Maturity does not affect recovery in a bankruptcy. So at the extreme, people will trade a short-term bond and a long-term bond at the same dollar price.” — Martin Fridson, CFA
- But in other circumstances: “do you get a bigger risk premium relative to treasurys in the short or the long end of the high yield market?” — Martin Fridson, CFA
- The first two studies came to opposite conclusions:
- Jerome Fons found wider spreads in short term bonds and narrower spreads in the longer end of the curve. (Financial Analysts Journal, 1994)
- Helwege and Turner looked just at pairs of the same issuer (pari passu) issues of the same name and found that, pretty consistently, spread on shorter-dated maturity of same deal was wider (Journal of Finance, 1999).
- “Our study (forthcoming in the Journal of Fixed Income) concludes that it’s not correct to say either that it’s always negative or always positive. We can reject the idea that negatively sloped curves are an illusion based on difference in credit quality among maturity baskets.” — Martin Fridson, CFA
- “Positive spread curves indicate low concern about default risk, and are most frequent in the BB sector.” — Martin Fridson, CFA
- “There’s been a transfer from high-yield bonds, which used to be the currency to finance LBOs, to leveraged loans. Clearly it could be better, but for a sponsor to put in 40% in equity is a reasonable cushion.” — George Varughese
- “LBOs involve large-scale borrowing to fund the acquisition of the target company, with the stated intention of bringing debt down to manageable levels by the time the next recession hits. We never know when the next recession will arrive, but with each month that elapses since the last recession, we know with certainty that we’re one month closer to the next one. Logically, therefore, the multiples of debt piled on an LBO should decrease as we get closer to the next recession and there is consequently less time to bring leverage down. What we actually observe, however, is that multiples increase as the economy gets closer to the next recession. This cannot be wise corporate financial policy.” — Martin Fridson, CFA
- “Are we late cycle? I’d put it in perspective to the three cycles the modern HY market has experienced. I’ve been a part of each of them. Each correction is cleaning up the excesses of a market cycle. Each time, that’s been LBOs. In 2007, the standard deal almost overnight became 10x leveraged. We’re not at that level yet. The Journal had an article this morning that the average deal was 6x EBITDA . . . that must be adjusted EBITDA. It’s more like 8x or 9x, and then they tell you why it’s really 6x.” — Kevin Lorenz, CFA
- “Two to 5b enterprise value LBOs, where you would tend to need a junior piece be a high-yield bond, are getting funded with first and second lien loans. The depth of the second lien loan market is increasing with large ‘bond-size’ placements readily achievable.” — Jarrod Kaplan
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