“There's an old saying about those who forget history. I don't remember it, but it's good.” — Steven Colbert
In the second quarter of 2007, Pinebank published a special investor letter titled, “Is the party over in high yield?” That letter correctly called the end of the credit bull market and onset of a major credit downturn. With the average yield on the Credit Suisse High Yield index piercing all-time lows, we believe it is an appropriate time to address this question once again. Where are we in the credit cycle, what opportunities remain and is it time to get short?
After a violent bear market in 2008 and rapid recovery in 2009 and 2010, we have entered into a period of relative stability (from a fundamental credit risk perspective) that is characterized by heavy issuance of new debt.
This phase of a credit cycle — “easy money,” and the wave of refinancing that it facilitates — reduces overall credit market risk by extending maturities, replacing loans that possess maintenance covenants with bonds that do not, and replacing floating-rate debt with attractive fixed-rate debt.
As a credit cycle ages, this initial phase of de-risking and balance sheet improvement eventually transitions toward more opportunistic debt issuance as management priorities shift from balance sheet repair to growth; often facilitated by access to cheap borrowing. We believe the market has begun to transition from the risk-reduction phase of the cycle to a phase where “easy money” is beginning to increase — rather than decrease — risk.
Make no mistake, aggregate, corporate credit fundamentals are now very strong and a broad degradation of credit quality won't happen overnight. It takes time to replenish the pool of bad bonds and loans outstanding, but the process has clearly begun. The balance of power has shifted convincingly to the borrower from the lender and the wave of inflows to bond and loan funds is causing investors to be less than discriminating both in terms of the absolute yields they will accept as well as the amount of risk they will take to obtain yield.
Away from greater leverage and lower coupons, we are seeing a marked increase in higher risk financings for small-cap borrowers, issuers in industries undergoing secular decline and asset light businesses. While these riskier deals come with additional yield, we have found historically that there is often no amount of incremental coupon that compensates for the equitylike risk of these transactions. As is typical in periods of easy money and excess lender demand, new debt deals are being priced faster than the market can effectively evaluate them; credit risk is being priced based on where it clears the market at the moment, rather than on a careful assessment of longer term business risk.
How should an investor react to current market conditions?
While credit fundamentals are strong and high yield looks “relatively” attractive compared with other asset classes in a low yield world, the growing asymmetry of bond prices and shrinking pool of distressed opportunities cannot be ignored. In particular, if one has gained exposure to the credit recovery via long-only or long-biased vehicles, it is time to reassess; not merely because yields are lower and spreads have tightened materially but also because the nature and level of risk in the credit market is evolving.
The lower risk pool of debt issued in the prior credit origination cycle is now being replaced with bonds and loans that possess (in many cases), more leverage, weaker covenants, longer duration, lower coupons and in some cases, riskier business prospects. As credit bull markets age, risk in the market tends to increase even as compensation decreases, leading ultimately to short opportunities and the next downturn. As a result, this is an appropriate time to consider shifting allocations from long-biased managers toward those that employ flexible, long/short credit strategies that seek to produce positive, uncorrelated returns through all phases of credit cycles.
At present, we are in a positive phase of the economic and credit cycle and the recent drop in yields and narrowing of spreads reflects this. Ultimately however, “easy” money ceases to be a credit positive and risk increases as borrowers employ greater leverage and investors become less discriminating in their relentless pursuit of returns. We write this column not to sound an immediate alarm but to clearly highlight the transition that is occurring in the composition and risk level of corporate credit.
So, is the party over in high yield? Not quite yet, but it's well past cocktail hour, the Grey Goose is gone and the underwriters are wheeling in kegs of room-temperature Natural Light. A few of us with more discriminating tastes are stepping back but the mutual fund crowd can't seem to get enough and are jostling for position at the tap. There is still some life in this party but as they say, “nothing good happens after midnight.”