After experiencing a tumultuous second half of 2014, high-yield bonds and leveraged loans rebounded with solid returns in early 2015 before continuing their bumpy trend toward the end of the first half. The BofA Merrill Lynch U.S. High Yield Bond index and the J.P. Morgan Leveraged Loan index returned 2.49% and 3.01%, respectively, beating all other U.S. credit asset classes and even some major equity indexes, including the S&P 500.
We observe numerous signs indicating the current credit cycle is in its latter stage. In fact, apart from energy and commodity-related sectors, most of the market appears richly priced and still exhibits tight spreads. Nevertheless, the market can remain in such a condition for quite some time.
As was the case at year-end 2014, the major risks facing the market continue to be driven by macroeconomic/geopolitical factors.
The U.S. Federal Reserve has been relatively consistent and predictable regarding its intention to raise the federal funds target. While the timing and severity of a policy move are still unclear, we do not believe that the market will react violently once the Fed moves rates up.
For below-investment-grade corporate credit, a rise in rates may end up being a non-factor. Historically, the Fed has raised short-term interest rates to combat inflationary pressures that result from strong economic growth. Granted, rising underlying Treasury rates negatively impact fixed-income instruments, but a vibrant economy typically positively impacts the creditworthiness of issuers, thus reducing the credit risk premium required by investors. Consequently, in most past periods of rate hikes, the net effect on corporate spreads is usually a wash, as spreads tighten in an offsetting action to the Treasury rate rise.
Outside of the U.S., economic weakness and/or excessive debt is affecting a number of other influential economies across the globe including China, Greece, oil-reliant economies such as Russia and Venezuela, and heavy commodity producing nations like Australia. Even Puerto Rico's ability to service its $70 billion-plus debt load is creating significant volatility and influencing investor sentiment within the broader high yield market.
As has been the trend for some time now, global central banks have taken significant accommodative steps to stabilize their respective economies and attempt to limit any spread of their problems to external markets. However, many of the issues facing global markets today are either unique to current circumstances or have not been experienced in a long time. Consequently, in many ways the investment community is moving through unchartered macroeconomic/geopolitical territory.
For the most part, the overall health of the high-yield market appears to be adequate, with several of its major metrics hovering around historical averages. Spreads, default rate, coverage ratio, near-term maturities and “aggressive financings” all portray a reasonable risk profile against the historical record. However, two significant factors, one plainly evident and another less obvious, cause us concern and bear close attention.
The evident metric is the market's leverage ratio, which is a simplified reflection of a company's debt burden in relation to its earnings. As the leverage ratio moves higher, the risk of default rises. Important to consider, however, is the rate at which the risk rises in relation to the leverage multiple, because as the absolute level of the leverage ratio increases, default risk becomes much more sensitive to it.
As of June 30, at 4.7x, the high-yield market's leverage ratio was just shy of its historical high mark, which was set in the third quarter of 2000. While we are not suggesting that 2015 is a similar time period to 2000, within a year of reaching 4.9x in 2000, high-yield bonds spreads widened to more than 1,000 basis points (from around 675 bps). The lesson is that at some level investors will deem the market too risky at the prevalent price and require higher spreads (i.e., lower prices) to offset the elevated risk of potential losses from defaults.
Decomposing the market's leverage ratio reveals the aforementioned less obvious yet quite concerning risk factor. After 20 consecutive quarters of EBITDA growth, high-yield issuers experienced back-to-back quarters of declining cash flow. Particularly concerning is that revenues, which reflect overall demand for issuers' products and services, declined in the first quarter of 2015.
Based on the last two quarters, it may be generalized that high-yield issuers are not generating the necessary operating performance to support their existing cost structure, which can only be remedied by either achieving growth or resizing costs. Growth, at least at the macroeconomic level, is not within any individual company's control per se, and cost reductions typically bear unfortunate consequences for areas like employment and capital investment. In either case, if such a trend exists, conditions will need to improve to keep investors from reallocating capital away from high-yield bonds and leveraged loans.
Overall market leverage is trending toward a level not seen since the dot-com bubble peaked in size during the early 2000s. Furthermore, the interest coverage ratio is similarly approaching a precarious range last reached during the 2008 financial crisis. What is most important to us is how we can mitigate the market's higher risk profile. Our answer will almost always be the same: to focus even more sharply on the current and prospective performance of the individual companies that comprise our investment portfolios.
One major risk factor that is not expressed in any reliable market metric is the “L” word: liquidity.
Now more than ever before, the lack of market liquidity is a major issue that managers need to deeply embed into their investment decision making process. An illiquid market cuts two ways: it clearly exaggerates volatility but likewise also can produce opportunities to the discerning investor. Large price swings due to a technical factor like liquidity (as opposed to a fundamental credit-specific factor) often times lead to mispricings and market inefficiencies. Being a provider of liquidity to the market during periods of illiquidity can be quite advantageous in exploiting a mispricing and capturing an asymmetric return for the risk being taken.
Given the current, “new normal” liquidity environment with low broker-dealer inventories and less market-making activity, we expect the price action in the market around the next inflection point to be dramatic, particularly if defaults start to tick up further. Such a stressed market condition could provide exceptional opportunities to a liquidity provider.
The good news is that the maturity profile of the market remains one area in strong health. A relatively small amount of bonds and loans will be coming due over the next 2.5 years, giving a substantial amount of time to companies to continue enjoying low interest payments as well as work out any profitability issues that may already exist or otherwise arise over the next two years. Also, because most maturities are pushed out several years, any rise in short-term rates should not affect issuers' existing interest payments, which in general, have been locked in at historically low levels. Furthermore, the primary market for both loans and bonds continues to be robust, which can enable companies to refinance what little debt that is coming due and push out maturities even farther. Also boding well for the leveraged credit market is its place within the context of the global fixed-income market. Outside of the emerging markets and troubled sovereigns, the U.S. leveraged credit markets offer compelling yields at a tolerable risk profile to an investment community bereft of many other options.
The high-yield bond market still offers an absolute yield that is very competitive with any of the other major fixed-income options. Additionally, as much as 80% of the revenues generated by U.S. high-yield issuers are derived domestically, meaning that the U.S. high-yield market is closely tied to the success of the U.S. economy. Given improving economic data and widespread expectations for growth in the U.S., high-yield bonds should benefit from positive economic tailwinds.
Macroeconomic/geopolitical factors and broad-market factors like commodity price declines continue to prevail as the primary headwinds impacting the leverage credit market's performance.
Visible market metrics like spread levels, default rates and near term maturities, coupled with an improving U.S. economy, support the case for continued investment in leveraged credit. At the same time, cracks are beginning to form in the market as evidenced by the negative effects arising from lower commodity prices, rate fears and a dearth of market liquidity.
Although the market will see more volatility in the near term, given the continued backdrop of easy money and active central bank involvement, we could easily envision a scenario where the overall market trend continues on its already lengthy bull run.
However, with high-yield issuers' debt levels continuing to escalate against the backdrop of falling profitability, investors must cast a keen eye toward examining each issuer's fundamentals and how their trends may impact creditworthiness.
David Breazzano is a co-founder of DDJ Capital Management LLC and has more than 34 years of experience in high yield, distressed and special situations investing. At DDJ, he oversees all aspects of the firm and chairs both the senior management and investment review committees.