I talk with many professionals in the asset management business each week. There have been a few recurring questions: where is the bottom in high yield and what is causing this downturn? Let me explain.
As per what has caused and is causing high yield bonds and loans to fall in price, this dates back to 2014 when oil prices started to drop. The various high yield indexes had somewhere between 15% and 18% of their holdings related to the oil industry at the time depending on what index you looked at.1 Investors began to worry and began to withdraw funds from this asset class as -$7.1B left bonds and -$16.4B left loans in 2015.2 With this, high yield managers had to provide liquidity to those investors that were exiting the asset class and this introduced another issue: liquidity.
With the implementation of the Dodd Frank regulations and the Volcker rule going into full effect in July, liquidity in the secondary market is not what it once was. Mutual fund and exchange traded fund (ETF) managers, authorized participants (APs) that handle the creation and redemption process for ETFs, hedge fund managers, institutional investors, and others managing and trading high yield debt had to work harder to find buyers for their bonds/loans. To keep portfolios in balance during periods of withdraws, portfolio managers had to liquidate portions of securities across the board in some cases, even selling their best securities in their portfolios, thus pressuring the broader market and resulting in virtually the whole market being repriced lower. Additionally, there was the fear that the Fed would raise rates and all yields along the Treasury ladder would rise. We continually argued that this wouldn’t happen for a whole host of reason, the most obvious was being a very weak global economy (see our piece “Interest Rates: Moderate is the Word”).
As we sit here today, the Fed raised the Federal Funds Rate, oil is $33, the 10 Year Treasury is 2.17%, the Middle East is imploding and the world is not growing. Various rating agencies and investment banks are forecasting 2016 default rates outside of energy/mining/commodities to be about 2%, nearly half the historical rate. Predictions are for the energy/mining/commodity segment to be about 10% or higher.3
If you are following my thought process here, we believe that what we have is a pricing issue, not a credit or fundamental problem. I will use a recent note from our research department as an example of what we are currently seeing in the high yield market. One of our holdings had preannounced Q4 and 2015 numbers and the analyst noted the following:
Excellent free cash flow generation, good leverage metrics (3x and lower on a market adjusted basis) and meeting expectations. For 2016 excellent free cash flows again but sales and EBITDA to be flat to down 8%. These bonds price in the $60s for a yield to worst over 16%. Is this distressed? It doesn’t look distressed to me, but the poster child of a no-growth planet.
For those not familiar with the term, free cash flow indicates that the company is generating cash in excess of their operating expenses and capital spending, providing the company with additional liquidity. In this case the company reduced debt levels during the fourth quarter with their free cash flow. Certainly not something we would expect to see of a company in severe distress or on the verge of some sort of default. We instead see this as the reality of a broken market in high yield.
This isn’t an isolated case; rather, we are seeing similar cases in our own portfolio and within the broader high yield market. There is not much growth in revenues/sales but profitability is decent, which as bond/loan holders is what we care about. We want the company to continue to pay their bills and maintain access to capital in terms of revolver balances, cash on the balance sheet, and/or free cash flow. I can’t tell you when the negativity and weak pricing for high yield bonds ends but keep in mind, bonds and loans have call and maturity dates so generally, barring a default, which we would not anticipate in companies like the one profiled above, as we move closer to these call and maturity dates, bond prices would generally move toward the call and maturity prices of par or higher, providing coupon income along the way and potentially a capital gain as prices move. The question for you: is volatility going to keep you from adding a high yield position where you can collect what we see as an attractive monthly dividend/income while we patiently wait for these prices to reflect the reality of the solid fundamentals that we see in so many cases?