The Origin and Growth of the High Yield Market

Most investors place the origins of the high yield market in the late 1970s, which would not necessarily be wrong if by the high yield market we mean “original issue” high yield. Truthfully, high yield lending has been going on for centuries. Back in the 1700s, the Rothschild family was a dominant high yield lender (lending at higher interest rates/yields to more risky borrowers) but their focus was on countries rather than companies. Over the last two centuries, as commerce and the modern corporation developed, the bond market developed right along with them. However, for decades, the focus of both sides (issuer and investor) was on highly rated companies, aided by John Moody’s development in 1909 of the basic ratings system (Moody’s Rating Service), which is used today.

The earliest modern era data we have on the high yield market came in 1958, when W. Braddock Hickman, a researcher for the National Bureau of Economics Research, produced a seminal piece of work entitled Corporate Bond Quality and Investor Experience. As the title suggests, he reviewed the corporate bond market and investors’ experience with it from 1900-1943. Hickman used the terms “low grade” and “high grade” to differentiate what we now refer to as “high yield” and “investment grade.” His conclusions were as follows:1

On the average and over long periods, the life-span yields realized on high-grade bonds were below those on low-grade bonds, with the result that investors, in the aggregate, obtained better returns on the low grades.

The foregoing may be summarized as follows: (1) Investors, in the aggregate, paid lower prices for, and thus exacted higher promised yields on, the low-grade issues; (2) default rates on the low grades were higher than on the high grades; (3) loss rates, which take into account not only default losses but also capital gains, were higher on low-grade issues; (4) the higher promised returns exacted on the low grades at offering proved to be more than sufficient to offset the higher default losses; (5) in consequence, life-span yields realized on low grades were higher than on high grades. The results were quite typical within major industry groups. Similar results were obtained for most of the longer assumed chronological investment periods.

The finding that realized returns were higher on low-quality corporate bond issues than on high-quality issues has implications for investment theory as well as for practical investment policy.

Hickman’s findings turned everything about investing in fixed income on its head. His conclusion was unmistakable in that low-grade bonds outperformed high-grade bonds over this period. The increased default rates of low-grade paper were more than offset by higher-coupon income and recovery rates on the defaulted bonds. Apparently, this superb piece of work was ignored until the late 1970s, when Michael Milken—a graduate student at the Wharton School—dusted this script off and launched what became the original issue high yield market as we know it today. Michael Milken and Drexel Burnham Lambert ultimately became synonymous with high yield.

The high yield bond market as we know it today first started to really gain traction in the mid-1980s and has steadily grown since.2

Historic Gwth of High Yield Market

There were several distinct periods of growth that assist in understanding the development of this market. Prior to 1985, the market consisted almost entirely of securities that were once investment grade but had since been downgraded. These securities became known as “fallen angels.” It was in the 1980s that Drexel Burnham, and eventually all of Wall Street, began to embrace the concept of original issue high yield bonds to finance everything from leveraged buyouts to significant new industries, including modernizing Las Vegas (Caesars World, Circus Circus, Bally’s), creating cable networks (Turner Broadcasting-CNN) and ultimately even financing the beginning of the wireless age (MCI and McCaw Cellular). It is important to note both then and now that the high yield issuers are not start-up companies, but generally, mid-sized companies with well-established product lines or services looking for an alternative form of financing to sustain or grow their businesses.

The high yield market offered several important advantages to issuers. Prior to the original issue high yield market, companies would have to finance themselves with equity and/or traditional bank debt. The problem is that equity financing is often very expensive and massively dilutive to existing shareholders, while bank debt is short term, has amortization payments and comes with restrictive covenants. Bank financing would not be effective in building out the massive infrastructure required in many of these cases. Thus, the long-term nature and fixed coupon payments provided by high yield bonds allowed for the stability needed for these companies, and the market growth began.

However in 1990, the growth of the market stalled as the country entered a significant recession and default rates climbed. Given the limited size and breadth of the market at the time, many wondered whether this asset class would survive. But survive it did and as the country emerged from this period, the high yield market growth resumed. Yet the truly exponential growth in the market would not begin until 1996 and did not take another breather until the end of 2003.

Several factors led to this exponential growth in issuance. First, the asset class gained the attention of many institutional money management consultants as the return profile from 1990-1995 had been very attractive. This demand enabled more companies to raise money in the high yield space versus bank debt or other forms of financing. This was both good and bad. It did bring in many new players on the issuance side of the market, but as the demand grew so did the ability to raise money on fictional business plans, especially in the “TMT” (telecommunications, media and technology) space as the internet and technology bubble developed. Like in the equity market, billions of dollars were raised by companies with no revenues and only a plan for the future. This ultimately led to the second “nuclear winter” in high yield which occurred in 2002, culminating with the high profile defaults of Enron and Worldcom and the collapse of the technology and telecom markets. Once again, a period of healing and consolidation began as issuance subsided. But issuance once again picked up starting in 2006 and the market now stands at about $1.5 trillion and growing rapidly, with record issuance in 2013 and near record issuance in 2014. 3

Annual New Issuance

As we outlined in our recent writing (“Overview of the Fixed Income Market”), high yield bonds are now a sizable and growing piece of the fixed income space, worthy of investors’ attention. For more on the history and development of the high yield asset class, a discussion the legislation and ratings methodologies that have created what we see as opportunities in the marketplace, and comparative historical risk adjusted returns with other asset classes, click here to read our updated piece, “The New Case for High Yield: A Guide to Understanding and Investing in the High Yield Market.”

1 Hickman, W. Braddock, 1958. “Introduction and Summary of Findings.” Corporate Bond Quality and Investor Experience, partial text from pages 14-15. Princeton, NJ: Princeton University Press for National Bureau of Economic Research.
2 Blau, Jonathan, James Esposito, and Amit Jain. “Leveraged Finance Strategy Weekly,” Credit Suisse Global Leveraged Finance. January 9, 2015, p. 4.
3 Acciavatti, Peter D., Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li.. “Credit Strategy Weekly Update.” J.P. Morgan, North American High Yield and Leveraged Loan Research. January 9, 2015, p. 7.
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High Yield in a Rising Rate Environment

HY rate piece

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Irrational Oil Markets

“Markets can remain irrational longer than you can remain solvent,” John Maynard Keynes

We would think if Mr. Keynes was alive today, he would certainly apply his famous quote to today’s oil markets. After collapsing almost 50% during the last half of 2014, oil continued to fall into the mid $40s during the first quarter of 2015 and many pundits are calling for further declines. Oil collapsing by 60% because of a temporary 2% over supply certainly seems irrational to us. Rather, our take is that supply-demand fundamentals will re-assert themselves aggressively by the fourth quarter of this year. This does not mean that prices will react immediately. It is likely that broken market psychology will take at least another quarter or two to react.

The energy industry and its various sub-sets remain one of the most interesting and attractive areas for long term fixed income investors. The current stress provides an excellent entry point, but also many traps in the way of companies that we do not believe will survive the current environment. Caution and selectivity is critical, as investors need to understand the underlying fundamentals, including hedging, cost structure, and capital needs to sustain production of each company in which they invest. We believe active management is essential as investors take positions not only in energy-specific names, but in the general high yield market, since energy is such a large component of the space. Click here to read our full piece, “Irrational Oil Markets.”

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Definition of High Yield

Just what is the formal definition of high yield? High yield, or its more polite acronym, non-investment grade, is based off of the ratings grids provided by the two major credit rating agencies, Moody’s and Standard & Poor’s. All bonds rated below Baa by Moody’s are considered high yield or non-investment grade. Similarly, all ratings below BBB by Standard & Poor’s are considered high yield. We remain perplexed as to how these two private companies came to monopolize the business and have become the definitive standard on who gets credit and on what terms. Ironically, even after their well-publicized gaffes in the scandals of Worldcom and Enron, and more recently with the ratings of structured products, they ended up with more power. Post the financial crisis, efforts to remove the power of ratings in the fixed income market have been undertaken, but have failed so far given how ingrained these ratings are in the system.

Investors should understand what the ratings agencies themselves say about their ratings. Among their various disclosures, the ratings agencies caution that their ratings are opinions and are not to be relied upon alone to make an investment decision, do not forecast future market price movements, and are not recommendations to buy, sell, or hold a security. So if these opinions have no value in forecasting where the security price is going and are not investment recommendations, what good are they? Candidly this is a question we have been asking for the past 30 years. We see the ratings agencies as reactive not proactive, yet many investors in fixed income rely almost entirely on these ratings in making investment decisions.

For instance, we see certain funds or vehicles setting arbitrary limits on holding only investment grade corporates, or only holding a small percentage of their portfolio in high yield bonds. As we have noted in prior writings, high yield bonds and loans encompass about 30% of corporate debt1, yet these securities are often given limited allocations purely due to their ratings classification. We believe that these restrictions based on ratings are a disadvantage to investors as they limit investment universe. Yet at the same time, we see these arbitrary restrictions as an inefficiency within the high yield market, creating an opportunity for investors who are able to access the entire spectrum of corporate debt.

For more on the history and development of the high yield asset class, a discussion the legislation and ratings methodologies that have created what we see as opportunities in the marketplace, and comparative historical risk adjusted returns with other asset classes, click here to read our updated piece, “The New Case for High Yield: A Guide to Understanding and Investing in the High Yield Market.”

1 Source SIFMA as of 9/30/2014 for total corporate debt. High yield bonds market size from Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update.”  J.P. Morgan, North American High Yield and Leveraged Loan Research, January 9, 2015, p. 40. Loan market size from Blau, Jonathan, James Esposito, and Amit Jain, “Leveraged Finance Strategy Monthly,” Fixed Income Research, January 6, 2015.
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Upcoming TV Appearances

Peritus’ Chief Investment Officer, Tim Gramatovich, is scheduled to appear on CNBC’s “Closing Bell” on Wednesday, April 8th, at 3:45pm ET and Bloomberg’s “Street Smart” on Thursday, April 9th, at 4pm ET.

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Overview of the Fixed Income Market

As we look at the high yield bond market, it is important to have an understanding of the fixed income marketplace and the investment options within it. The first thing to note is the sheer size, which is massive (just under $40 trillion).1 Somewhat surprisingly, mortgages represent the second largest single subcategory of the bond market; this helps to explain why problems in the mortgage market nearly took down the entire financial system in 2008. The largest subcategory is U.S. Treasury debt.

FI Asset Class 9-30-14

Yet, a sizable 22% of the fixed income universe is represented by “corporate credit” through leveraged loans, high yield bonds and investment grade corporate bonds. What comes as a surprise to many investors is that the non-investment grade sector of loans and bonds has grown to become a major asset class, now over $2.2 trillion. After record issuance in the leveraged loan and high yield market in 2013, we saw 2014 levels near these records, indicating continued growth and that this segment of the market will likely continue to make up a larger percentage of the fixed income pie in the future.

By looking at the chart above, it is obvious that corporate credit plays a major role in financial markets, yet, for some reason, bonds have always been considered too complex for individual investors and often remain misunderstood.  While it is true that large players, such as insurance companies, pension funds and banks, dominate the landscape, bonds at their core are simple. A bond is a loan. A company can issue debt (bonds) or equity (stock). The debt/bonds rank ahead of equities in a company’s capital structure, so are considered less risky. This ranking means that bondholders have a priority claim on the company’s cash flows and get paid first. Corporate bonds have a maturity and an interest rate, creating a contracted stream of income for bondholders. They typically pay this interest twice per year but trade with accrued interest, meaning that a buyer can buy the bond any time before the pay date but would have to pay the seller the accrued interest up to that point. The maturity is the date at which the issuer is obligated to pay the bondholder back the “par value” of the bonds. Companies generally have the ability to refinance at some point prior to that maturity, but must typically pay the bondholder a call, or tender premium (pre-payment penalty), to do so. This finite exit strategy, generally either via maturity or refinancing, is one of the great features that we see of bonds versus equities.

Another misunderstanding investors have relating to bonds is that a bond is issued and then goes away into the hands of investors, never to trade again. Most people do not understand that corporate bonds have an active and liquid secondary market, much like stocks. The difference is that the “bond exchange” is not a physical location like the New York Stock Exchange. Rather it is an electronic market created and maintained by large banks and investment banks. These features apply to both high yield and investment grade bonds.

For more on the history and development of the high yield asset class, a discussion the legislation and ratings methodologies that have created what we see as opportunities in the marketplace, and view compare historical risk adjusted returns with other asset classes, click here to read our updated piece, “The New Case for High Yield: A Guide to Understanding and Investing in the High Yield Market.”

1 Blau, Jonathan, James Esposito, and Amit Jain. “2015 Leveraged Finance Outlook and 2014 Annual Review,” Credit Suisse Global Leveraged Finance. February 19, 2015, p. 136.
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High Yield Bond Investing: The Opportunity in Volatility

Blog 3-30-15

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The New Case for High Yield

Throughout its nearly 35 year history, the high yield market has often been viewed as a confusing or an alternative asset class.  However, the reality is that this is a large, developed and liquid asset class.  We have provided this “owner’s manual” for those investing in the high yield market, to shed some light on this often misunderstood market.  In it we detail the history and development of the space, discuss the legislation and ratings methodologies that have created what we see as opportunities in the marketplace, and compare historical risk adjusted returns with other asset classes.  Additionally, we describe our own investment philosophy and approach to the high yield market.  We believe that the benefits from investing in the high yield market are undeniable.  Click here to view our updated piece, “The New Case for High Yield: A Guide to Understanding and Investing in the High Yield Market.”

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Interest Rates and Bonds

So at long last we know whether the word “patient” stays or goes: it’s gone and Treasury yields have actually declined as a result. So far this year we have seen rates go from a 2015 low of 1.19% on the 5-year and 1.68% on the 10-year on February 2nd, and then spike a month later at 1.70% and 2.24%, respectively, on March 6th. So an over 50bps move in a month all over the worry about the word “patient” and whether rates will rise as early as June. Only for rates to fall after the statement was released and the key word removed.

At the end of the day, does a rate rise in June versus September versus December really matter all that much? We know that the Fed will be increasing the federal funds rate at some point in the future, as it has sat at a historic low of 0-0.25% for the six years since the financial crisis. It has nowhere to go but up. But markets are forward looking mechanisms so will price in expected interest rates moves ahead of actual moves. So as we sit today, has the market already priced in an interest rate move or could we expect a big spike in rates from here?

An ultimate move in the federal funds rate will not be a surprise to anyone and we don’t expect that once the Fed does begin to take action, they’ll move rapidly in raising rates. If recent history has shown us anything, it is that today’s Fed is cautious and seemingly not wanting to surprise or shock markets. There are also a number of headwinds that we expect to temper a strong move in rates, both by the Fed and in Treasury markets in general, including the strong U.S. dollar, inflation below the 2% target, still mixed domestic economic data, and the rate of U.S. government bonds relative to their counterparts throughout the developed world. For instance, looking at the rate of the U.S. 10-year Treasury relative other 10-year government bond rates, it seems hard to make an argument that buyers won’t be there and ultimately temper rates from spiking.1

World bond rates 3-24-15

So while short term rates will move up once the Fed starts to take action, we don’t expect to see a large and rapid increase on rates on the longer-term bonds, such as the 5-year and 10-year.

With all this speculation and concern about rising rates, what does the mean for financial markets once the Fed starts to take action? Specifically for fixed income, investors often seem to be under the notion that anything “bond” related is highly interest rate sensitive and will take a hit if rates rise. However, looking at the 25-year correlation chart below, we see that is far from the truth.2

15 yr correlation as of YE 2014

Certain asset classes, such as investment grade bonds have a high correlation to Treasuries, thus have much more interest rate sensitivity. That means if rates (yields) increase in Treasury bonds, and prices decline, we would theoretically see the same sort of action in investment grade bonds—price declines. However, as noted above, high yield bonds are slightly negatively correlated to Treasuries, so we would expect to theoretically see minimal impact from a move in Treasuries, or even an increase in high yield bond prices.

Looking at the actual returns for the high yield asset class, in the 15 calendar year periods since 1980 where we saw Treasury yields increase, high yield bonds posted an average return of 13.7% over those annual periods.3 A few other things to keep in mind, high yield bonds have historically been much more linked to credit quality than interest rates. We would expect to see rates rise during stable to improving economic conditions, which we would expect to be favorable to business fundamentals and credit metrics, and thus to high yield investors.

While we don’t expect a rapid increase in rates, if rates do rise, high yield bonds have a good historical track record in this type of environment. Given the low to negative Treasury correlations versus other asset classes, an allocation to high yield bonds may serve to improve a portfolio’s diversification and potentially even lower risk depending on the mix of assets.

1 Data sourced from Bloomberg as of March 24, 2015.
2 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. A153.
3 Data sourced from: Acciavatti, Peter Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2008 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 2008, p. 113. “High-Yield Market Monitor,” J.P. Morgan, January 5, 2009, January 5, 2010, January 3, 2011, January 3, 2012, January 2, 2013, and January 2, 2014. 2008-2012 Treasury data sourced from Bloomberg (US Generic Govt 5 Yr), 2013 data from the Federal Reserve website.

 

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Upcoming TV Appearance

Tim Gramatovich, Peritus’ Chief Investment Officer, will be a guest on CNBC’s “Closing Bell” on Wednesday, March 25th at 3pm ET.

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