Given the market’s weakness and the volatility over the last quarter, we think it’s worth taking a look at where we have been and where we think we are going.
Where We Have Been:
Unless you were invested in Treasuries or short the markets, the third quarter didn’t look good for anyone. We have seen a swift and massive repricing of financial asset classes throughout the world. We begin Q4 just as we began Q3, with all eyes on Europe and how they will address the sovereign debt crisis and, more specifically, the solvency of Greece. In the U.S., we have seen weakening economic data and consumer confidence over the past three months. The equity markets have taken a massive hit, as the markets seem to be waking up to the fact there is little to drive growth. The thought now seems that at best the L-shaped “recovery” continues or at worst, we enter a double dip recession.
As the “risk-off” trade has been in full swing, the high yield bond market has also felt an impact. To put some returns in perspective, take a look at the following:
While the high yield market has taking a hit, we have definitely fared better than the equity markets.
Looking Forward:
As we sit here today at the beginning of the fourth quarter, we are looking at spread levels in the high yield market that have not been seen since October 2009.3
Current spread levels do seem to price in a recession. Looking back at the trends in the chart above, we see spreads spike to over 800bps just as we are entering recessionary periods. For instance, we saw a spike in late 1990, as we entered the 1991 recession; a number of spikes over the 2000-2002 period as we faced the tech bubble bursting and the recession at that point; and then most recently a massive spike in 2008, as the financial crisis emerged (though we would argue the 2008 spike in spreads to almost twice that of the historical peaks was an anomaly that we would not expect to see again).
So if we are currently sitting at spread levels not seen since October 2009 and spread levels that are pricing in a recession, what do we see as the outlook for the high yield bond market? Well, first let’s address the issue of a double dip recession. The reality is that defining a “double dip” is more of a technical issue. For instance, what is the difference between +0.5% growth or a -0.5% retraction? For all intents and purposes, from our perspective, there is really no difference. Maybe we avoid a double dip, maybe we don’t, but the reality is that there is anemic, if any, growth and companies will have to continue to deal with this. While many of the leading economists have upped their probability of another recession, the majority of those probabilities are still under 50%.
And a further comment on the point of a potential recession. Even if there is a double dip, we would not expect a massive decline in GDP, such as we saw in 2008. First and foremost, there is no massive domestic liquidity crisis or bubble that we are coming off of this time around. Second, the decline in 2008/2009 was compounded by the fact that orders just stopped as companies worked through existing inventories. This lead to a severe contraction in orders and economic output. However, as we sit today, companies have still not ramped inventories post the 2009 decline and are running relatively lean, meaning that there is not a huge inventory balance that can be worked through. This means we would see a softening in orders as demand softens, but we would not see the vaporization we saw during the last cycle.
Finally, as we think about spreads now at levels not seen since late 2009, we have to consider fundamentally, how do we compare to that time? We would argue that we have seen improvement on many fronts. While the unemployment needle has not moved much, and we would not expect a rapid recovery in unemployment given the caution with which companies are being managed, we have seen recovery in other areas. For instance, the banking sector in the U.S. has been forced to execute disciple and recapitalize. Corporate balance sheets have made massive progress in delevering and increasing liquidity, with Corporate America now sitting on record amounts of cash. As we have explained before, the crisis of 2008/2009 and the complete lock-up of liquidity has resulted in a significant mind-set change for corporate management, as they have spent the past three years cutting costs, improving profit margins, paying down debt, extending debt maturities, and increasing cash and liquidity balances. And while the markets may have bought off on the “V” or “U” shaped recoveries, the management teams we see in the high yield names that we cover largely had no such expectation, nor are they in the full expansion mode that we saw prior to the last recession. Rather, that have been taking a cautious approach, as evidenced by the fact no significant re-hiring has taken place.
Another benefit of recently going through a recession and having seen little in the way of demand pick up since then is that the most financially vulnerable of companies have already been weeded out, defaulted and restructured. This fact, along with the massive refinancing done in the debt markets over the past couple years, providing for that additional liquidity and extended maturities, means that the default outlook over the next few years for is for default rates well below historical averages, and significantly below what one would expect given the current spread levels.4
In their recent analysis, J.P. Morgan stated that the “implied default rates based on today’s (spread) levels are 8.5%.”5 So even if there is a surprise pick up in the default rates, the market does already seem to be pricing that in. To put an 8.5% default rate in context, as the chart above notes the average for bonds is 4.3% and we have only seen levels higher than 8% during recessions. Right now the default rates are sub-2% and are expected to remain around that level for the next couple years.
As we look at where we are today and the potential outcomes going forward, we see the high yield bond market as positioned well from not only a fundamental perspective, as discussed above, but also from a technical perspective. Taking current spread levels of just over 900pbs6 in the context of historical data, 900bps has shown to be an attractive entry point. In looking at the prior six times when high yield bond spreads crossed the 900bps threshold, J.P. Morgan determined that the return performance over the subsequent periods was as follows:7
While history is not always perfectly correlated to the future, this would indicate that historically over the long-term, a blow out in high yield spreads has provided an attractive and profitable entry point.
As we look forward, we fully recognize that the current issues faced throughout the world are real and significant. If there is a sovereign collapse in Europe, the ramifications could be widespread. However, we do not see that as a certainty, nor do we see conditions getting as dire as they were in 2008/2009. At the same time, corporate balance sheets seem to be positioned well for the uncertainty ahead, management teams (at least in most of the names we cover) seem to be managing to reasonable and conservative expectations, and the uncertainty ahead seems to be priced in to current high yield bond levels. We view the high yield bond market as an attractive opportunity for tangible yield and potential capital gains in this environment.
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