Flash Update - The US High Yield Market - A Prescription(Rx) for Trouble

A Prescription (Rx) for Trouble

High yield issuers’ profitability is again coming under pressure just as it had in 2007-2008.  However, what is even more alarming is that these marginal credits have ramped up their balance sheet risk (i.e. leverage ratios) to levels far in excess to what existed during the 2007-2008 credit crisis in an ill-advised effort to try to maintain earnings per share.  History (and common sense) tells us this is a prescription for disaster.

Also of note, even within a limited population such as the Fitch High Yield Credit universe (67 names), we can see there is significant dispersion in key fundamentals.  Clearly, within the even larger universe of the entire high yield population (approximately 1250 names) significantly greater dispersion can be expected to exist, offering even greater investment opportunities for skilled managers to add value through superior security selection. 

Profitability                                                                                                                Figure 1

As can be seen in Figure 1, the profitability of the typical (i.e. median) high yield company dropped significantly in 2008 to -0.99%.  However the equally-weighted average (i.e. mean) high yield issuer experienced a much greater drop to -7.78% in 2008.  This illustrates that there are significant outliers with respect to profitability in the Fitch universe of high yield issuers. 

Importantly, more recently we can see that the profitability of both the median issuer and average issuer has again begun to drop off in 2012 as well.

Balance Sheet Risk (i.e. Leverage)                                                                            Figure 2

In figure 2 we see that after the credit recession of 2007-2009 the leverage ratio for both the median and the mean high yield issuer pulled back by 2010.  However, today we see these issuers are taking on a lot more balance sheet risk (leverage) recently - precisely at a time when profitability has been coming under pressure.

Conclusion / Opportunity

The high yield sector is overvalued and leverage is increasing precisely when profitability is deteriorating.  This offers a manager who focuses on the worst 100 or 200 credits of the entire high yield universe a very asymmetric return profile from the short side.

Figure 1.

*Source:  Fitch

Figure 2.

*Source:  Fitch

Tradex Global Advisory Services, LLC

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