FLASH UPDATE: High Yield Defaults are Minuscule - Are You Comfortable?

“When the default tidal wave eventually hits, it will be very big,” said Marty Fridson, CEO of FridsonVision, LLC.  Mr. Fridson expects $1.6 Trillion (face), or $752 Billion (market value), of high yield corporate debt to default between 2016 and 2020.  This implies a 30% default rate cumulatively over that four year period.  The global default rate in junk bonds fell to 2.8% at the end of December 2013.  By way of comparison, according to Moody’s, the global high yield default rate finished 2007 at 0.9% and subsequently peaked at approximately 19% at the end of 2009.  The average default rate over the last 25 years is approximately 5.0%. 

In the last 25 years, every period of sustained default rates below 5.0% have resulted in multi-year periods of default rates that exceed 10% (see Chart 1).  Low current default rates are a poor barometer of a company’s ability to survive.  At the end of December, the spread between junk bonds and Treasuries broke below 400 bps for first time since July 2007 and the spread between junk bonds and investment-grade bonds hit all-time tight levels.  High yield companies have had incredibly cheap and nearly unfettered access to capital in the recent easy money environment.  Despite this access, many of the lower-tier companies in the high yield universe have been unable to compete with their peers, grow the top-line, innovate, generate positive cash flow or EBITDA.  Taking all of this into account, combined with the unprecedented record high yield bond issuance over the last two years (see Chart 2), it is quite clear that junk bond investors are being paid very little to take on a huge amount of default risk. 

Chart1

Chart 2

Tradex has done a tremendous amount of research on the lower tier of the junk bond universe, with a particular focus on single-B and CCC-rated bonds.  Historically, academic studies show that (on a cumulative basis) more than 45% of CCC rated bonds default within 4 years of issuance.  We agree with Mr. Fridson’s default forecasts and think that the ability to identify and be short of worst-of-the-worst, highly levered, longer-dated, subordinated or unsecured junk bonds in the lower-rated tier will be an incredibly successful strategy over the next five years. 

Richard Travia

Director of Research

FLASH UPDATE: New Home Sales (NHS) down 7% in December

New Home Sales (NHS) fell 7% in December.  In addition, both October and November had been revised down.  However, several points are worth noting...NHS is notoriously a volatile number and December was an unusually cold month.  Looking somewhat longer term, we see that while NHS had pulled back sharply after the rise in mortgage rates in 2Q-13, they had been building since that time.  Overall, NHS gained +16.4% in 2013, while Existing Home Sales announced last week was essentially flat for the year in an environment where home prices continue to post solid gains.

Several additional reasons for guarded optimism in the overall housing market are still present.  Housing inventories are still moderate to low while the labor market continues to improve.  So while December NHS looked bleak, all eyes will be focusing on December’s Pending Home Sales report to judge the recovery in home sales.

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: Existing Home Sales (EHS) up 1% in December

The recent rise in mortgage rates in 2013 has provided for a slowdown in certain measures of the health of the housing market and so December’s +1% rise in Existing Home Sales (EHS) is somewhat encouraging.  The consensus estimate was for a +0.6% gain. 

However, clear signals of housing shaking off the effects of the rise in mortgage rates were still missing.  November’s EHS was revised down sharply from -4.3% to -5.9% and it was off -0.6% year-over-year...  And while sales prices continue to rise (+9.9% Y/Y), it had been rising more rapidly 6 months ago.

The next data release of interest is Pending Home Sales due next week. 

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: The Challenge with REITS

Real Estate Mortgage Trusts (REITS) are familiar to most investors and, as we know, they come in various types.  Office property and residential mortgage REITS are two of the largest sectors.  The first invests typically in hard illiquid assets while the latter invests in raw mortgages or mortgage-backed securities.  From physical properties to raw loans to mortgage-backed securities, investors in REITS can choose from a wide spectrum of real estate-related assets representing a similar wide spectrum of liquidity, from low to high.  One of the “magical” properties of REIT investing is that investors seemingly are able to convert low-to-moderately liquid assets into highly liquid securities by investing in the equity of a REIT.

But this magic is not without a high cost; the equity market can extract a high cost for this liquidity.  The high-grade MBS market of 2013 is a very good example.  Annaly Capital Management (NLY) and American Capital Agency Corp. (AGNC) are a couple of cases in point.  Both of these REITS invest predominately in high grade agency MBS and were down approximate 30% in price in 2013.  This was due in some degree to spread widening in the underlying agency mortgages (due primarily to anticipation of Fed “Tapering” its bond buying program).  But agency MBS did not fall anywhere near 30% in price in 2013!  Even correcting for leverage, it is clear that a large part of the fall in price for these agency mortgage REITS was due to the equity markets raising the equity risk premium in this sector.  Equity volatility can add significant downside to a simple investment into high grade and highly liquid residential MBS!

Investors have another option to choose from.  An MBS relative value trading strategy that invests in highly liquid agency mortgages can still provide extremely strong liquidity, carry and hedged, non-directional returns.  The ability to generate alpha from a liquid, active trading strategy, as opposed to a static, beta-driven investment also comes with much greater transparency to the underlying holdings and most importantly…without equity market volatility.  Please contact Tradex to learn more about this investment strategy. 

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: The Ramifications of Easy Money Policies

Traditionally, as the economy heats up, interest rates rise...making it more expensive to borrow money and possibly more difficult.  Conversely, as the economy cools, interest rates fall...making it cheaper to borrow money and in some cases less difficult.  This can result in unintended consequences. 

Amid the end of the Internet boom and the shock of 9/11, at the direction of then-Fed Chairman Alan Greenspan, the Fed turned on an "easy" money policy to try to combat an economic slowdown.  The Fed pumped money into the US economy and slashed its main interest rate - the Federal Funds Rate - from 3.5% in August 2001 to 1% by mid-2003.  The Fed Funds Rate was held at 1% for one full year until June 30, 2004 when the target rate started to be raised.  In the opinion of many, the Fed held this rate too low for too long.

Many economists now blame Greenspan, in hindsight of course, for the lax bank supervision during that period as well.  Lee Hoskins, former President of the Cleveland Fed from 1987 to 1991, said that to find "partial causes" of the credit turmoil, "you have to go back to the Fed's decision to push the federal funds rate down to 1% and leave it there for over a year."  Short term interest rates tend to be a leading indicator of longer term interest rates.  As the Fed was lowering short term interest rates during this period, lower longer term interest rates spurred home buying, while at the same time a minimally regulated financial services sector was creating mechanisms for those with little to no creditworthiness to borrow.  

On June 29, 2006, under the leadership of new Fed Chairman "Helicopter" Ben Bernanke, the Fed Funds Rate peaked at 5.25%.  This was then reduced steadily, culminating at a target rate of 0-0.25%, which was set on December 16, 2008.  This near 0% rate has famously been accompanied by several rounds of Quantitative Easing (QE) and is expected to continue to be held for the foreseeable future.  At its December 2013 meeting, the Fed Committee indicated that, based on its assessment of measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments, it will likely be appropriate to maintain the current target range for the Federal Funds Rate well past the time that the unemployment rate declines below 6.5%, especially if projected inflation continues to run below the Committee's 2% longer-run goal.  

Throughout the life of near 0% interest rates, asset prices have generally inflated strongly across the board.  In the example of the Greenspan experiment, housing was the asset class that soared to record highs and then collapsed.  In the Bernanke zero-rate experiment, corporate high yield bonds was the asset class that soared to record highs.  We believe that similar to housing, certain companies will collapse.  Additionally, as high yield bonds have increased in price and tightened in yield to all-time records, bond issuance has been unprecedented.

2013 PIK Bond issuance, a type of loan that allows the borrower to pay lenders back in additional loans in lieu of cash, was more than $16.5 B, dwarfing the prior peak of $11.1 B in 2007.  According to the BIS, more than 30% of PIK Bonds from the last cycle have already defaulted.  Nearly 60% of loan volume in 2013 was issued as cov-lite and record paces of high yield issuance has gone on unmitigated for nearly six years.  Combine this with academic studies that show nearly 50% of all CCC-rated issues default within 4 years of issuance, and we think there is a serious high yield bubble primed to deflate over the next several years.  

Holding interest rates at 1% for one year had serious unintended consequences that indirectly helped cause the subprime debacle.  Former Fed Chairman Greenspan handed that mess over to soon-to-be former Fed Chairman Bernanke.  Now, Fed Chairperson-elect Yellen will inherit a situation where there is no historical data to help predict future results.  We think that holding near 0% interest rates for 5+ years (and counting) will also have serious unintended consequences and we will be short overvalued, highly levered, vulnerable US high yield companies while that story plays out.

Richard Travia

Director of Research