High Yield Bonds Losing Their Luster? Afraid so…

The Tradex Group Weekly Blog

January 29, 2013

By Richard Travia, Director of Research

High Yield Bonds Losing Their Luster?  Afraid so…

Investors are realists, and when they see a political and economic landscape littered with talk of fiscal cliffs and $16 trillion debt ceilings, they measure the scene, assess the risk, and naturally gravitate to safer investments.

So it goes with the current corporate credit market, especially the relatively risky high-yield debt market, where more assets are flowing ahead of what seems to be a tumultuous 2013.

But are investors taking on too much risk in the high-yield market? That’s our view, as too many companies with frail balance sheets are benefitting, unwisely in our view, due to investors’ continued ample appetite for yield.

                                                                                                                                            

The Financial Times calls the latest debt issuance from both companies as a “dash for trash.”

Two vivid examples stand out – Tenet Healthcare and Denbury Resources.

Both are emblematic of the recent trend of high-yield bond issuance that has debt selling with coupon yields below the 5% level. According to Standard & Poor’s, high-yield debt is triggering record low yields in 2013, especially for junk bonds maturing in seven years or more, with ratings that the rating agency accurately describes as being in “deep junk bond territory”.

Both Tenet and Denbury are emblematic of the trend toward what The Financial Times calls firms with “fragile” balance sheets.

This from The Times:

Companies with fragile balance sheets are capturing such low coupons as investor hunger for the bonds remains high, even as yields carved out new record lows on Wednesday at 5.64 per cent.

Investors are now accepting less in risk premium, or spread over US Treasuries, to hold junk bonds than they were only a few weeks ago. Since the start of the year, the spread has shrunk almost 50 basis points to 4.62 per cent, according to Barclays’ indices.

That outlook should continue unabated, with more and more of those fragile firms driving coupon rates from approximately 7% to 5%, and lower.

Look at Tenet. The health care firm just sold $850 million in 4.5% secured notes, due in 2021. That is a record low yield for high-yield bonds (B-rating) with maturities of seven years or more.

Denbury’s recent 4.6% yield on 10.5 year notes set another record yield hungry investors might want to avoid - new lows for subordinated bonds.

That’s a big departure from trends we’ve seen even in the past few weeks to open the year.

Dealogic reports that about $21 billion in so-called “junk bonds” hit the street already in 2013, a big uptick over the $12 billion the market saw over the first few weeks of 2012. Moreover, average coupons on those 213 deals clocked in at 6.8% - well above the Tenet and Danbury deals, but heading to a downward trend.

Still, that’s not stopping investors from pouring $1.1 billion into high-yield debt in the first week of 2013, alone. But with yields at record lows, and the quality of new high-yield debt, in our view, in significant decline (Moody’s reports that covenant protections on high-yield bonds are at weakest levels in two years), investors best beware.  We expect the lesser-known, non-flow names to be hit extremely hard just on the technicals of ETF and mutual fund redemptions.  We also expect that many of the lower quality companies in specific sectors may restructure, go out of business, etc., where the bonds may sell-off to recovery value or to zero.  In the likely event of rising interest rates, the above mentioned scenarios will be compounded (as an example, without any credit impairment, the negative convexity will cause a generic high yield bond to lose 16% on a move in the 10Y Treasury to a 4% yield). 

After all, “fragile” is not a theme you want to hang your hat on going into 2013. But with increasingly lower coupons on high-yield bonds, “fragile” should be the watchword even for yield hungry investors coming out of January.