FLASH UPDATE: How will the HY story end?

Hindsight is a wonderful thing.  It is easy to go back, review past events and to poetically postulate on what could happen next.  The age of internet has given everyone the power to quickly and easily refresh their memories.  If that is the case, why are investors still reaching for yield in the lowest rated junk bonds when they know how the story will end?  We have seen this story play out before, and expect that it will again end badly. 

Michael Milken first started pitching junk bonds for the masses in the early 80’s.  Thirty years later, the Fed has replaced Milken as one of the biggest supporters of junk bonds thanks to 0% interest rates and easy money policies.  Investors have appeared incredibly complacent by owning this asset class without reservation; the same asset class that always gets hit hard when a whiff of increased defaults comes to the fore.  For now, money is still flowing into mutual funds and ETFs that invest in junk bonds.  We have seen the pace starting to slow over the last three weeks though, with $559 m of purchased high yield funds in the week ended February 26^th, which was proceeded by $804 m of inflows the week before and $1.45 b the week before that.

After a year of abundant liquidity and near record setting HY issuance, the HY default rate remained below historical averages and decreased from 2012 to 1.04% (the 8^th lowest rate since 1971).  According to Ed Altman, sixty-four companies with debt greater than $100 m filed for Chapter 11 bankruptcy protection in 2013, 7% less than in 2012.  The number of bankruptcies is less than the historical annual average of 75.  Altman, Marty Fridson and many other well-known prognosticators are starting to sound alarm bells, warning of an impending rise in the default rate and bankruptcies.  While some investors have ignored these warning signs, Tradex has been preparing.

We know, through the power of hindsight, that 45% of CCCs default or restructure four years after issuance.  After record issuance in 2012 and 2013 and an inevitable spike in the default rate, Tradex will be ready.  We will be short of the worst performing, highly levered, subordinated junk bonds that benefitted from indiscriminate, credit agnostic, yield-hungry buying.  Michael Milken’s run as “junk bond king” ended  abruptly with him spending two years in jail.  We don’t know exactly how the HY story will end this time around, but we are pretty sure it will end badly.  

Richard Travia

Director of Research