As I sit in my living room late on a Sunday
night, with the kids and the wife asleep and the dog by my side, I start to
think about all the things that keep me up at night. Those that know me
well, know that the late hours are among my most productive. In the
spirit of having a productive Sunday night, I just opened up an article written
by thestreet.com titled "High Yield Fundholders Have No
Reason to Fear Janet Yellen".
Since I am
always interested in hearing arguments against our event-driven, short-biased
high yield thesis, and I'm constantly trying to understand the other side of
the trade, I dug into the brief "details" of the article… -- High
yield is not in bubble territory because defaults are low and spreads to
Treasuries are not at all-time tights. Oh, and high yield issuance
quality has remained strong because the majority has been used by companies for
refinancing purposes. Lastly, Janet Yellen will only raise rates if the
economy gets stronger. -- Well, with that said, I should sleep like a
baby tonight. I am glad it is that easy...but for just a few minutes let
me think more deeply about these points.
I would argue
that low defaults are actually a leading indicator of trouble to come in the
high yield market. In 2007 and 2008, the HY default rate was below 2%
every month, with the exception of December 2008. By March 2009, the
"recovery" had begun in equity markets, the liquidity spigots were
open and the money had begun to flow again. 2007 and 2008 was among the
most severe credit crises and recessions ever, many market participants were
taken out and very few survivors, if they choose to remember correctly, would
likely tell you that high yield is not in bubble territory because defaults are
low.
Where the 10Y
Treasury trades (yielding 2.48% - very close to Spain's 2.59%), gives no
indication of risk in the market. It is manipulated and may be prone to
rise, or to stay low, for many different reasons. If Yellen decides one
day that the economy is strong enough to bear a rise in rates, I think there
will be unintended consequences that will eventually come to the fore.
Once rates rise, it will be extraordinarily important to understand why
they are rising, which could have a serious impact on high yield bonds.
The fact that HY bond spreads to the 10Y are not at all-time tights
doesn't lead me to believe that there is nothing to fear. Every sustained
period of CCC bonds' OAS below 10% since 1997 has resulted in significant
spikes in OAS above 20%.
Two Harvard
Business School professors, Greenwood and Hanson, recently published a research
piece arguing that a good indicator of an overheating credit market is a high
share of corporate debt issued from low-rated issuers. High yield bond
issuance has been at all-time historic levels of issuance five years in a row.
In 2011, 2012 and 2013, we saw levels of COV-Lite issuance reach all-time
levels not seen since 2007 and in particular, single-B rated bonds with weak
covenants were issued at multiples higher than before the last crisis. As
we know, and our advisor Dr. Ed Altman has reinforced, nearly 50% of CCC-rated
issuers default inside of 5 years after issuance. We question the quality
of the junk being issued.
Companies that have used new debt issuance
over the last six years to refinance old debt, have done so at the cost of not
reinvesting in their businesses. Top lines have declined, EBITDAs have
fallen precipitously, free cash flow is nil, leverage has spiked and
vulnerability is high. After
second thought, I may not sleep like a baby tonight, but I do know that our
investors are protected in case high yield fundholders do have something to
fear.
Please reach
out to Tradex if you'd like to further discuss the short high yield opportunity
and click here http://m.youtube.com/watch?v=HKOjf1_4Bus for a link to an animated short
movie on the state of the HY market.
Richard Travia
Director of Research
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