Monday, September 1, 2014

FLASH UPDATE: Ready, Set, Pop!

When balloons inflate, it is typically a long and slow process and always difficult to tell when they are full.  Towards the end, the balloon stretches and stretches, making room for those last few short breaths.  When you've reached the end though, it just doesn't feel right and you start to think more cautiously.  Of course as we all know, balloons burst.  Once that magical maximum capacity is reached, the balloon POPS in spectacular fashion, exploding with vigor - loudly and violently.  

There are three phases in the trajectory of the current fully-heated high yield market:  1) Overbought conditions, 2) Rate tantrums, and 3) Defaults.


Overbought Conditions
Clearly we have been in "Overbought" territory for quite some time.  According to the BAML Master High Yield Index, the average current high yield bond price is 104.10.  The average new issue clearing yield is 6.28%, down from 7.33% two years ago.  In the last year alone, the CCC new issue clearing yield has fallen from 8.77% to 7.79%.  The average yield-to-maturity is 6.18%, down from 7.35% two years ago.  


Forward calendar volume is already starting to reflect a small amount of hesitation in appetite, coming in at 19% lower than this time last year.  After growing rapidly over the past 10-15 years, high yield now comprises roughly 15% of the overall corporate (investment grade) bond market, which itself is estimated at roughly $9.8 trillion, trailing the U.S. Treasury market ($12.1 trillion outstanding) but larger than the municipal bond market ($3.7 trillion outstanding), according to first-half 2014 estimates by industry trade group Securities Industry and Financial Markets Association (SIFMA).  In 1996, the  high yield market was $200 billion.  

  
As the market has grown and issuance has exploded, Cov-Lite, PIK and PIK-Toggle issuance has had a resurgence, on pace to surpass the most recent highest annual volume in 2008.  PIKs are viewed as more highly speculative debt securities.  Essentially, the company through in-kind payment is creating more debt in a situation where it doesn’t have the capital to service the debt.  This blatant disregard for credit risk among the already obvious reach for yield is clearly setting up the next default cycle.

  

Rate Tantrums
On May 22, 2013, Former Fed Chairman Ben Bernanke announced that the Central Bank would begin scaling back its monthly asset purchase program.  This was followed up with a June 19th press conference, where he optimistically described then-current economic conditions, and reiterated that the taper would commence later in 2013.  In the next 48 hours, the 10Y Treasury yield rose approximately 35 bps, from 2.20% to 2.55%.  The 10Y Treasury yield hit 3% by the end of 2013.    


The value of the USD vs other currencies also rose significantly on the announcement, with some EM FX falling as much as 15-20% vs the USD.  In the four weeks following the May 22nd announcement, high yield ETFs and mutual funds saw $12.3 billion in redemptions.  This alarming outflow was only recently surpassed by outflows in the July-August 2014 technical sell-off ($12.6 billion in outflows).  Given that the Fed makes up approximately 90% of the new-issue MBS purchases, the reaction in the mortgage market was even more violent.  Annaly (NLY), a well-known mortgage REIT, lost 35% of its value from the date of the announcement to the end of 2013.  

  
The stock market continued to show relative strength though, only selling off approximately 5.5% in the month following the original announcement.  These collective reactions caused what is now referred to as "Taper Tantrum".  

The nervousness in the market about a new and improved tantrum is starting to become evident.  Bloomberg reported caution from UBS and other market participants last week.  Larry Hatheway, UBS's Chief Economist said, “The main show is soon to arrive.  With the ‘taper’ nearly complete, there are fundamental and institutional reasons aplenty to fret that last summer’s ‘taper tantrum’ will be find its sequel. Beware ‘rate rage.’”.  The Barron's this weekend is calling for significant forthcoming volatility in the bond market, suggesting that the announcement to raise rates may come as soon as the Fed's September 16th meeting.  As US Treasury yields hit lows due to geopolitical concerns and buying from sovereign debt relative value players, the rise could catch many off-guard, despite pretty much everybody knowing in their heart that it's coming.  

Investors notoriously chase returns.  The St. Louis Fed recently wrote a paper on the dangers of chasing returns (it was focused on equity mutual funds, but the premise holds true), which pointed to a high correlation of flows to past returns, of course resulting in inflows at exactly the wrong time.  Despite the recent ETF & mutual fund outflow hiccup in high yield, overall growth of the market has been unprecedented since 2010.  Some ETF operators have even caught on to the fear of rising rates, putting together what the Barron's expects could be a recipe for disaster - Long High Yield ETFs hedged with Short Treasuries.  (Although I agree that interest rates will rise over time, perhaps significantly, in the fickle world of trigger-finger happy retail investors, at the first sign of a risk-off environment these products could lose on both sides of the trade.  Investors thought all they were doing was protecting their coupon, when in reality they were ignoring credit quality again.)  


Defaults
Dr. Ed Altman, a world renowned expert on corporate bankruptcy, is an advisor to our short-biased high yield fund, and has conducted in depth research on the current credit bubble.  The current benign credit cycle, which has been near or below 2% for the last five years, is expected to considerably increase over the next three to five years.  Without taking the currently fully heated credit environment into account, it is clear that high yield default rates are incredibly cyclical.  The average annual default rate since 1971 is 3.14%, with below average default cycles lasting three to four years typically, and above average default cycles lasting one to two years.  Any sustained period of extraordinarily low defaults has typically been followed by a significant spike in default rates.  

The corporate high yield sector has been refinancing and increasing their debt significantly and consistently since the current benign credit cycle started in 2010.  New high yield issuance topped $200 billion for the first time ever in 2010.  2011 new high yield issuance was just below $200 billion, and 2012, 2013 and 2014 (the pace through the 1st half) have all topped $200 billion since.

Issuance is unprecedented, and the quality of that issuance is clearly suspect, with CCC issuance 21.5% of all high yield issuance, a figure not topped since 2008.  The 2nd quarter's CCC issuance jumped to 25.9% of total high yield issuance, a figure only second to the all-time record in 2007.  The five-year cumulative mortality rate for CCC's is 47.4%, a sobering statistic given the amount of low-rated debt issuance since 2010.  46% of the 1st half high yield issuance was Cov-Lite, another factor which typically results in lower recovery rates should the debtor company default.  Dr. Altman's well-known Z-Score metric, which quantifies a company's probability of default, shows that the credit quality of companies in the peak of the current cycle is lower than that of the last cycle peak in 2007.  


Marty Fridson's recent study suggested that the next default upsurge may be $1.576 trillion of face value between 2016 and 2020, a startling prediction given high yield's lofty status, which on average continues to trade well above par.  The price of weak credits typically fall well before the default rate spikes.  As an example, we point to 2007 and 2008 where the default rate was below 2% for every month except December 2008.  By the time the big spike in defaults occurred, the recovery (and QE) were already well in place.
    
  
Please enjoy your Labor Day and be safe.  I will be in NYC tomorrow for meetings if you'd like to meet, and I'll be at Citi Field for a Goldman event on Thursday (followed most likely by the US Open) if you'd like to catch up then.  We look forward to speaking with most of you in further detail about the current opportunity set throughout the next few months.  

Richard Travia

Director of Research

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