Fixed Income Commentary: Recent High Yield Selloff: Caution or Opportunity?
TCW Investment Management
By Jamie Farnham
June 23, 2011
Fixed Income Commentary: Recent High Yield Selloff: Caution or Opportunity?
Fixed Income Commentary
June 22, 2011
The spring season has tested the mettle of the high yield market. A common inquiry on investor minds of late is whether this is a short-term bump on a longer journey or alternatively that risk is rising for high yield investors. In this note we will touch on (i) relative value, (ii) fundamentals and (iii) the potential interest rate effect on high yield.
Relative Value – Short-Term Bump or Long-Term Turn?
While the recent downtrade in high yield has been relatively substantial, for reasons we will make clear, we view it not as the start of a protracted bear market, but rather as a mid-cycle correction. Our perspective is that the high yield market continues to season through Phase III of the credit cycle, a multiyear period of range-bound but gradually tightening risk premium (i.e. spreads). Over the course of Phase III, the pendulum gradually swings from deleveraging to greater shareholder emphasis, eventually resulting in rising debt levels.
High yield continues to have attractive longer-term relative value as current option-adjusted spreads (OAS) are nearly 100 basis points above the long-term median of approximately +475 bps vs. Treasuries. This is unusual as high yield spreads typically are tighter than the median for much of the length of Phase III. One can gain a better perspective by viewing spreads of the current Phase III. The longer-term trend of gradual spread tightening is evident while seeing short-term rangebound swings. High yield spreads are also wide of where they have tracked in previous cycles. In short, high yield risk premiums are trading wide of both long-term and short-term trends.
High Yield Credit Cycle
High Yield Spread Since Late ‘09
Credit Cycle Pattern
Fundamentals Remain Solid
Credit fundamentals remain on solid footing even in the absence of a robust economic recovery. This is accomplished via equity offerings to reduce debt levels and/or growing cash flow to accomplish organic deleveraging. Since mid-2009, credit statistics have shown consistent improvement. Though increases in dividend and LBO activity are evident since 2009, the high yield market remains considerably far away from the leveraging trends of the credit boom years. In past cycles this credit improvement trend typically lasts three years before leveraging trends take hold.
Corporate managers have utilized the primary markets to enhance liquidity by refinancing existing debt to extend maturities. The 2013-14 maturity wall has been halved since December 2008, a shadow of the once daunting $750 billion level facing the leveraged finance markets at the time. Notwithstanding the record-breaking size of the high yield new issuance market of 2009 and 2010, issuers utilized proceeds largely to extend maturities. In fact, since 2009 over two-thirds of proceeds have been used for refinancing purposes.
Looking forward, we do not believe the leveraged finance market in general stands materially vulnerable to a marked increase in the default rate. Lending conditions, both as evidenced from Federal Reserve Loan Officer Surveys and high yield primary market activity, are operating normally. Combined with improving fundamentals, default rates likely will remain at relatively subdued levels, absent substantial unforeseen shocks.
High Yield Fundamentals
Loan/Bond Refinancing Progress
High Yield – Use of Proceeds
Federal Reserve Senior Loan Officer Survey
Prospect of Rising Interest Rates
Another uncertainty facing global markets is the prospect of future inflation. Whether due to an inability to right-size fiscal deficits over time or playing chicken with Federal government debt limits, catalysts for rising interest rates have the potential to materialize. While rising rates would negatively impact high yield bonds by lifting benchmark Treasury yields, their elevated income (e.g. average coupon of approximately 8.25%) would inherently mitigate some portion of the hit to capital.
Furthermore, inflation has the potential to benefit levered balance sheets for several reasons. First, rising rates generally coincide with economic growth and growing business cash flows which logically would keep default rates low. Historical data is consistent with this point as seen in the chart to the right. Second, balance sheets can indirectly benefit from inflation as asset values are nominal (i.e. would inflate) while debt levels remain static.
Cumulative Maturities
High Yield During Rising Fed Fund Periods
Legal Disclosures
For Information Only
This publication is for general information purposes only. Past performance is no guarantee of future results. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision.
Subject to Change
Any opinions expressed are current only as of the time made and are subject to change without notice. TCW assumes no duty to update any such statements. The views expressed herein are solely those of the author and do not represent the views of TCW as a firm or of any other portfolio manager or employee of TCW. Any holdings of a particular company or security discussed herein are under periodic review by the author and are subject to change at any time, without notice. In addition, TCW manages a number of separate strategies and portfolio managers in those strategies may have differing views or analysis with respect to a particular company, security or the economy than the views expressed herein.
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