and Fixed Income Outlook
December 11, 2012
Are you saying high-yield bonds are negatively convex?
Yes, they are negatively convex. You aren’t able to generate high capital gains as yields start to come down further, because the companies will begin to refinance the debt out of 8%, 9%, or 10% bonds into 5%, 6%, or 7% bonds. We are at the point where the return profile is very negatively skewed. The upside is basically your yield; but that’s nothing to sneeze at.
A lot of people say spreads on high-yield bonds are still cheap at over 500 bps.
I hear that a lot, too. I’d probably argue that, given how low Treasury yields are, the spreads are less meaningful here.
They are less meaningful to an extent. Compared with Treasury bonds, the data indicate that high-yield assets are a very good income generator. I don’t think the credit cycle will turn sharply here, though. We are at a point in the credit cycle that I’d call a “benign point,” where defaults just bump along. Underwriting since 2008 has been relatively decent, and the use of corporate proceeds hasn’t been egregious. There’s been some silliness, but, by and large, it’s been okay, and it takes time for problems to surface.
We’ve started to see more and more payment in kind deals surface, but at what point do you start to say things have gotten too frothy? The technicals in spread markets are very bullish here. Net supply for spread products in 2013 is projected to be negative, even before accounting for the impact of the Fed’s purchases continually pushing people out the risk spectrum. What stage of the game are we at here?
We’re at a stage where you want to be very picky when it comes to the credits in which you invest. It’s become a bond-picker’s market. There are plenty of one-off opportunities. From a complete top-down perspective, the most you’ll likely get in high-yield is your yield. With silly season in underwriting just starting, it takes time as the seeds are being sown. The minefield is being laid for the next credit cycle to get worse down the road. You don’t know which payment-in-kind deals will blow up, but some will. The seasoning period takes two to three years before the defaults escalate.
Getting back to your comment about the benchmark being broken, another way of looking at the spread is to compare the absolute yield of high-yield bonds with CPI. If you back out CPI and look at your real yield, you get a CPI-adjusted yield. This gives you a result of 300–400 basis points over Treasury bonds, which is well within the normal range in real terms.
Are there any specific names you’ve been long or short?
In the credit space, we have been playing the convergence trade in Europe. We started buying these credits late last year, focusing on investment-grade corporates – particularly large names like Telefonica, Finmeccanica, Telecom Italia S.p.A., and others that are in the wrong zip code, so to speak, by being in peripheral countries.
What appeals to us is that these companies have a lot of financial flexibility. Look at a name like Telefonica: It’s one of the largest telecom companies in the world. It has holdings in Latin America, and you have a 70-billion-euro market cap below your debt as a cushion. Debt was trading at cents on the euro, with yields up to 8%, that is, trading as cheap as high-yield. We loaded up on those late last year and into this year. We had to take a longer-term view that the eurozone would not fall apart. We ran a sensitivity analysis on each country, and projected that, even if they left the eurozone, these credits would lose their investment-grade status.
But guess what? They’re trading cheaper than bonds that have never been investment-grade.
So, are you looking at what these companies would look like if their respective countries exited the eurozone?
I’m old enough to remember the Brady bond crisis, and I’ve approached the eurozone crisis the same way. You have too much debt, so you’ll see some restructurings. I’m always thinking about what my margin of safety is. If I can at least have a roadmap of the worst-case scenario of what it can trade down to, then I can make an intelligent decision about at what price it looks compelling. I don’t avoid situations. There’s always a price at which it makes sense. We took each country and put them into restructuring, and we asked, “What would it take to fix each country’s debt structure by knocking off a certain amount of debt?” I’m always thinking, at what price?
Would you like to send this article to a friend?Remember, if you have a question or comment, send it to .