The high yield corporate credit markets have rallied along with equities since October 2011. There are two distinct types of assets within high yield credit: bonds and bank loans. Historically, the performance of high yield bonds correlates very closely with other risk assets like stocks while bank loans have been able to produce positive returns in all markets (with the exception of the 2008 financial crisis due to circumstances that are unlikely to be repeated).
A high yield bond manager must manage two key risks: interest rate risk (because bonds are fixed income instruments) and credit risk (because high yield bonds are issued by leveraged companies). Bank loan managers, on the other hand, do not deal with interest rate risk (because loans pay interest at floating rates) and focus entirely on credit risk. Bank loans also enjoy strong asset coverage and are the first debt to be repaid in a leveraged company’s capital structure. Cumberland views bank loans as a strong foundation in all high yield credit portfolios as well as a defensive holding when risk assets sell off.
High yield credit markets are highly cyclical and are currently enjoying one of the strongest rallies in their modern history. Since March 9, 2009 – the day the S&P 500 hit its post-crisis closing low of 676 and the spread on the Bank of America/Merrill Lynch High Yield II Index hit +1897 basis points, high yield bonds have rallied back to a current spread of +599 basis points.
Since October 2011, the beginning of the most recent equity rally, the spread on the Bank of America/Merrill Lynch High Yield Bond II Index has tightened from +868 basis points on October 7, 2011 to +599 basis points on March 15, 2012. The yield over that period dropped from 9.76% to 7.086%. But that only tells part of the story – it is necessary to look more deeply at this market by rating category to see what has unfolded.
BB-rated bonds – the highest quality high yield bonds – have seen their spreads tighten by 673 basis points since October to +431 basis points and the yields drop by 781 basis points to 5.4% at March 15, 2012. B-rated bonds’ spreads tightened by 292 basis points and paid 6.98% at that date.
Finally, CCC-rated bonds, the lowest quality and therefore the riskiest high yield bonds, saw their spreads tighten by 406 basis points and paid 11.41% on March 15, 2012. High yield bonds are hybrid debt/equity instruments. While they are fixed income instruments that are exposed to the risk of rising interest rates, they also pose equity risk because holders would suffer significant principal loss were their issuers to default. There is a significant difference, however, between a bond rated BB and one rated CCC in terms of the odds that it will default and the risk of loss posed to the holder.
While Moody’s Investors Service and Standard & Poor’s do a respectable job of rating companies (far better than they did in rating mortgages), their ratings are far from perfect and tend to lag behind the actual credit quality of a company. For that reason, Cumberland Advisors has developed its own proprietary model that it uses to forecast default risk based on its view of the factors that are most likely to lead a company to fail. The key to successful investing in high yield credit is understanding that each company, regardless of its Moody’s or S&P credit rating, must be analysed individually.
For example, today there are many CCC-rated companies that are the result of large leveraged buyouts done in the year or two prior to the 2008 financial crisis. These companies have been able to reduce their debt and extend debt maturities and are highly unlikely to default. While these companies remain highly leveraged, they are in a position to service their debts and offer very high yields to experienced investors with sharp pencils. As a result, despite their low rating, they may constitute reasonable investments for a small percentage of a portfolio. The question for investors is whether they are being properly compensated for the risks involved in owning specific instruments.
The outlook for high yield credit remains positive at the beginning of the second quarter of 2012. There are several reasons for this. The most important is that the Federal Reserve has publicly stated that higher interest rates are at least two years away.
As a result, interest rate risk is off the table at least through early 2013 (if one wants to be prudent and haircut the Federal Reserve’s stated late 2014 timetable by six months or so). The second reason why high yield should continue to perform well is that the default rate should remain well below historic norms because corporate balance sheets and liquidity levels are very strong.
Goldman Sachs projects a 2012 default rate of 2.6% compared to a historical norm of 4.6%, and most default candidates are already trading at distressed levels. Experienced managers should be able to avoid defaults and produce attractive risk-adjusted returns in today’s market as long as they keep in mind that absolute yield levels are going to start levelling off once they breach the 6% level (as this is being written in mid-March they are about 7%).
Michael Lewitt, Vice President and Portfolio Manager