Wednesday, June 15, 2011

U.S. High Yield Market - how good can it get?

Fitch and Moody's recently reported slight upticks in their May 2011 high yield market stress metrics. Despite the increase, absolute measures remain well below peak recession period levels and are roughly on par with pre-recession levels.  More specifically, on June 1, Moody's pointed out that their liquidity stress test for May 2011 increased slightly for the first time in a year.  Fitch recently published stress test was included within an overview of the U.S. high yield market that provided history and a summary of key measures as follows:

1) Post the 2009 default spike (13.7%), defaults plummeted to 1.3% in 2010 and remain extremely low at 1.1% on a YTD basis at May 31, 2011.
2) Issuing company fundamentals have recovered from a deep recession driven slide as revenue and EBITDA have grown since mid 2009 through 2010.
3) Post the 2008 and 2009 recession, high yield market bond upgrades have trended up while downgrades have sequentially trended down.
4) The high yield market grew from $852B to $1,078B between December 2009 to May 2011.
5) Companies remain focused on liquidity as corporate cash to debt levels remain high while cap-ex spend remains below 2008 to 1Q09 levels despite a recent uptick.
6) Issuer credit terms tightened during 2008 and 2009 but have since loosened sequentially during 2010 and 2011.
7) Improved fundamentals and demand for yield drove a massive issuance rally during late 2009 to 2010.  This trend continues through May 2011. A significant issuance rally also occurred in the levered loan market as well.
8) A large volume of the overall market (57%) was issued during the most recent 29 months as of May 2011.
9) Refinancing dominated the use of proceeds during 2009 and 2010.  Growth financing has picked up some in 2011 and is expected to continue.

Fitch points out that on an overall basis, the market expanded with low rates and strong growth and raises the question of what comes next?  Fitch's data is consistent with other data, research and antedoctal evidence I see in this market (commercial and investment bank credit research, company comments as well as discussions with public company CFO's and institutional investors).

Conditions today in this market are currently benign as the current worry level in this market is low. As a result, spreads are narrow.  This therefore may be the most likely source of near-term risk at this juncture.  More specifically, since spreads are narrow and may not get much narrower an investor can get hurt here when and if spreads widen which could occur in front of fundamentals rolling over.

Ironically, the best way and time to buy these bonds may be when fear is great and fundamentals are in question resulting in wider spreads and lower prices. The last great opportunity here was the Fall of 2008 when spreads and yields blew out.  Yields in the market moved to approximately 30%, when fear was  high and market liquidity low.  As I write, fear is low, market liquidity is high and spreads are narrow against base rates (ten year treasury yields) that are low. 

For individual investors, the current period may or may not be the best time to be a buyer depending upon  risk tolerance, holding period and economic viewpoint.  Buyers here today are buyers because have to be (i.e. they are bond managers) or because they want to be (they are comfortable owning high yield bonds at 7% - 8% yields) and are betting that current conditions persist (spreads and interest rates remain where they are or narrow further) during their holding period. If economic growth continues at a slow steady rate allowing spreads and rates to remain stable, then a 7 to 8% return may look favorable relative to other alternatives in the stock and bond markets.

On the other hand, current favorable fundamentals in the issuers, the general lack of yield in the US credit markets and narrow spreads negatively skews the risk/return profile in this market in my opinion.   As a result, yield chasing may be risky as bonds may be overvalued or put another way, how much better can things get in this market (can interest rates go lower and/or spreads narrow further)?  What are you willing to bet on? The devil is in the details tied to individual bonds and overall market conditions.

As Fitch indicates, post the late 2008 to early 2009 financial crises, the market reopened which resulted in a big refinancing wave and amend and extend trend.   These factors and improving fundamentals caused defaults to plummet.  While much of the recent activity was to refinance existing debt, debt issuance tied to growth is expected to continue to rise looking ahead, therefore "growth" opportunities and transactions are expected to increase.

Some of the companies I have spoken to recently are now beginning to go into the investment mode again.  If the economy craters this sentiment will change.  As of now, companies are raising their heads out of their foxholes and are looking to make growth type investments.  Costco is looking to expand both in the US and internationally.  While casino companies are focused on Asia expansion, they are also now focusing on expansion possibilities in Illinois, Massachusetts, Ohio among other U.S. jurisdictions. Although not a high yield borrower, Walmart recently indicated they intend to selectively expand in the U.S. in a small store format to compete with the up and coming discount retailers. Are expansion plans as robust as they were before the crises?  Data I have viewed suggests the answer is no. However, evidence is mounting that activity may continue to pick up in the U.S.

Despite the favorable fundamentals in the market, looking forward, I am inclined to look elsewhere in the markets for positive risk/return opportunities owing to current perceived high valuations.


Foley, Keith, Tom Marshella, Adam McLaren and John Purchalla, "Liquidity-Stress Levels Increase For First Time in Nearly A Year", SGL Monitor Flash, Moody's Investor Services, June 1, 2001

Verde, Mariarosa, "Credit Trends & Default Outlook", Credit Market Research, Fitch Ratings, June 9, 2011

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