In the context of today’s fundamental backdrop and default outlook, spread levels suggest investors are being fairly compensated, relative to other points in the cycle, for the amount of risk they are taking.
While the search for yield is nothing new, it has certainly intensified in recent months as low, and even negative-yielding debt continues to dominate the investment landscape. But for investors who may normally turn to higher-yielding assets, such as high yield bonds and loans, a number of potential concerns—slowing economic growth, the elongated credit cycle, and an increase in defaults—remain top of mind.
One big question, in particular, is around valuations—and whether spreads, at current levels, are compensating investors for the amount of default risk they’re assuming. The short answer, in our view, is yes—based on a few key considerations:
- Market and issuer fundamentals
- Supply/demand dynamics
- Historical default and recovery rates
Market & Issuer Health
Broadly speaking, high yield issuers appear to be more disciplined compared to the years preceding the global financial crisis. Looking at U.S. high yield bonds, for instance, the volume of leveraged buyouts—higher-risk deals that involve a significant amount of borrowed money—is lower today versus 2006/2007.1 In addition, CCC bond issuance has been somewhat muted relative to the years leading up to the financial crisis. Issuance of higher-risk payment-in-kind or deferred bonds has also been lower, accounting for less than 1% of total issuance in recent years.1
RECENT U.S. ISSUANCE TRENDS ARE HEALTHIER COMPARED TO 2006/2007
Driven by a reasonably strong economic backdrop over the past few years, corporate earnings have been solid and leverage levels largely stable. Additionally, due in part to lower financing costs over the last decade, interest coverage ratios appear relatively healthy.
As a result, defaults—the biggest potential risk for high yield investors—continue to hover around 3%, slightly below long-term historical averages.2 While an increase in defaults across more challenged sectors—energy and retail, namely—has contributed to a slight uptick in overall defaults this year, we do not expect to see a widespread or material increase in defaults in the near term.
U.S. HIGH YIELD HISTORICAL DEFAULT RATE
From a technical standpoint, we believe the high yield market overall remains supported. Demand is steady, coming from both the re-investment of existing capital and new capital entering the asset class. Given the ongoing search for yield, we believe demand should remain healthy, and with the relatively muted forward calendar, the market should be well-supported going forward.
That said, economic cycles by nature have an end date, and we will eventually go through another recession. And while we don’t expect the next downturn to be as severe as the financial crisis—based on the generally more conservative financial profiles of high yield issuers today—we would certainly anticipate an increase in defaults through the next cycle.
Spreads in the Context of Defaults
While defaults do entail a potential loss of principal, there are typically opportunities to recover a portion of that through a restructuring process. Although past recovery rates do not indicate future results, factoring in long-term recovery assumptions for various high yield assets—from senior secured loans and bonds to unsecured bonds—can provide a general idea of what the implied default rate should be based on the current spread levels across various recovery assumptions.
For example: High yield bonds are currently offering spreads of roughly 400 basis points (bps) over the risk-free rate.3 If an investor assumes a recovery rate of 50% for high yield bonds—very close to the long-term average recovery rate for senior unsecured high yield bonds4—a spread of 400 bps would imply an 8% default rate in order to fully erase any excess spread that should be required over a risk-free opportunity. For context, the last time U.S. high yield bond defaults reached 8% was during the financial crisis. Even assuming a 30% recovery rate—significantly lower than the long-term average for senior unsecured high yield bonds—a spread of 400 bps would imply a 5%–6% default rate in order to fully erase excess spread, a rate not seen since 2008/2009. This scenario appears overly pessimistic given the current state of the economy and previously mentioned fundamental backdrop.
Of note, these assumptions do not fully capture potential trading volatility in the asset class during periods of economic weakness, but they do help frame the relative level of risk premium in the market for long-term, strategic investors. Every investor is different, and risk/reward thresholds can vary significantly. As such, while these assumptions are no guarantee of future results, they can enable investors to identify—based on their own assumptions and future expectations—whether current spread levels look attractive in light of the risks they expect to encounter going forward.
LOSS GIVEN DEFAULT SCENARIOS
Poised to Capture Relative Value
In today’s uncertain environment, we think a bottom-up, credit-intensive approach is key. While we believe the markets look fairly stable from a fundamental standpoint, there are a number of potential risks—escalating trade tensions, ongoing Brexit negotiations, concerns around commodity pricing—that could impact high yield going forward. Concerns surrounding slowing global economic growth and the possibility of a recession also linger.
Rather than trying to time investment decisions around these factors, we see value in taking a rigorous, bottom-up approach to credit selection, aiming to choose credits that can withstand headwinds and hold up through cycles. An active approach can be particularly advantageous, as it can allow managers to move away from credits that exhibit fundamental weakness in favor of healthier issuers. If or when defaults do increase, investors can benefit from partnering with managers who have a long track record of handling these situations. As we mention in our recent podcast—Distressed Debt: How This Cycle May Be Different—managers with deep resources and an experienced team are very well-positioned, in our view, to manage high yield assets through market volatility and drive attractive risk-adjusted returns.
1. Source: J.P. Morgan. As of February 2019.
2. Source: Credit Suisse. As of August 30, 2019.
3. Source: Bank of America Merrill Lynch. As of August 30, 2019.
4. Source: Moody’s Corporate Default & Recovery Rates. As of February 2019.