“High yield” is one of those topics that many authors and readers seem to love to wring their hands over. A recent example is this article, on which I commented in an effort to provide some perspective: The High Yield ‘Fear Factor’ – Hype Or Harbinger? And this one: Leveraged Loans Major Concern for Janney’s Fixed income Chief.
Credit risks abound in all credit investments, like high yield bonds, senior secured loans (sometimes called “leveraged loans”), collateralized loan obligations (“CLOs,” which are securitized vehicles that buy loans), business development companies (“BDCs,” which are companies that lend to small and medium sized companies). But they are nothing new and are the sort of risks that bankers and credit professionals have been analyzing, modeling, managing and projecting for years.
But you say you don’t invest in high yield?
Not so fast. Many investors who only invest in equities insist that “high yield” is something too risky that they would never touch. Many don’t realize that their equity portfolios are chock full of high yield companies, and that, as stockholders, they are actually in a riskier position – lower down the liability side of the balance sheet – than the investors in those “too risky” high yield bonds and loans that are senior to them.
Do you own any mid-cap funds? Any small-cap funds? The overwhelming majority of corporations are “non-investment grade,” also known as “high yield” or in less polite company, “junk.” Most but certainly not all of the S&P 500 are investment grade, but the overwhelming majority of mid-caps and small-caps are non-investment grade. Since a company has to pay its debts and stay in business in order for its equity to be worth anything, that means that high yield bond and loan issuers have to service and repay that debt on an ongoing basis before they can pay dividends on their stock. And if they don’t service their debt, they go bankrupt and their equity is worthless.
In short, when you buy the equity of a company, you are taking both the “existential” risk (credit risk) of that company servicing its debt and staying in business, as well as the “entrepreneurial” risk (equity risk) of the company growing and doing well by its shareholders. The two risks are obviously connected, but are also very different. There are many companies that stay in business for many years, pay their bills and service their debts, but go nowhere in terms of growth and profitability. Those companies are fine investments for their creditors, like high yield bond and loan investors, who only want their interest and principal paid when due. But they may be lousy equity investments, since the equity investor takes all the risk that the debt investor takes, plus the additional risk of being an equity owner. But he/she doesn’t get paid the interest and principal the debt owner does, and only gets what’s left, if anything.
Readers know I’ve often compared this to a horse race where buying the debt is a bet that the horse will merely finish the race. Even if they come in dead last, as long as they don’t die on the track and finish the race (i.e., stay in business and pay their debts), you win the race. Buying the stock is more like betting on the horse to win (or place or show). In other words, the horse has to not just drag itself across the finish line (i.e., stay in business). It has to excel to some extent.
From a risk/reward standpoint, I would want to be sure I was getting a much bigger payoff for taking the additional risk of my horse having to “excel” in the race than the reward I might settle for if all my horse (business) had to do was finish the race (i.e., stay in business). That’s why I believe that there is no reason to take equity risks if you can make an “equity” return with a credit investment. (Our Savvy Senior “Income Factory” portfolio currently pays a distribution of over 11%, an equity return in my book, for a portfolio that mostly bets on horses merely making it around the track in one piece.)
It’s also why everyone (even strictly equity investors) should keep an eye on the high-yield market
To that end, some of you may be interested in this article by the folks at Standard & Poor’s: Where is the Leveraged Loan Market Now? 10 Years After the Credit Crunch – LeveragedLoan.com
S&P are the real “pros from Dover” when it comes to understanding corporate credit, and has a research department that has closely followed the credit markets, default and recovery rates, etc. for decades. [Disclosure: I worked there for 15 years and started their corporate loan rating business in the mid 1990s.]
The article suggests that while there are risks in the current high yield environment, the view is much more balanced than one might think from the scare headlines we have been seeing recently, like the ones cited above.
One very hopeful sign is that high yield portfolio managers themselves are more optimistic than they were six months ago, believing that the lower than normal default rates experienced in recent years will likely continue even longer than previously believed. Here is a quote from the report:
This bodes well for low default rates. And in LCD’s Quarterly U.S. Default Survey, conducted in March, portfolio managers again pushed out their forecast for when the U.S. leveraged loan default rate—2.4% at the end of March—will top its 3.1% historical average. Nearly two-thirds of the survey respondents (64%) expect this to be a 2020 event, while those expecting a breach in 2019 slid to 27%, a dramatic shift from the 93% with that expectation at the third-quarter 2017 reading.
I find this heartening. There are several factors affecting the market outlook. Here are the highlights:
- Credit quality is down, with single-B and below issuers accounting for over 50% of the market now, versus only 32% ten years ago. (Those are “default” ratings, an indicator of the borrower’s likelihood of not paying interest or principal on time. Since virtually all of these loans are secured by collateral, typically all of the borrower’s assets, the loans also receive a “recovery” rating, which is based on an analysis of the likelihood of recovery in the event of default. A well-secured loan often receives a recovery rating higher than the issuer’s default rating.)
- But investors are being compensated somewhat better for the risk they are taking. One measure of this is the “spread per turn of leverage” or SPL, which measures how much additional compensation the lenders receive for each additional turn of the borrower’s balance sheet leverage. The idea is that the more highly leveraged the borrower, the greater spread over LIBOR the lender should receive. Currently borrowers are paying 76 bps per turn of leverage versus only 65 bps per turn of leverage in 2007.
- Interest coverage ratios, which measure how well borrowers can meet their interest obligations, are up from ten years ago. At the end of 2017, borrowers on average could cover their interest obligations 4.8 times, versus only 3.2 times in 2007.
- Sponsors of leveraged buyouts have been putting more equity in their deals lately – another good sign, since the purpose of many large loans is to M&A activity. Recently, equity represented 46% of the purchase price of new LBOs, while ten years ago it was only 36%.
- Finally, the so-called “Maturity Wall” of current leveraged loans outstanding that will come due between 2018 and 2020 represents only 11% of all loans outstanding. This means borrowers have done a good job of refinancing and extending their debt maturities into the future, so there aren’t a lot of maturities bunching up over the next couple years. Since refinancing is often a catalyst for default if a company is in a weakened condition, having a low percentage near-term “Maturity Wall” is another indicator that defaults should stay low for the next couple years.
- The recent US leveraged loan default rate (2.4%) is only about 3/4 of the historical average of 3.1%.
While these statistics relate directly to the leveraged loan market, the companies that issue loans are much the same cohort that issues high yield bonds, so the trends this report describes relate to the high yield bond market as well.
In our Savvy Senior “Income Factory” portfolio, as well as the “Widow & Orphan” portfolio described recently, we hold a number of credit oriented funds that are listed in the articles linked. In general, this report from S&P and our reading of current economic and financial market developments suggest no reasons to vary our policy of continuing to focus on high yielding credit and credit-like investments, of the sort described in those articles.
Steven Bavaria, a former executive of Bank of Boston and Standard & Poor’s, is a financial writer and consultant. Check out his book Too Greedy for Adam Smith: CEO Pay and the Demise of Capitalism (link to Amazon), and his articles on “income growth” investing on Seeking Alpha (Steven Bavaria’s Articles).
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.