Be it interest rate concerns or talk of a bond bubble, the high yield market has faced a step back over the past couple weeks. We’ve addressed the interest rate concerns at length—see our blog “Is This Time Different?”—and at the end of the day, history would indicate that high yield bonds have historically performed well during a rising rate environment.
Turing to the bond “bubble” talk, let’s look at the 2005-2007 period when we really did see concerning conditions in the high yield bond market. Looking at the Credit Suisse High Yield Index as a proxy for the market, we saw spreads break 400bps in July 2005 and stay under this level until bottoming out at 271 bps in May 2007.1This is a far cry off of the spread of 475bps that we sit at today.2 And while concerns have recently been raised about loosening underwriting standards and a pick-up in “covenant lite” activity in the loan world, we certainly aren’t seeing the lack of discipline across the board as we saw in 2005-2007, where deals were getting down at massive multiples (many of which have since proved unstainable) and we saw telling signs like an abundance of PIK (pay-in kind versus cash interest pay) and dividend deals. Over recent years, market issuance has been dominated by refinancing rather than this sort of activity and transaction multiples for M&A have been relatively tame. So, this isn’t 2007 and we don’t see conditions that warrant labeling the high yield market a “bubble” that should be avoided. If anything, the volatility that we have seen over the past few months speaks to rationality—markets can’t continually go up and we would see a periodic step back as healthy.
We’ve heard lots of other reasons why we are seeing sellers in the market, and there seems to be some inconsistencies in some of these reasons. I’ve heard the concern that if rates do rise, that could lead to a set-up in defaults. A couple things to keep in mind: generally we see rates rising during periods of stronger economic activity. We would think that for a substantial rise in rates to happen, we would need to see the economy improve off of where we are today. That doesn’t mean that we won’t still potentially see the Fed take short term rates up little next year at some point, but we would expect that for this Fed to make a big move, they would certainly need to see improved economic conditions, especially in areas such as unemployment and underemployment. And on the flip side, if those strong economic conditions are there by mid-2015 and beyond, then that is a benefit to corporate credit as we would presumably see improved financial prospects for these companies…and one would then think improving financial prospects would in turn equate to lower defaults.
Maybe this is an obvious statement, but the other thing to note as we think about defaults is that higher rates don’t necessarily mean that costs get more expensive for high yield bonds issuers—high yield bonds are fixed rate securities and the fact that so much of the market has refinanced bonds over the past few years and locked in low rates (saving on interest costs) positions them well to manage through the environment ahead. And with the fixed coupon on these securities, that helps keep free cash flow cash generation steady.
On the flip side, potentially higher interest rates mean that companies needing to refinance would face likely higher rates to do so—but again, we don’t see a massive spike in rates on the horizon so that could well mitigate this issue. Additionally, it is important to keep in mind the amount of bond maturities over the coming years. As you can see from the chart below, of the $1.6 trillion market, we only have a very small portion maturing between now and 2018/2019 when maturities start to pick up, so this bodes well for any sort of refinancing risk in the near-term as we seemingly have years of runway.3
Turning to another issue we have seen mentioned several times over the past week or two: concerns are being raised that companies are focusing on more shareholder friendly activities, such as using cash for stock buybacks. While yes, that can be an issue, there are other caveats to consider. For instance, while we never like to see cash go out the door for stock buybacks or dividends, we often see this occurring in companies that are generating good cash flow that they want to do something with—and free cash flow generation is virtually always a positive. As a bond holder, it is also important to keep in mind that these sorts of equity-focused actions can easily be turned off should that cash flow be threatened. Additionally, active managers can avoid the credits where the company is levering up to unsustainable levels or using cash they don’t have to spend to fund these shareholder friendly activities.