By Ben Nickoll
The U.S. high-yield bond and loan markets were
on a tear in 2011 — until the euro zone debt crisis
and fears of global contagion hammered investor confidence. New
issues fell off a cliff, declining from $182 billion in the
first half of the year to just $59 billion in the second half
(through November). Yields hit 10.2 percent in the fourth
quarter, a level that typically signifies recession.
But the news isn’t all bad. While investors
remain cautious, we are starting to see tentative signs of a
recovery in the high-yield asset class — and I believe
a much stronger rally is still to come. In my view, the recent
sell-off has created a buying opportunity.
Yields are attractive compared with both U.S. Treasuries and
investment-grade bonds. During recent market volatility, credit
spreads for companies rated below investment grade increased by
more than 250 basis points to about 750 basis points, pushing
yields out to 8.8 percent. At the same time, ten-year U.S.
Treasury rates rallied from 3.1 percent to 2 percent and
five-year U.S. Treasuries rallied from 1.7 percent to below 1
percent. As a result, the credit spread of high-yield bonds
(with an average duration of 4.5 years) was more than 7.5 times
the yield on five-year U.S. Treasuries — a level never
This dramatic movement in the spread of high-yield bonds and
loans over U.S. Treasuries signifies that investors are
demanding a greater premium to compensate for the increased
credit risk of noninvestment-grade debt. However, this widening
spread is simply not justified by the fundamentals. The balance
sheets and cash flows of companies rated below investment grade
are stronger and more robust than they have been for years.
For starters, current aggregate financial leverage is not
high for many high-yield borrowers, now running at or slightly
below the long-term average of 3.6 times. Interest rate
coverage is 3.7 times, up from the long-term average of 3.2
times. In addition, investors in search of yield may provide
increased price support for this asset class.
High-yield credit also looks attractive compared to
equities. High-yield debt is a hybrid asset class falling
between fixed income and equity that has the advantage of
offering gains while also potentially providing a certain level
of downside protection due to promised interest and principal
payments. In my opinion, the current slow-growth macroeconomic
environment should favor high yield over equities. For example,
from 1990 to the present, there are nine instances of
low-growth quarters in the U.S. (real GDP growth of less than 1
percent), and high yield outperformed equity in six of the nine
instances by an average of 2.2 percentage points.
Yet investors continue to focus on the so-called wall of
maturities and the risk this poses for high-yield debt.
However, North American high-yield borrowers have actively
addressed this refinancing risk. At the end of 2008, the
aggregate volume of high-yield bonds and leveraged loans
maturing between 2012 and 2014 amounted to $710 billion, but by
November 2011 this number had been reduced by more than half,
to $285 billion. Given that the 15-year average monthly U.S.
high-yield bond new issuance volume runs $9 billion, I am
confident there is sufficient time and capacity to absorb these
refinancings in the coming years.
High-yield debt is equally vulnerable to interest rate
increases, but the effect from a total return perspective is
less severe than for investment grade, since the credit part
makes up a larger proportion of total returns. In September
2008, when Lehman Brothers disclosed its bankruptcy, the
monetary base in the U.S. increased by a staggering 3 percent
per month, on average, mainly due to quantitative easing
programs designed to stimulate the economy. However, this
growth in money supply is not yet fully reflected in consumer
price inflation. Inflationary pressures should flare up quickly
once liquidity leaks into the broader system, and with the
ten-year U.S. Treasury rate about 2.0 percent and annual CPI at
3.5 percent, the U.S. could enter another period of negative
real interest rates.
A combination of company-specific attractive fundamentals,
the macroeconomic environment and a lack of alternatives makes
North American high-yield credit an interesting asset class.
Cash-rich corporate balance sheets with low leverage and modest
refinancing needs in the coming years indicate low default
rates in the near term. A low-growth environment in the medium
term naturally should put fixed-income investments at an
advantage over equities. Altogether, I believe investors can
earn more competitive returns in high-yield credit. AR
Ben Nickoll is a principal officer and portfolio manager at
GLG Ore Hill, a credit-focused,event-driven hedge fund and
structured product manager based in New York.