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 seen before.
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.