“Were your view of the high-yield and leveraged loan markets to be formed purely by media chatter, you would have to wonder how it is even possible for a fund to reduce a large cash balance in such a “tight” and low-yielding market. The simple answer is that the index, taken broadly, might be low yielding and while most participants are focused on the new issue calendar, we have found some unloved, seasoned secondary issues that have come under pressure for one reason or another. These new investments have been purchased at prices in the 70s and 80s and, we believe, there is limited downside at these levels. They also offer price upside potential and significant current income while we wait for our deep value thesis to materialize.”
– Thomas Lapointe, Portfolio Manager of Third Avenue Focused Credit Fund
Third Avenue’s quarterly letters are pure gems. Not only are we reminded of the genius of Marty Whitman, but we are also offered a variety of investment ideas and lessons from across the firm – ideas and lessons that have been accumulating in our office’s binders for years. In their most recent letter, Lapointe provides us with an update on what’s really happening in the high-yield markets. We’ve highlighted some of his points below, demonstrating why a differentiated approach to credit selection can generate superior returns, even in a low rate environment. An argument we’ve repeatedly made at Broyhill.
Myth #1: Bank Loans and High Yield Both Pay 6.5%, So Buy Loans
On its face, this seems like a logical enough thing to say – if two pieces of paper have the same yield, then you will want to buy the more senior paper, so that you have better protection if something goes wrong. Plus with loans, you get close to zero duration (to protect you when and if rates rise) and the “free option” on LIBOR rising. So, for the last six months or so, every mutual fund wholesaler worth his salt (and looking for an easy commission) is out pitching loan funds as a better alternative to high yield and also convincing people to take their money out of cash or longer duration investment grade corporate bonds.
While the indexes do have similar yields, the bank loan index has a couple of large issues that trade at 40 cents to 60 cents and have 30% to 50% yields to maturity, but will most likely default before they mature and that yield is fictitious. When you back out the yield of loans that will probably default, the index yield drops about 100 basis points to about 5.5%. Just because loans yield closer to 5.5% doesn’t make them a bad investment. In fact, we believe they will do very well versus most all other fixed-income securities over the next one to two years, but we think high-yield bonds will do better.
This is why: We believe that we are in a low default environment – 2% to 3% – for the next two years. We also believe the economy will slowly improve, but not feel that great, say 2% to 3% GDP growth. In that environment, spreads look attractive today and could even tighten.
Myth #2: Sell Because Yields Are At All Time Lows
Spreads matter most, not yields. Yields are a function of where Treasury prices are. The extra spread you receive over Treasuries is the compensation required for loss given defaults (defaults less recoveries). Generally, you also need to get paid extra for the perceived lower liquidity and volatility of high-yield bonds and loans; but, ultimately, it is just the losses on defaults that matters to your return. Whether yields are low or yields are high all depends on what yields are being compared to. Taken in isolation, the 6.5% average yield of the J.P. Morgan High Yield index is not a meaningful statistic. What matters most is the historically wide spread between the high-yield index and Treasuries, which is currently about 600 basis points, which is wide in historical context given the current and expected defaults.
Myth #3: Inflation Is Bad!
Nothing in investing is universally good or bad for everyone and inflation is no different. The biggest problem that high-yield companies have is that they owe someone too much debt 10 years from now. If they can pay that debt back with inflation-adjusted dollars they will be better off. All companies sell something and, if they can raise their prices while maintaining the same margin, they will have more EBITDA dollars to pay the fixed coupons on their debt.
High-yield bonds and loans are generally much lower duration than most other fixed-income asset classes. In fact, high-yield bonds and loans are the only fixed-income assets that are negatively correlated with Treasuries. They also have wider spreads versus Treasuries, so if Treasuries back up they have some cushion to absorb versus rate increase.
Myth #4: High-Yield Underwriting Standards Have Deteriorated!
There is no doubt that this has happened in the past. However, the same does not hold true for 2012. Most of the lowest rated debt offerings coming to market now are refinancings. We will see underwriting standards decrease at some point. In the past you needed about 10% to 15% of the whole high-yield and loan market to be of dubious quality for default to increase above the 4% average. Bonds and loans also take time to default, generally three to four years after being issued. For these reasons, absent a significant turn in the economy or some other extraneous shock, I believe defaults will stay low for the next two to three years.
Myth #5: We’re Careening Towards A Wall of Maturities
Not true: Less than 6% of the debt outstanding in the high yield and loan market is coming due in the next two years. This is a very low number. Effectively what happened is that every CFO in America almost lost their jobs in 2008-2009 because they forgot to refinance. Because they want to protect their companies (and their necks) they have spent the last two years extending their maturities and now are refinancing 2015 and 2016 maturities. With the strong market and low Treasuries, companies are also lowering their average coupon and interest expense. This should have the compound effect of lowering the default rate and giving companies extra free cash flow to invest in their businesses. If a company has not been able to refinance in the last year, there is something seriously wrong with the company or its balance sheet.
In our experience, forecasted maturity walls do not cause waves of default. Cyclical or secular forces, as well as liquidity problems, drive default rates. Maturity walls that are public knowledge are generally financed away. In 2012, we were told to watch for the wall in 2014. Back in 2010, we were told we would be at the wall already. It is rare that the market will slam into something that is clearly visible in the distance.
Lapointe concludes by articulating a view held at Broyhill for the past several years. “We continue to believe that default rates will remain below their long-term historical averages, as companies refinance their debts before they come due and the economy continues to improve slowly. High yield and bank loans should perform well in this environment, and a carefully selected portfolio of high conviction, deep value stressed and special situation ideas has the potential to perform much better.”
We believe the description “carefully selected and high conviction” are key to any sound investment strategy. When applied to the high yield markets today, we believe we can construct a portfolio of bonds with above average yields and below average risks. This can be accomplished by balancing performing credits with attractive yields, stressed credits suffering from temporary issues at meaningful discounts to par, and special situations trading at discounts to the net asset value of the issuing company.
As we discussed in the past, see Junk in the Trunk, the high yield market has historically provided higher returns than stocks (with less risk) when economic growth has been sluggish, as it is today. For our part, we still see tremendous value in the niches identified above, and continue to focus our efforts on shorter maturity, higher quality, high-yield bonds, just in case we find ourselves in a warm pot next to our naive amphibian friends.