By Jeremiah S. Lane, Eddie O’Neill Nov 04, 2022
For yield-hungry investors, the buffet is open. After more than a decade of extremely low interest rates, the leveraged credit markets in Europe and the United States are awash in yield, and not only for the riskiest credits.
Historically, periods of extraordinary returns have followed when credit is as cheap as it is now. And while many investors have expressed concerns about default risks, our stress tests indicate that careful credit selection may be able to mitigate the pressure. All in all, we think the opportunity in leveraged credit is better than any time since the end of the Global Financial Crisis―but we also know it can’t last forever. Whenever the market moves, it may well move quickly.The Yield Buffet
A recent, highly publicized transaction provides an example of what is happening to yields in the leveraged credit market. Recently, a consortium of banks sold the high-yield portion of the debt used to fund a large leveraged buyout at a discount of some 16.5 cents on the dollar and a 10% yield. We think the same debt would have come in around the 4% range just last year. But even more astonishing than that move is the fact that even a triple-A tranche of a collateralized loan obligation (CLO) now yields 6%. Put another way: The most secure leveraged credit is available for yields 2% higher than a B-rated leveraged buyout credit yielded last year.
Another way to understand the sheer magnitude of the shift in yields is by looking back at every trading day over the last 10 years and counting the number of days that featured higher yields, higher spreads, or lower prices than today. As Exhibit 1 shows, the percentage is in the low-single digits across many of the leveraged credit asset classes. To take U.S. high yield as an example, yields have only been higher on 1% of trading days in the last decade, prices have been lower less than 0.5% of trading days, and spreads have only been higher on 16% of trading days.
Relative Value by Spread, Yield and Price
What this means is that there are risk-return profiles to please nearly all comers. Those investors seeking 7%-9% returns on relatively high-rated debt for 8-10 years can do so. Those investors seeking higher returns while avoiding single-name concentration or triple-C exposure have that option. We think total return investors can find opportunities in short-dated capital structures. This is why we call it a yield buffet: The opportunities come in many flavors.This Buffet Is Not All You Can Eat
Rising interest rates and the retreat of traditional lenders set the table for the current smorgasbord of yield options. For years, interest rates were artificially low, and prices fell quickly as those artificial supports disappeared. But banks have also stepped back from originating leveraged loans and high-yield bond issuance. That’s partly because rising rates mean they need more capital to meet regulatory requirements and partly because investors have lost their appetite in an uncertain macroeconomic environment for relatively high-risk fixed income products. Financing is both expensive and very difficult to find, hence the high yields we are seeing now.
However, the market for debt financing will eventually begin to function again. Europe is already in recession, and our base case scenario is that the United States will enter one as well. That raises the possibility that central banks will pivot to easing mode, giving banks more breathing room to lend again and potentially reversing the outflows we have seen in high-yield debt. Yields and spreads are likely to fall as prices rise, a process that may occur more quickly in the United States than in Europe because of the deep uncertainty in the latter about energy prices and the Russia-Ukraine war. In both markets, however, the opportunity will fade.
History bears this view out. When the high-yield bond index has been below 85, as it is now, investors enjoyed 12-month forward returns of 31%. However, high yield has only traded below 85 for 20 days out of the last 10 years. Twelve-month forward returns have been very strong at prices below 90, but have tended to fall off significantly once prices are between 90 and 95 (Exhibit 2).
12-Month Forward Returns based on Historical High Yield Index Price Levels1
The potential spoiler for our enthusiasm, particularly heading into a recession, is the potential for a wave of credit defaults. We recognize that many people are looking back nervously at the Global Financial Crisis for clues about what may be coming next, but we see two reasons to question the comparison.
First, we do not see any systemic risk to the financial system this time around. The level of hung debt – meaning debt for mergers and buyers that investors no longer want – on bank balance sheets is a small portion of what it was during the global financial crisis. According to our calculations, even very significant writedowns would amount to a fraction of earnings for many major players.
Second, we think that companies are in a better position to pay their debts than they were in 2008 and 2009. We recently stress-tested all of our portfolio holdings and were pleasantly surprised with the results. In the United States, we saw surprisingly strong earnings at our portfolio companies, with pockets of weakness in businesses that have been hit hard by supply chain issues or can’t raise prices to offset higher input costs. In Europe, where the recession will likely be deeper, our portfolios have much higher interest cover ratios than they did going into the financial crisis. The market for leveraged loans and high yield is much different than it used to be, too: borrowers are bigger (and therefore, in our view, likely to be more resilient), and equity cushions are larger.
However, we do think selectivity is key. Leveraged loan and high-yield indexes contain not only businesses with strong growth potential, but also businesses that are not likely to thrive in the long term or, less delicately, what we call secular losers. The hunt for yield is over, but the hunt for credit investments that can weather a downturn never will be.
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