The High Yield Credit Cycle & What You Need To Know!Adam Parris
I wanted to share with you a few lessons I’ve learnt reading about the High Yield Credit Cycle from the portfolio managers – Ed Meigs and Sean Slein – at First Eagle Investment Management.
- Investor confidence returns to the High Yield Market before the Equity (Stock) Market, as experienced in 2008.
- Credit Cycles: Investors respond to the historical environment—what has been happening in their recent memory—not to what is happening in the current environment.
- Widening credit spreads may imply a possible recession ahead.
- Throughout the credit cycle, defaults tend to be clustered in specific sectors.
Relevance of high yield assets to equity investors (stock) investors
Understanding high yield provides equity investors clues as to how open the credit market is, how much risk investors are willing to take at any given point in time and, essentially, trends within the economy – which sectors are doing well and which are not doing as well.
They (Ed Meigs and Sean Slein) believe the high yield market specifically and the fixed-income market generally will lead the equity markets, just on a macro level. For example, in late 2008, the high yield market began to recover as the primary market opened up and investors began to dip their toe in the water and add risk to their portfolios.
The equity market did not begin its recover until early March of 2009, while the high yield market was in recovery for probably two and a half months before that. Conversely, back in June of 2007, the high yield market had reached its highest level as far as its spreads to Treasuries for the cycle and began to incrementally widen out, beginning in late summer and early fall, which led the equity market by another three to four months. The equity market peaked in October of 2007.
High yield can be a leading indicator because high yield upside is capped to the coupon that you’re receiving and the par level of investment that you’re going to receive back, hopefully, at maturity. With equities, on the other hand, since it’s a residual claim and since you can hold them much, much longer you upside is theoretically uncapped. So equity investors tend to perhaps be a little more patient if a company misses a quarter or two, where many high yield investors will seek to transition out of companies fairly quickly when they see performance begin to erode.
An important fundamental concept about the high yield cycle is that at every stage, investors are responding to the historical environment – what has been happening in their recent memory (recently bias) – not what is happening in the current environment.
The environment for high yield [in 2012] is a lot different that it was back in 2006-2007 – years when spreads were very tight. Companies have generally focused on repairing balance sheets and also modifying their cost structure, so they’re in a much healthier financial condition. High yield issues have generally been using the proceeds from the primary market to refinance their debt, not to leverage transactions. So the general market leverage is a lot lower than it was three to four years ago.
Because investors respond to the historical environment – what has been happening in their recent memory – not what is happening in the current environment, it results in the market generally mispricing risk, resulting in spreads that are tighter than they have been historically, despite an environment where leverage is going up and market risks are going up, as well. Conversely, as the market gets defensive, as spreads begin to widen and other elements of corporate distress, the market will overprice risk or spread levels will be distorted to a degree that may overstate market risks. As the credit cycle moves forward and as spreads tighten, we would expect more leveraged buyouts and equity-friendly transactions to occur and refinancing activity to decline over time. We are beginning to see more M&A activity.
Definition of a few concepts mentioned.
Investment Philosophy within the High Yield Fund.
Fundamental basis – built from the ground up, credit-by-credit basis building what we consider to be a margin of safety into our investment. Our safety of margin is a little bit different than on the equity side, but philosophically it’s the same concept. We look at the margin as buying a bond at an appropriate place in capital structure, with an appropriate cushion of leverage to enterprise value.
First try to ascertain where we are in the credit cycle. When we determine what sectors we want to avoid, it’s because of the risks we see embedded in man individual firms within the sector. Throughout the credit cycle, defaults tend to be clustered in specific sectors.
We keep a close eye on what the market is telling us. As we move forward, we would expect fewer refinancing transactions and more equity-friendly-type transactions and, along with that, credit spreads to continue to tighten. So the market will get riskier, but spreads will be implying that, actually, risks are going down. And then during that process, as the market gradually becomes a little bit riskier, we’ll become, very gradually, a little bit defensive and our portfolio risk will likely move inversely with the risk of the market.
The high yield market tends to be a very new-issue-driven market, so most things that are added to our portfolio when the market is open are coming from the new-issue market. New issues are priced at a discount to existing paper and so it’s an attractive way to get involved in a new name.
Free cash flow is very important, because that dictates the company’s ability to repay debt over time. And, obviously, the overall capital structure, the overall amount of leverage is going to be a key driver as well.
Avoiding companies with high fixed structures, those that are relying upon unrealistic growth to service their debts, and those whose survival depends on the new-issue market remaining open.
We will buy discounted bonds that have fallen out of favour with the market for whatever reason. Because the spread is just a combination of the coupon and the price.
So the lower dollar price increase the overall yield on the security. We generally look at the spreads and the spread per turn of leverage (Defined as: As the change in yield of the issuer’s high yield debt relative to the increase in the ratio of debt to EBITDA) that we’re getting at any given point in the capital structure. Generally, the higher up in the capital structure you are, the lower the leverage you have. And each point in the capital structure has its given yield.
Yours in Investing
Adam C. Parris
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Additional Links and Sources.
First Eagle Investment Management – Strategies & Insights.
High Yield Notes from both 2012 & 2013 interviews for the PM’s Perspective insights series. By Ed Meigs and Sean Slein Discuss Investing in High Yield is an issue of The PM’s Perspective at First Eagle Investment Management.
Article by Searching For Value