PMC Weekly Review - July 28, 2017
Just as Miss Gulch (the mean neighbor in the Wizard of Oz who wanted to have Toto put down) turned into the Wicked Witch of the West, the high yield credit market from 2007 has changed substantially into what we know today. In fact, one of the comparisons between 2007 and today is the tightness of credit spreads. The high yield market in 2007 was characterized by tighter monetary conditions and new issuance being driven by leveraged-buyout (LBO) financing, leading to a higher amount of CCC-rated issuance. In contrast, the high yield market in 2017 is characterized by relatively accommodative monetary policy, limited LBO transactions (despite healthy mergers and acquisitions (M&A) activity), and new issuance dominated by BB-rated companies. In short, although there are similarities between 2007 and 2017, there are also vast differences in the factors driving high yield markets today.
The weighted average Option Adjusted Spread (OAS) of the Bloomberg Barclays US Corporate High Yield Index (or the gap between high-yield bonds and comparable-maturity Treasury bonds), now at 334 bps , recently crossed 2007 levels. Historically, the median spread is 534 bps,2 but this can be misleading, as the high yield market’s makeup has changed. Since 2012, 55% of new issuance has been BB-rated, compared to a 20-year average of 42%.1 As a result, the Index now comprises 45% BBs (on a par value basis), up from 36% at the end of 2007.2 The largest high yield issuers today are generally publicly traded companies raising capital for either corporate M&A or refinancing. This is in contrast to a decade ago, when roughly one-fourth of new issuance was LBO financing, with CCC new issuance at 15%, versus 7% today.1
As alluded to, the high yield market has shifted from an environment of elevated LBO transactions to more sensible financing. LBO volumes have declined significantly over the last few years, with LBOs as a percentage of new issues at 3% YTD, representing a mere fraction of 2007’s peak levels of 33%.1 Companies have been able to execute M&A transactions successfully by using their large cash positions, their own equity, or sound financing that employs less leverage. This is a positive development, as most companies are exercising fiscal discipline, and there are few signs of a credit bubble developing, even though we’ve entered the latter stages of the credit cycle.
Another change affecting the high yield market is global monetary policy. In 2007, monetary policy was not nearly as accommodative as it has been since the 2008 crisis. Currently, lower borrowing costs continue to inhibit companies from increasing their leverage ratios. On average, below-investment-grade bond issuers’ interest coverage ratios stand at 3.0x, just under the historical average of 3.2x.1 These metrics suggest borrowers can support their debt service for the foreseeable future. In addition, default rates have generally been well below their historical average of 3.8% for several years (excluding a spike in the Energy sector in early 2016 due to falling oil prices).1 And, when excluding the commodity sectors, the default rate falls to a mere 0.5%.1 Additionally, with the weakest of the commodity companies now weeded out, and increased stability in energy and commodity prices over the last 12-18 months, defaults in the commodity sectors are down to 2.5% so far in YTD 2017.1 The general decline in the number of defaults since the financial crisis affirms the assumption that refinancing at lower costs has reduced the debt burden of many high yield issuers, leading to better overall credit fundamentals. The technical conditions of the high yield market also appear poised to remain supportive in 2017. During the second quarter, $23 Billion of high yield issuance came to market and was easily absorbed by strong demand.1 Industry-wide flows into high yield mutual funds have been strongly positive, and we think this trend will continue, as non-dedicated high yield investors will likely continue to move into the sector in pursuit of its strong recent performance and high income characteristics.
Also encouraging is the quality of this issuance, or the way high yield companies have used the money they’ve raised. The past several years have been dominated by the three Rs—redeem, repay, refinance—and most new issuance has been to redeem existing bonds, repay banks, or refinance outstanding debt. This means that companies aren’t dramatically increasing debt, but rather are either lowering their financing costs or extending the maturity of their debt. According to a recent survey by J.P. Morgan, in the first half 2017, refinancing accounted for 64% of issuance, while acquisition activity accounted for 17%. The three Rs should continue to provide investor demand for the high yield market, even at these low yield levels. Finally, unlike high-quality fixed-income securities that tend to perform best when an economic slowdown drives interest rates lower, high yield securities often perform well during periods of economic growth, as growth generally improves profits and reduces the risk of default. Thus, persistent 2% economic growth, supported by employment growth and rising wages, produces support for the asset class.
Overall, limited investor leverage, the composition of new-issuance since early 2009, and a focus by corporations on deleveraging versus releveraging have made the high yield market much healthier today compared to 2007. So, while high yield credit spreads resemble those of 2007, the dynamics of the market today are far more akin to being “Somewhere Over the Rainbow” than broomsticks and flying monkeys.