- Fundamentals remain generally stable and high yield appears to be fairly valued, despite relatively low all-in yields.
- We are monitoring shifting dynamics that could lead to a weaker consumer and lower operating margins, but we aren't seeing any near-term signs of stress.
- With the surge in BBB issuance, fallen angel risk is top-of-mind for most. We believe the near-term downgrade risk is low and issuers are generally well-positioned to refinance upcoming maturities.
- Distressed ratios have ticked up modestly in recent months, but remain well below the peak in 2016. Signs of stress remain isolated to certain industries.
What are your current views on high yield fundamentals?
High yield fundamentals have been fairly steady over the past year as management teams have limited debt growth, while EBITDA is up modestly. Most high yield companies are benefiting from the drop in rates and have been able to lower their interest costs through bond refinancing and floating rate loan adjustments. This has led to generally stable interest coverage ratios.
It is interesting to note that the high yield market, as represented by the Bloomberg Barclays US Corporate High Yield index, has the highest average credit quality – highest percentage of BBs and lowest amount of CCC & below – since October 2002 (Exhibit 1).
Exhibit 1: Credit quality composition of the high yield index
Source: Bloomberg Barclays US Corporate High Yield Index. Data from October 2002 to September 2019.
In addition, the index is near the shortest duration on record at 3.07 as of September 30, 2019 (Exhibit 2). This is important to keep in mind when comparing spreads historically as high yield is better quality and shorter duration than ever before. In other words, although yields are low, we view high yield as being fairly valued for the given level of risk.
Exhibit 2: Duration of high yield index declines to all-time low
Source: Bloomberg Barclays US Corporate High Yield Index. Data from October 2002 to September 2019.
Which financial metrics are you closely monitoring at this stage in the cycle?
We are paying close attention to operating margins. Revenue growth has slowed in 2019 as management teams have been hesitant to spend on capital expenditures, or capex, given US/China tariff tensions, Brexit uncertainties and global growth concerns. Many US high yield companies have been able to maintain operating margins through cost cutting efforts and with the help of lower commodity prices. The tightening labor market could start to put upward pressure on wage expenses, leading to lower operating margins and cash flows.
In general, the US consumer has been very resilient for the past several years. A strong job market, low interest rates and falling commodity prices, such as lower gasoline prices and decreased utility expenses, have led to a positive environment for the consumer. We are looking for any signs that the consumer is starting to pull back on spending. Given personal consumption makes up nearly 70% of US GDP, a weaker consumer could present problems for the economy.
Has the rise in outstanding corporate debt caused stress in the high yield market?
No, the increase in outstanding debt has not caused a significant increase in the distress ratios of US high yield issuers. The majority of new corporate debt issuance has been from high quality investment grade companies rather than high yield issuers. The outstanding high yield debt has not grown the past five years as debt levels hover around $1.2 trillion (Exhibit 3). Stable high yield debt has been the result of limited net new issuance, many private equity sponsor transactions getting funded in the leveraged loan market and a lack of fallen angels.
Exhibit 3: High yield corporate bond market growth lags BBBs
Source: Bloomberg Barclays US High Yield Index and Bloomberg Barclays US Corporate Index (BBB data). Data from July 2014 to September 2019.
That being said, within investment grade credit, the growth in corporate debt has been significant, increasing by 56% over the past five years, through September 2019. More importantly, BBB non-financial bonds have grown by 82% over this same timeframe. The growth in BBBs has been largely due to mergers and acquisitions, to fund share repurchases, and capex. As management teams recognized there are limited benefits of being an A-rated issuer versus a BBB issuer, they have become more aggressive in their optimal capital structure, resulting in a rise of BBB-rated debt.
As high yield managers, we pay close attention to BBBs as that market segment can have a significant influence on high yield market levels, especially if credit quality deteriorates. The combination of a weaker growth environment and an increase in fallen angels could be one scenario that may lead to a higher proportion of distress ratios in the high yield market. However, at this point, we believe the near-term downgrade risk is low as the economic backdrop remains generally supportive and corporate fundamentals are stable. In short, we don't believe the BBB credit bubble is ready to burst anytime soon.
Are you concerned about refinancing risk associated with upcoming maturities?
In addition to fallen angel risk, we keep a close watch on the upcoming maturity walls. During times of stress, particularly when the high yield markets become less liquid and new issuance comes to a standstill, those companies with near-term maturities are at risk of being unable to refinance these obligations, potentially triggering default. While there's been a slight buildup in front-end maturities in recent years, we believe the high yield market is positioned to withstand a typical market disruption. Most issuers have prudently termed out their maturity profile, reducing the risk that companies are unable to refinance near-term maturities.
Have you witnessed an increased in distressed bonds?
We define the distress ratio as companies trading below 70 cents on the dollar. Using this definition, distressed bonds have ticked up slightly to 4% since the recent September 2018 lows, but remain well below the peak of 19% in January 2016 according to JP Morgan (Exhibit 4).
The uptick in distress ratios is due to multiple dynamics including the decline in energy prices trading in late 2018, stress associated with China tariffs, opioid litigation in the pharmaceutical industry, potential healthcare policy shifts, wireline competition and heightened retailer deterioration.
Exhibit 4: Distressed bonds have modestly increased, but remain well below peak levels
Source: JP Morgan. Data from January 2010 to July 2019.
Which sectors or industries do you believe are most at risk of future distress?
In our view, the sectors most at risk of future distress include energy, healthcare, pharmaceuticals, retailers and telecom wirelines.
- Energy remains a large part of the high yield market. Any deterioration in oil and natural gas prices could lead to an increase in defaults.
- Healthcare includes a number of private equity companies that have relatively high leverage. Surprise billing legislation – a solution aimed to curb unexpected out-of-network charges for consumers – is likely to lead to lower revenue for several healthcare companies.
- Pharmaceuticals have been under pressure from lower generic pharma pricing and potential opioid settlements.
- Retailers – Department stores and specialty retailers have been under pressure from on-line retailers.
- Telecom wirelines have been in slow decline as residential customers move to wireless.
However, each sector has its own risks and recent trends are not necessarily symptomatic of broader stress in the high yield market. The broader high yield market has remained resilient year to date against a backdrop of macro and geopolitical uncertainty. Looking forward, while we are cognizant of potential macro headwinds, we view the underlying fundamentals of the high yield market as remaining supportive in a slow but stable economic environment.
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