As many of my readers know, one of my favorite spaces within the ratings distribution of the bond market is the "BB" and "BB/BBB - 5B" as it presents the best risk/reward profile within the ratings spectrum. High yield has had a banner year thus far:
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The quality categories have the following attributes:
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There are, however, headwinds facing the high yield/crossover market, among these are:
- The global macro situation - the slowdown facing the largest economies (and therefore their corporate entities) creates a situation where growth in key metrics (revenue, EBITDA, Operating margins and cash from Operations) will be harder to achieve.
- Overconfidence/complacency - as the market has done well and more individuals are searching out yield, there is the risk that deals are printed with weaker covenant protection and companies are funding in the unsecured market that should be funding in the secured market.
- Demand - demand for yield has attracted many retail and institutional investors into the space that might not normally occupy the space creating yields that are tighter than they would otherwise be.
These risks, while present, have not yet begun to materially affect the market although I believe they will catch up with investors in the intermediate term. That said, Fitch ratings recently presented to the NYSSA (New York Society of Securities Analysts) their views on the market and data which continues to support investment within this market. What follows are some of their presentation points that should be considered when investing in the sector.
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This is where I see the greatest risk of complacency, the default and recovery rate for high yield has been below average. This low level of defaults (and high recovery rates) cannot be sustained indefinitely, but it looks steady and favorable for the near-term.
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The number of issuers defaulting has begun to increase, which bears watching for a turn on the good times we have been having.
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The distress ratio has picked up, but is still within reasonable levels.
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Fundamentals, however, continue to be strong and supportive of the high yield asset class. While I expect these to moderate somewhat, the risk in not near-term.
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Another positive factor is the use of proceeds from the issuance, with a greater percentage being used to refinance and grow the business (CAPEX).
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As I stated earlier, one of the risks/headwinds I see facing the market is the global slowdown we are witnessing. Should global GDP continue to contract, it is reasonable to expect default rates to increase - although I do not expect it to be of the same magnitude as earlier slowdowns due to the strength of the balance sheets at the current time.
Bottom Line: The high yield market continues to have fundamentals that support its continued performance over the near-term. I would expect demand to continue to be strong across the unsecured and levered loan markets as investors seek out yield and companies are all to happy to supply it to them. It is, however, times like this when investor vigilance has to be high, looking for signs of weakness as complacency is the greatest risk.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: This article is for informational purposes only, it is not a recommendation to buy or sell any security and is strictly the opinion of Rubicon Associates LLC. Every investor is strongly encouraged to do their own research prior to investing.
