By Anthony Harrington
In its latest reports on U.S. and European high-yield corporate debt, the ratings agency Fitch flagged up the fact that the trailing 12-month default rate on this asset class rose above 2% for the first time since October 2010, hitting 2.2%. However, the high-yield space continues to provide very attractive returns for investors and Fitch says that the default level remains on track to be between 2.5% and 3% by the end of 2012, despite increasingly difficult trading conditions.
The funding environment for the weakest companies in the high-yield universe began to sour in the summer of 2011, following a further escalation in the European debt crisis, disappointing data on the critical US housing and labor markets and disruptions caused by the US debt ceiling debate. Defaults have since been heavily concentrated at the ‘CCC’ level. The share of ‘CCC’ or lower rated bonds trading at the distressed level of 80% of par or lower remains significant at $55 billion. This is down from $65 billion at the beginning of the year but due almost entirely to defaults leaving the universe of performing issues.
When you have a large enough universe of stocks then a 2% failure rate for a fund is simply going to “prove” the validity of the high-yield premium being paid out for that debt. It is not going to damage that premium significantly. As Fitch points out, the weighted average recovery rate on defaults through May was strong, at 56.9% of par.
Unlike a stock, which can slip from tens of dollars to cents, or even become valueless, corporates are still worth something when they default. Liquidators extract value, there are working parts to sell, and increasingly, there is collateral to back the bond. With investors getting slightly better than half their money back even where defaults occur, the overall returns stay strong. Moreover, the fact that the bonds are traded below par when a company is perceived as running into difficulties, gives active corporate debt fund managers an opportunity to add to the capital value of their holdings through the time honored strategy of buying low and selling high. All it takes is picking the troubled companies who have a good shot at recovering.
In other words, an active bond manager has to know the companies his or her fund is investing in extremely well, at least as well as an equity manager. But it is important for potential investors in high-yield funds to realize that an equity fund manager and a bond fund manager are looking for very different things when they look at a company. An equity fund manager will only see an improvement in a stock holding if the market judges that the company involved (or at least the sector it is involved in) is increasing its earnings potential and is showing tangible signs of fulfilling that potential.
In some ways corporate debt managers set a lower bar. They are not particularly interested in a company’s growth potential except tangentially, in that a company becoming more cash generative will provide even better security on the bond. Obviously a company that is prospering, that is growing, is a better debt prospect by a mile than one that is losing money. But strong growth is not a necessary prerequisite for a debt manager. What they want is a company that at the very least can just keep on trucking, earning enough to enable it to stay the course and repay its debt in full on maturity, or, which comes to the same thing, be an attractive enough proposition for it to be able to roll over that debt on or near maturity with another corporate bond. Equity managers hunt growth, corporate debt managers look for stability. It’s as simple as that.
However, this distinction also means that companies that would be unattractive to an equity manager, since they lack a growth story, may well be quite attractive to a corporate debt manager, since they generate a solid, if unexciting cash stream.
What investors should not do is to allow that lack of excitement in some instances of corporate debt to cloud their judgment of the returns that corporate debt has been generating from 2009 to the present. Increasingly institutions are realizing that while banks might not love CCC rated companies, their debt can have a very useful role to play in investment portfolios generally. The high-yield space looks set to become ever more interesting to a wider range of investors over the next few years—even if the “once in a lifetime” opportunities to profit from high yield have passed for the present.