The High Yield Market is "Completely Out of Control."

The title of this post comes from a quote from a buy side friend working at one of the largest hedge funds out there. I 100% agree with his assertion. Howard Marks also agrees (see his most recent letter here: http://www.oaktreecapital.com/MemoTree/Ditto.pdf). He writes:

"Regardless of the reason, things are happening again today - especially in the credit world - that are indicative of an elevated, risk-prone market:
  • Total new issue leverage-finance volumes - loans and high yield bonds - reached a new high of $812 billion in 2012, according to Standard & Poor's, surpassing by 20% the previous record set in pre-crisis 2007.
  • The yields on fixed incomes securities have declined markedly, and in many cases they're the lowest they've ever been in our nation's history. Yield spreads, or credit risk premiums, are fair to full - meaning the relative returns on riskier securities are attractive - but the absolute returns are minimal. I find it remarkable that the average high yield bond offers only about 6% today. Daily I see my partner Sheldon Stone selling callable bonds at prices of 110 and 115 because their yield to call or yields to worst start with numbers - 'handles' - of 3 or 4 percent. The yields are down to those levels because of strong demands for short paper with perspective returns in that range. I've never seen anything like it.
  • As was the case in the years leading up to the onset of the crisis, the ability to execute aggressive transactions indicated the presence of risk tolerance in the markets. Triple-C bonds can be issued readily. Companies can borrow money for the purpose of paying dividends to their shareholders. And CLOs are again being formed to buy leveraged loans with heavy leverage."
I find it interesting: Many many people realize the market is heavily overvalued in terms of compensation of return versus risk, but they still are buying. Maybe they NEED to buy because they are an insurance company or pension that can't find yield anywhere else that high yield bonds. Or maybe they NEED to allocate capital because they are getting inflows from retail/new investors. Maybe they think all is clear for the foreseeable future and hence are happy to clip a fat coupon for the interim period. I am hearing primary markets are simply a food fight amongst large funds trying to get whatever allocation they can get a hold of to put money to work for coffers that seem to be only growing from demand in the asset class.

In all honesty, it is very very hard to be a mega fund in high yield credit. How many times can you look at TXU or CZR/HET? Accounts were a little busy at the end of the year getting up to speed on Mittal but that too has been a buying frenzy. Where the value lies, in small, off-the-radar, thinly traded securities, is marginally off limits to these funds because 1) They can never get size on a position to move the needle 2) If they did get the size they wanted, they'd be a huge % of noteholder base, a position a lot of funds do not want to be in when everyone is running for the exit.

From talking to people on the syndicate desks it looks like issuance will continue to ramp throughout the month, especially considering some of the macro concerns (debt limit being hit, more negotiations on grand comprise) that await us in February / March context. I wouldn't be surprised if we also saw a big M&A issuance calendar as we move throughout the year.

In September 2012, I wrote a post entitled "An Open Letter to CFOs Across America." It seems like many CFOs / corporate treasuries read my post and took the advice to heart. We've seen a significant amount of refinancing,  dividend deals, M&A (to a lesser extend than I would have thought). For those that were around in 2005/2006, you may remember this exact feeling you are feeling today. Probably less so because absolute yields are just so low now relative to that time period.

The problem of course is bullish behavior which turns into recklessness continues until it doesn't. A very good friend and mentor of mine once said "Liquidity in the market, just in general, it can change on a dime." I often tell this story but in 1Q 2007, I met with a number of CSFB salesmen about the current market environment at that time (crazy). One of the quotes I wrote down, and still remember to this day: "It seems overdone, but its hard to imagine what's going to stop this." We know how that turned out.

Howard Marks, in his letter, also wrote:

"Equities are still being disrespected, and equity allocations reduced. They they are not being lifted by comparable income-driven buying."

A tenet, never proved, but often said in passing among the buy side is that the credit guys lead the equity markets. When credit gets shaky, soon after equities do as well. Its hard to tell if the forced buying, i.e. yield chasing, will spill over into the equity market in the form of stretched valuations. In theory though, when credit is robust, investors start pulling out things like the LBO calculator, or sum of parts valuation - in evaluating spin offs, that almost inevitably lead to higher equity values.

What excites me? The next cycle. Even assuming a modest default rate of 5-6%, given the amount of high yield and leveraged loans that have been issued in the past few years, the notional values are enormous, especially if you thrown in a few wildcards of huge complexes that file (Maybe not another Lehman, but another behemoth that will keep distressed investors busy). Add to this any opportunities that comes out of Europe and distressed investors will stay more than busy.

In the interim, companies are still filing for bankruptcy (THQ, Penson, etc). As distressed investors our job is to source, evaluate, and analyze those situations as they come across our desk and look to allocate capital where the return is much more commiserate for the risk, while offering downside protection in a margin of safety. That feels MUCH better than buying CCC bonds with a 6 handle.


Anonymous,  1/14/2013  

This is unfortunately what happens when government takes a stance of rescuing institutions which have had leverage destroy them. It is unfortunate but the US regulators and government (and by extension all taxpayers/voters) have brought this on themselves.

Anonymous,  1/15/2013  

Getting excited about the "next cycle"? Been hearing that since 2008. Recall all the distressed debt Hedgies with thier power point presentations on how much debt is coming due and how it will all blow up blah blah blah. Fact of the matter is that if the government keeps interest rates at zero, you may want to educate your kids on how to benefit from the "next cycle" because it could take a while.

eah,  1/16/2013  

commiserate for the risk

Huh? You mean commensurate -- 'where the return is commensurate to the risk'.

David Merkel 1/16/2013  

Agree that relative value is poor, but we need two things to happen before we wash out:

1) Borrowers that are unlikely to make coupon payments.

2) Overlevered lenders that depend on coupon payments for themselves to remain whole.

So look at the owners of the riskier notes -- what condition are they in... that will give you a clue to the future performance of the markets.

Anonymous,  1/17/2013  

It seems to me that the credit markets are very robust because people continue to shun the equity markets and yet need "yield."

This is likely more of a foreshadow that the equity markets will do quite well in the next 2 years than anything negative occurring in the debt markets. Overall equities are fairly to under valued. This is especially true with financials.

Interestingly, you can purchase Oaktree with a 4.6% dividend. So you get the best distressed investor, with a good dividend yield, and also get to take advantage of any upside in the equity markets.

I know where my money is going............


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.