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Fixed-Income Insights

How does today's high-yield market compare to the last three periods of elevated yield spreads and distressed credit conditions? Here's a look.

 

In Brief

  • Recent fears about a slowdown in the U.S. economy have been accompanied by concerns about the end of the credit cycle and deterioration in the U.S. high-yield market.
  • Are those fears justified? An examination of conditions in the high-yield market of 2015 versus those of three prior periods of stress for the asset class—1989, 2000, and 2007—may prove useful.
  • Based on measures of leverage, interest coverage, and credit quality for newly issued bonds during each period, stress levels in 2015’s high-yield market are nowhere near those of prior periods.
  • The key takeaway—Overall, the deterioration in the high-yield market that accompanied the widening yield spreads and increased default rates of past cycles is not evident today.

 

The August–September 2015 rout in U.S. equity and credit markets has stirred investors’ fears that the end of the current U.S. economic cycle is near. Seven years of economic growth—all of them subpar compared with prior expansions—already exceeds the average length of historical U.S. recoveries. Those who believe in a fixed expiration date for economic cycles would hold, then, that recession is just around the corner. But this simplistic view ignores historical facts. As economists have said before, expansions don’t die of old age, they get murdered. The prime suspect in these cases is aggressive central bank policy designed to reduce rising inflation, often by slowing the economy. 

And while this has recently happened elsewhere (Brazil is a prominent example), the United States is not likely to follow. U.S. inflation is not worrisome. The U.S. Federal Reserve is not on track for aggressive tightening; the central bank’s current intent instead is to allow continued expansion, not contraction. 

What, then, is the performance of the U.S. high-yield market telling us? Does recent spread widening (that is, an increase in the yield differential versus U.S. Treasuries) indicate the end of the credit cycle, a deterioration in the financial standing of high-yield issues that normally presages a spike in yields, an increase in defaults, and poor performance for high-yield bonds? Or is it a reflection of investor nervousness about global events that eventually may have little influence on high-yield securities, many of which are issued by companies with U.S.-focused businesses? 

Almost by definition, the time we have spent in economic expansion suggests we are farther along in the credit cycle than when corporations began debt refinancing six years ago. Significant M&A activity, wider yield spreads and an increase in defaults, at least in the energy sector, support the perception that credit risks may be increasing. However, corporate fundamentals suggest that we are not at the brink of broad difficulties associated with late credit cycles. Stable leverage, continued earnings growth and contained interest expense suggest that while risks exist in specific areas such as energy and mining, opportunities remain available for active managers willing to research individual credits to find attractive opportunities.

Over the past 30 years, there have been three clear credit cycles—beginning in 1989, 2000, and 2007—where high-yield spreads have spiked, defaults increased, and recession eventually followed. Looking at the characteristics of high-yield securities during these periods will provide a baseline against which we can assess the creditworthiness of the high-yield sector today. We will use this analysis to answer the following investor questions about the current market.

Is Leverage Approaching Dangerous Levels?
The first characteristic to compare across periods is leverage. Leverage (defined as the ratio of an issuer’s debt relative to earnings) provides an indication of potential financial stress. In an economic downturn, reduced corporate earnings could create debt or interest payment problems if leverage is too high. If the downturn is accompanied by rising interest rates, payment and refinancing problems can be exacerbated. 

One useful way to measure leverage is to look at the characteristics of new high-yield issues. Table 1 indicates that new issues in the high-yield market in the first half of 2015 had less leverage than during the previous three stress periods. At 5.0 times EBITDA (earnings before interest, taxes, depreciation and amortization), debt in 2015 has been lower relative to earnings than the 5.3–6.1 times EBITDA during previous stress periods. For additional perspective, the 5.0x measure of 2015 is close to the 4.9x average of the most recent five years, 2010–14. While this metric is worth monitoring, the market does not appear to be in dangerous territory.  At five times earnings, current leverage does not seem excessive.

 

Table 1. How Do New High-Yield Bonds of 2015 Compare in a “Stress Test”?
Yield spread, leverage, and interest coverage data for indicated periods

Source: Credit Suisse. Data through June 30, 2015. Yield spreads represented by the Credit Suisse High Yield Index.
Past performance is no guarantee of future results. It is important to note that the high-yield market may not perform in a similar manner under similar conditions in the future. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Are Earnings Adequate to Sustain Interest Coverage?
Comparing earnings to interest expense provides a quick overview of company’s financial health. Interest is often a significant item on high-yield balance sheets, and with recent low rates, investors would expect low expense relative to earnings. The numbers do not disappoint. Table 1 indicates that issuers of new high-yield securities in the first half of 2015 had measurably better financial health by this metric (3.0x), compared to the range of the three periods of high-yield stress over the last 30 years (1.6x to 2.5x). 

The relative strength of 2015’s interest coverage versus previous periods extends to specific rating categories. The interest coverage of ‘B’ rated (3.0x) and ‘CCC’ rated (2.3x) new-issue securities in 2015 is actually higher than the entire high-yield category for the 1989 and 2000 periods. By this measure, new-issue credits today would have to deteriorate significantly in credit quality (from ‘B’ rated to close to ‘CCC’ rated) to match the characteristics of the high-yield market during past periods of stress. This ratio suggests that the high-yield market today is within normal measures of financial health.

Is High-Yield Debt Riskier Today Because of Its Structure?
Another measure of risk for high-yield investors could be the late-cycle tendency for debt to be structured for interest payments (coupons) to be deferred, or paid “in-kind” (PIK) with additional debt rather than with cash. These PIK or deferred notes can be viewed as more speculative types of deals. Such payment structures enable borrowing by a company without the capital to service the debt. Similarly, so-called toggle notes give the issuer an option to pay interest in cash, in kind (often at a higher rate), or a combination of the two.

Where do the new issues of 2015 fall in this spectrum? The structure of new high-yield issues today is not creating riskier instruments for investors. According to J.P. Morgan, through August 2015, there were no PIK or deferred structures among newly issued high-yield bonds, and only 0.3% of the new-issue supply was structured as toggle notes. This compares to a yearly average of 3.0% of new issues structured as PIK or deferred and 5.8% as toggle notes during the 2005–08 period. (PIK securities were not available in the earlier stress periods.) It appears that investors today are not being asked to absorb the structural risk of non-cash paying securities that characterized the last credit cycle.

How Do New Issuance Credit Ratings Compare to Historical Periods of Stress?
In a broad comparison of new issues rated split ‘BB’ (that is, carrying a ‘BB’ from one credit rating agency and a ‘B’ from another ) or higher to those rated ‘B’ or lower, the quality of new issues in 2015 exceeds that of the last three periods of high-yield stress. Table 2 shows that new issuance in 2015 remains tilted toward the higher credit-quality end of the high-yield spectrum. The deterioration in issuer creditworthiness, or the pursuit of higher yield at the expense of lower quality that may have characterized past periods of high-yield stress, seems absent today. More than 50% of new issues in 2015 were in the higher-quality half of high-yield ratings compared with 23% to 33% during periods when high yield was in the early stages of distress. Investors today are able to choose from a universe of new issues that is generally higher in quality than during past periods when the market performance of high-yield issues became a concern.

 

Table 2. Credit Quality of New High-Yield Issues in 2015 Is Higher Than the Last Three Periods of Market Stress
Percentage of new issues by rating category for indicated periods

Source: Credit Suisse and J.P. Morgan.
Past performance is no guarantee of future results. For illustrative purposes only and does not represent any specific Lord Abbett mutual fund or any particular investment.

 

Does More Issuance for Acquisitions Suggest a Tilt Toward Dangerous Borrowing?
Bonds sold for the stated purpose of corporate acquisitions increased from an average portion of 20% of new issuance in the 2010–14 period to 37% so far in 2015, according to J.P. Morgan. While this appears to be a concerning trend, it may actually reflect a more risk-averse business environment where financing is inexpensive and it is easier—and more economically effective—to buy than to build new businesses. Regardless, the 37% figure for 2015 compares favorably to 44%, 52%, and 46% in 2006, 2007, and 2008, respectively. A related comparison provided by Credit Suisse suggests that in the first half of 2015, leveraged buyout (LBO) acquisitions as a percent of high-yield new issuance were only 4.9% of proceeds, compared with 25–30% in 2007. Neither the level of issuance for acquisition nor the portion of LBO acquisition financing seems to be cause for concern. 

Furthermore, acquisitions are not inherently high-risk decisions. Many represent intelligent and profitable purchases. Thorough credit research is likely more effective at distinguishing between problems and opportunities than the gross level of debt issuance for acquisition. It also is interesting to note that the portion of new issuance for refinancing should be expected to decline, because most companies already have refinanced and because gradually rising rates will reduce future refinancing opportunities. 

Is the Financial Health of the High-Yield Sector Improving or Deteriorating?
While it is difficult to capture and summarize the balance sheets of all issuers in the high-yield market, the ratio of upgrades to downgrades issued by major credit rating agencies may be an effective proxy for improving or deteriorating credit quality. At 0.9 for the first eight months of 2015, the ratio has declined, from 1.2 in 2014, and is close to the 0.8 measure for 2007. This metric bears watching, but further analysis suggests that the energy sector may be responsible for the apparent deterioration. As the largest component within the high-yield universe, energy-related companies were downgraded to reflect the dramatic drop in the price of oil, but could skew the upgrade/downgrade ratio to a lower level that is not representative of the broader high-yield sector. The ratio remains a key indicator of the sector’s credit standing, but needs to be viewed for now in the context of the oil-price decline.

What Conclusions Should We Draw from All This? 
Characteristics of today’s high-yield market do not seem to resemble those of prior periods of credit-cycle stress. Leverage does not seem excessive. The ratio of earnings to interest expense suggests that companies are better able to keep paying coupons. Investors are not being asked to accept securities with riskier structures; in fact, they are being given the opportunity to choose among new high-yield issues of relatively high quality. To be sure, it is likely that there will be an increase in distressed and defaulted credits in the energy sector. But overall, the deterioration in the high-yield market that accompanied the widening yield spreads and increased default rates of past cycles is not evident today. 

 

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