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Fixed-Income Insights

Companies' refinancing of high-yield debt has lowered interest costs, extended maturities, and helped shore up balance sheets. 

In last week's Market View, we examined why the spread between the yield on high-yield bonds and that on U.S. Treasuries is below the long-term average, and why it may stay that way for some time. We concluded that market fears that yield spreads will widen soon, and that prices on high-yield debt will correct, appear to be unfounded. Why? One reason we touched on last week was that spreads typically rise in anticipation of increasing defaults. But indications are that default rates will remain low through the end of 2015.

This week, we'll take a closer look at one reason why default rates likely will stay low, and examine other positive trends for the market. The first factor to consider is the rate at which companies are refinancing their high-yield debt. Companies refinance their borrowings when they can issue new debt at lower interest rates. Lower interest rates mean decreased interest costs for the company, as the payments it has to make on its debt are smaller.

Considering that more than 50% of the issuance in the high-yield market since 2010 has been for refinancing, according to J.P. Morgan, there has been a steady decline in interest expense for issuers in the high-yield market. (See Chart 1.)
 

Chart 1. Refinancing Has Helped Reduce Interest Expense for High-Yield Issuers
Last 12 months of interest expense as a percentage of total debt outstanding for high-yield issuers, as of February 28, 2014 (latest available data)

Source: BofA Merrill Lynch Global Research.
LTM interest expense (%) = last 12 months of interest expense as a percentage of total debt outstanding.
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. 


The current wave of refinancing has led to lower financing costs for companies, which makes them more likely to be able to pay their debt, strengthen their balance sheets, and improve their credit profiles. The relief from higher interest costs also could free up cash for capital spending to boost revenue growth. More important, it could make these companies better able to withstand economic downturns.

That last point may be underscored by another noteworthy trend. An additional effect of the refinancing push is that the maturity dates of the debt (when final repayment is due) are extended into the future. For instance, if debt were issued in 2005 with a 10-year maturity, the principal had to be repaid in 2015. If a company refinanced that 2005 debt in 2010 at a lower interest rate, with the new bonds due in 10 years, the maturity would be extended to 2020, meaning there is another five years until the final repayment is due.

Chart 2 illustrates how this has played out in recent years. In December 2008, for example, the high-yield market had a large volume of debt coming due in 2013–16. This "maturity wall" led to fears in the market that this volume of repayment would cause difficulties for issuers. The recent refinancing wave has replaced much of this debt, and now, in March 2014, maturities of bonds have been pushed well out into the future, mainly into 2018 and beyond.
 

Chart 2. The Maturity of High-Yield Debt Has Been Extended
Dollar amount of high-yield bonds maturing in indicated years, as of February 28, 2014 (latest available data)

Source: Credit Suisse.
The historical data shown in the chart above are for illustrative purposes only and do represent any specific Lord Abbett mutual fund or any particular investment. 


With more time until their debt is due, and lower interest expense in the interim, high-yield issuers are much better positioned to meet their debt obligations. Therefore, default rates should remain low. In fact, as of the end of February 2014, high-yield defaults were projected to remain less than 2% until the end of 2015, according to J.P. Morgan North American High Yield and Leveraged Loan Research.

One final point to consider is that more refinancing means that fewer new high-yield bonds are being issued, which creates an appealing supply and demand dynamic in the market. Zane Brown, Lord Abbett Partner and Fixed Income Strategist, has noted that issuance of high-yield securities will likely decline in 2014, as many companies have already taken advantage of low interest rates to sell new debt or refinance outstanding obligations. J.P. Morgan forecasts that 2014 issuance of high-yield debt will decline to $300 billion, from $400 billion in 2013.

Last year, investor interest in high-yield securities and bank loans was sufficient enough to bid up prices of such debt in an environment of falling prices among longer-maturity Treasuries. "A continuation of that 'search for yield' mentality in 2014 could produce similar demand for higher-yielding, rate-insensitive fixed income at a time when substantially fewer bonds may be available for purchase," said Brown.

As a result of all the factors we’ve listed here, yield spreads on high-yield bonds relative to Treasuries could remain below average for a continued period of time, and supply and demand factors could create a continued positive environment for high yield. This could give investors the opportunity for attractive income, with the additional prospect of total return.

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