Wednesday, January 22, 2014

High Yield Market Looking Overvalued And Underprotected

The high yield (AKA junk) bond market is a funny thing.  Everyone who invests in this asset class knows they are buying IOUs from higher risk issuers who offer extra interest and extra restrictions on what the issuer can do in order to compensate the investors for the higher risk.  Sometimes investors are more concerned with the extra risk involved and sometimes they are more interested in the extra interest offered.  But relatively few junk investors seem to look beyond the rating and the yield, and almost all seem to have very short memories.  The junk market appears to me to be approaching an extreme and I would caution anyone tempted to chase yield in this market to be very careful.

As I observed shortly after starting this blog (, the junk market is prone to excesses.  In part due to the relatively small size of the junk market compared to institutional balance sheets, when there is trouble in the junk market money flows out very quickly and amid a dearth of buyers bond prices tend to crash and spreads get very high, very quickly (see: 2008-2009).  Conversely, when money is flowing into junk bond funds and institutional buyers are chasing yield with abandon the exact opposite happens: bond prices start rising and spreads get vanishingly small relative to the risk involved in owning these bonds.  I believe that the junk bond market is increasingly in bubble territory and danger is rising even as investors are getting ever lower spreads in reward.

As you can see below, high yield spreads are well below the 5% level (3.86% as of the most recent print) and beginning to approach the lows last seen during the height of the credit bubble in 2007.

If the party continues, past history suggests that spreads could decline (briefly) below 3% so while the junk market is in the danger zone it may not have reached the furthest excesses possible.

In case you don't find simple spread levels convincing, there are some other indicators of trouble in the new issue market.  Since the vast majority of high yield bond  are callable by the issuers at a fixed price (par plus a premium that usually starts at half a year's coupons and declines as the maturity date approaches) and the issuers are usually run or advised by people who know very well when to take advantage of what the junk market has to offer, junk issuers aggressively call bonds, refinance, and issue additional debt when spreads are tight and terms are easy.  Guess what junk issuers are doing in today's market?  In addition to the second consecutive year in which high yield bond issuance exceeded $300 billion, 2013 was a near record year for the issuance of PIK/toggle notes.  PIK/toggle notes are junk bonds that give the issuer the option of paying coupons in additional bonds instead of cash, meaning that the outstanding amount of debt actually grows after the bonds are issued.  Why might issuers choose to pay coupons "in kind" (PIK = pay in kind) rather than in cash?  It is hard to come up with plausible reasons aside from an inability to actually pay cash coupons.  Think of these bonds as Option ARMs for risky, highly leveraged corporate borrowers.

Covenant protection for investors on newly issued junk bonds has also cratered in 2013.  While you can see this by comparing the covenant package of just about any newly issued junk bond with the bond it refinanced, an even easier way is to watch the Moody's High Yield Covenant Quality Index.  This is a simple numeric indicator of the average quality of covenants in new high yield deals ranging from 1 (best quality) to 5 (no protection to speak of).  The index has spent the bulk of 2013 between 4 and 5, meaning that covenant protection for bond buyers is near historically weak levels.

So what does this mean for junk investors?  If you own junk bond funds, re-evaluate your allocation to junk.  While you might think that the fund owns older, higher quality bonds, just about every junk bond fund is having its bonds called and replaced by new bonds with lower coupons and far weaker covenants.  If you own individual bonds, expect to have any older bonds called away.  It is up to you whether to continue buying junk bonds, but be aware that what is available in the market today has very low spreads and higher risk than at any time in the last seven years.  At the very least, it is probably wise to consider buying higher average credit quality (BB/Ba rated) junk and stay away from the riskiest, most highly levered issuers.  If you own generic "multi-sector" funds or "go anywhere" funds, look carefully at how much junk they own and consider whether this level of risk is acceptable given your goals and risk tolerance.

It is frustrating to have to stay away from an asset class that has a number of attractive attributes (higher income, limited duration/interest rate risk,  built in exit strategy via maturity or calls), but the nature of this market requires discipline in order for a prudent investor to be successful over the long haul.  The silver lining is that we can say one thing with absolute certainty: at some point the junk market will blow up again and investors who did not get hurt by the inevitable implosion will be well-positioned to once again buy junk at very attractive spreads and likely the chance to make significant capital gains.

As always, this is my own musings rather than investment or legal advice.  Do your own due diligence, consult your advisors, take your own risks.  I am just some stranger on the internet babbling away and might very well be dead wrong about all of this.

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