Unless we are in for a full-blown repeat of the last financial crisis, which I do not think we are, the sharp decline in the high yield price amid a glut of negative economic news is an attractive buying opportunity for risk-tolerant investors.
High quality companies
The composition of the high yield market has changed since 2008. The weakest high yield companies exited the universe via default in 2008 and 2009 and have not returned. New issuance over the past two years has been primarily of BB/B-rated credits and not the riskier CCC-rated credits that have a greater chance of defaulting. CCC-rated credits currently make up only 13.6% of the market vs. 22.2% at year-end 2008.
Balance sheet strength
The companies that survived the credit crisis aggressively delevered and built large cash balances. Cash has expanded from approximately 5% of the average corporate balance sheet in 2008 to about 7.4% by the end of 2010 – the highest level since 1959. Leverage, as measured by LTM DEBT/EBITDA, declined from a peak of 5.3x in the third quarter of 2009 to 3.9x in the first quarter of 2011.
Low refinancing risk
The memory of high yield capital markets closing for several months in 2008 and 2009 motivated many company management teams to increase cash and extend their debt maturity profiles. Once the capital markets reopened in 2009, new issuance soared, with each subsequent year setting a new record. The primary use of the proceeds of this record new issuance was the refinancing of existing debt. This has allowed companies to push out their maturities beyond 2013/2014. We see very little refinancing risk for our portfolio companies for the next few years.
Defaults at historic lows
The default outlook today is benign and significantly improved compared to 2008. We are forecasting a default rate of between 1% and 2% for 2011 and 2012, roughly in line with Wall Street firm estimates. We base this conclusion on the strong position (record cash balances and corporate profits, lack of impending debt maturities, reduced overall company leverage) of high yield companies today.
In contrast, at the end of 2008, JP Morgan projected a default rate of 8% (par-weighted) for 2009 and continued elevated levels through to 2011 and beyond. The actual default rate peaked in the autumn of 2009 and was 10.3% for the year. Avoiding defaults is the essence of high yield investing. So long as we can avoid defaults, a company will eventually trade back to par, even if it experiences a temporary price correction. The ‘pull to par’ in high yield is an attractive feature of the asset class and one that distinguishes it from equities.
Spreads out of line with default rate expectations
Current spread levels are wide of their long-term mean and median, unlike the period prior to the crisis when spreads were at record tights. Spreads in our BB/B universe are now well over 600 basis points; current spreads on the BofA ML US high yield BB/B cash pay index are pricing in a default rate of approximately 7%. We believe defaults will come in somewhere between 1% and 2% suggesting spreads have significant room to tighten.
In short, we believe the current market correction represents an attractive buying opportunity for investors with cash and in high yield investors are being compensated for the risk they are taking, particularly at current prices.