UNDER THE SCOPE Walking the Line Is There a Magic Line for High Yield Spreads? April 2014 Is a credit spread of 400 bps a magic line for high yield? Is it easily crossed like the Maginot Line, is it a line that the market struggles to stay on one side of like the Mendoza Line, or is it a failed idea like the Mason-Dixon line? Or does it matter at all? Investors have become increasingly focused on the demarcation of 400 bps in high yield land, some even calling for a pending collapse of the asset class. From our analysis of previous cycles and the underlying fundamentals, we think that reports of high yield s immediate demise are greatly exaggerated. However, the lack of credit differentiation within the market requires a thoughtful approach to credit selection and risk management as the current cycle extends. In this Under The Scope, we highlight some of the unique characteristics of today s market that help explain current spread levels as well as share specific concerns about the pricing of credit risk. Today s Conventional Wisdom During the first quarter of 2014, the average spread in the high yield market approached 400 bps, with some major market benchmarks dipping below 400 bps. The move in spreads garnered much attention in the press while investment reports circulated warning that spreads below 400 bps cannot be sustained. Despite the focus on spreads, which started the year inside of historic averages, high yield still has outperformed all major equity indices year-to-date through mid-april something that few pundits, if any, predicted at the start of the year. We think it is important to put the current spread level in historical context when evaluating prospective return potential of the asset class. Compelling historical precedent exists for spreads to remain low for some time once the 400 bps line has been breached, allowing the high yield market to deliver attractive absolute and relative returns. Moreover, spreads appear to more than compensate investors within the context of the current default environment. Historical Precedent: Below the Line There are two notable periods when spreads stayed inside 400 bps for an extended period of time: December 1996 May 1998 and July 2005 June 2007. Once the high yield spread fell below 400bps during these periods, it remained inside of that level for 18 and 24 months, respectively. Exhibit 1: Previous Low Spread Environments Mark R. Shenkman Chief Investment Officer Bob Kricheff Portfolio Manager bob.kricheff@shenkmancapital.com Alexander Chan Quantitative Strategy and Analytics alexander.chan@shenkmancapital.com Matt Russ, CFA Business Development matt.russ@shenkmancapital.com Stephen A. Sharkey Analytics Analyst stephen.sharkey@shenkmancapital.com For more information, please contact: Nicholas G. Keyes, CFA, CAIA Director of Business Development marketing@shenkmancapital.com +1 (203) 348-3500 Period Months Average STW Annualized HY Return Average Coupon 1996-1998 18 358 12.62% 10.32% 2005-2007 24 346 8.51% 8.44% Based on the Credit Suisse High Yileld Index. Source: Credit Suisse, Shenkman Capital Similar to today s conditions, both of these prior cycles occurred during benign default environments and economic expansion of low-to-mid single-digit real GDP growth. However, the one glaring difference is 10-year Treasury rates averaged 6.23% and 4.64%, respectively, versus sub3% today. While both of these past periods had higher interest rates, the high yield market still posted annualized returns in excess of the average coupon. In addition, history bears out that economic expansions can continue longer than the current cycle. Data from the National Bureau of Economic Research (NBER) show that since the early 1980s economic expansions have lasted an average of 95 months, while the current expansion has lasted only 58 months thus far (see Exhibit 2). This leaves a potentially long runway for continued economic growth, which can help credit spreads stay low. Furthermore, when we take into account this historical context, along with the fact that central bank officials have indicated they remain intensely
Walking the Line 2 focused on economic growth, it is likely that policy rates remain low over the medium term in order to support the gradual recovery. Exhibit 2: Economic Cycle (months) Peak Trough Contraction Expansion Cycle Contraction Expansion Nov-48 Oct-49 11 37 1945-2009 Average 11 58 Jul-53 May-54 10 45 1982-2009 Average 11 95 Aug-57 Apr-58 8 39 Current Cycle 58 Apr-60 Feb-61 10 24 CBO Forecast 102 Dec-69 Nov-70 11 106 Fed Forecast 90 Nov-73 Mar-75 16 36 Jan-80 Jul-80 6 58 Jul-81 Nov-82 16 12 Jul-90 Mar-91 8 92 Mar-01 Nov-01 8 120 Dec-07 Jul-09 18 73 Source: NBER, Congressional Budget Office, Federal Reserve Summary of Economic Projections, Shenkman Capital Spreads Relative to Default Rates High yield spreads compensate investors over the risk-free yield of U.S. Treasuries for default risk, among other risks. Thus, today s near-400 bps spread-to-worst (STW) must be considered relative to the low default loss rate of the current high yield market. Exhibit 3 shows the excess spread (market STW default loss rate) earned by high yield investors in the recent low default environment as well as historically. As the far right column shows, the market STW was 409 bps while the default loss rate was only 40 bps as of March 31, 2014. This equates to an excess spread of 369 bps, which is still greater than the historical periods shown below. We do not expect the default loss rate to increase enough to reduce the excess spread meaningfully in the near term, even when factoring in recent defaults and likely defaults in the TXU capital structure. Exhibit 3: Average Excess Spread over Time 700 bp 600 bp 583 bp 500 bp 400 bp 343 bp 414 bp 392 bp 480 bp 409 bp Excess Spread 300 bp 200 bp 100 bp 240 bp 335 bp 317 bp 421 bp 369 bp Default Loss 0 bp 79 bp 75 bp 59 bp 40 bp 1986 Mar14 1994 1998 2004 2007 2013 Mar14 Mar 14 Represents periods in which the average default loss rate was below 100bp for at least 12 months as reported by Credit Suisse. Source: Credit Suisse, Shenkman Capital We believe it is likely that spreads remain low due to a number of factors that appear to be in place for an extended period: 1) the ability of leveraged companies to refinance debt at lower rates while extending maturities, 2) gradual economic improvement, 3) an increased number of companies that can access the leveraged bond and loan markets, and 4) improved access to equity markets for leveraged credits. The maturity wall of 2012 2013 that worried investors back in 2009 was largely extended out several years (see Exhibit 4). Clearly, credit quality of some companies did not warrant access to the capital markets, but the market has been forgiving, even blind at times. The upshot of such access has been outperformance of riskier
Walking the Line 3 credits in 2013 as well as improvement in the quality of many issuers able to reduce interest costs. Further evidence of the impact of the improving economy is highlighted by a record high ratio of rising stars to falling angels during 2012 2013, as shown in Exhibit 5. Exhibit 4: Scaling the Maturity Wall: High Yield Maturities by Year Exhibit 5: Rising Star / Fallen Angel Ratio 250 200 As of Nov-09 As of Sep-13 2.5x 2.0x 1.9x 2.1x 2.1x 150 1.5x 1.2x 100 1.0x 0.9x 50 0.5x 0.5x 0 2012 & Earlier 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 & Greater 0.0x 0.1x 2008 2009 2010 2011 2012 2013 LTM Source: J.P. Morgan. Amounts show Global USD High Yield Issues Source: J.P. Morgan, Shenkman Capital Lack of Credit Differentiation Significant compression of spreads and yields in the high yield market occurred as a result of a low interest rate/low default environment, as well as the exceptional ability to refinance and extend maturities. This wholesale compression worries us. We believe that the lack of differentiation for credit quality, as exemplified by a tight dispersion of spreads among high yield credits, will likely revert to some extent at some point. Exhibit 6 shows how the standard deviation of spreads is currently lower than previous periods. A reversion to credit differentiation, or wider dispersion in spreads, should reveal the good from the bad and favor thoughtful credit selection. Exhibit 6: Standard Deviation of Year End Spreads 2500 2220 2000 1865 1832 1735 1500 1000 500 915 523 698 508 724 659 548 854 635 552 511 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Based upon the Credit Suisse High Yield Index Source: Credit Suisse, Shenkman Capital Most notable to us is the compression of spreads in the CCC sector of the market. CCC spreads, excluding TXU, have tightened 43% from 1150 bps to 650 bps over the past 24 months. The CCC sector is the only rating category that is inside of its average spread during the 2004 2007 period (see Exhibit 7). In other words, CCC spreads today are even richer than the last credit expansion. We view this as a signal that there is less focus on credit quality and more focus on pure beta. In the event of a repricing of risk, the lesser quality segment of the market will be at greater risk of reversion. However, given the CCC sector is only approximately 17% of the market, a reasonable widening of this rating tier should only impact the high yield market s returns modestly and the leveraged debt markets would remain attractive relative to other debt assets.
Walking the Line 4 Summary Conclusions We do not find that a spread of 400 bps on the high yield market represents some special line that signals a peak in the high yield market. Every historical period has its own nuances, but there is reasonable precedent for the market staying in this range and producing attractive returns for some time. While current conditions can persist, the lack of credit differentiation within the market is certainly a concern for us. The blind buying of risk has created attractive levels for sellers of riskier credits but less so for buyers. A lack of differentiation highlights the importance of disciplined credit analysis and a conservative approach to the leveraged debt markets at this point of the cycle. With this line of reasoning, investors can preserve capital and take advantage of the current economic trends, even when credit differentiation does return to the high yield market.
Walking the Line 5 Disclaimers and Notes 1. Shenkman and Shenkman Capital are the marketing names for Shenkman Capital Management, Inc. and Shenkman Capital Management Ltd. Shenkman Capital Management, Inc. is registered as an investment adviser with the U.S. Securities and Exchange Commission. Such registration does not imply any specific skill or training. Shenkman Capital Management Ltd is a wholly-owned subsidiary of Shenkman Capital Management, Inc. and is authorized and regulated by the U.K. Financial Conduct Authority. U.K. Investors: This material is provided to you because you have been classified as a professional client or eligible counterparty by Shenkman Capital Management Ltd as defined under the U.K. Financial Conduct Authority s rules. If you are unsure about your classification, or believe that you may be a retail client under these rules, please contact Shenkman Capital Management Ltd and disregard this information. Current performance may be lower or higher than the performance quoted. 2. The Credit Suisse High Yield Index is designed to mirror the investable universe of the U.S. dollar denominated high yield debt market. The Credit Suisse High Yield Index is unmanaged, not available for direct investment and does not reflect deductions for fees or expenses. 3. For Exhibit 7, all information is as of February 28, 2014. STW Data for High Yield is from the BofA Merrill Lynch U.S. High Yield Index H0A0 (excludes bonds priced below $50); BB-rated spreads are from the BofA Merrill Lynch U.S. High Yield BB-Rated Index (H0A1), B-rated spreads are from the BofA Merrill Lynch U.S. High Yield B-Rated Index (H0A2), CCC rated spreads are from the BofA Merrill Lynch U.S. High Yield CCC-Rated Index (H0A3). Default Data is from Credit Suisse, and the issuer weighted default rate has been adjusted to include the anticipated TXU default. The BofA Merrill Lynch U.S. High Yield Index (H0A0) has an inception date of August 31, 1986 and tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly. The BofA Merrill Lynch BB US High Yield Index (H0A1) is a subset of the BofA Merrill Lynch U.S. High Yield Index (H0A0) that includes all securities rated BB+ through BB-. The BofA Merrill Lynch Single-B U.S. High Yield Index (H0A2) is a subset of the BofA Merrill Lynch U.S. High Yield Index (H0A0) that includes all securities rated B+ through B-. The BofA Merrill Lynch CCC & Lower US High Yield Index (H0A3) is a subset of the BofA Merrill Lynch U.S. High Yield Index (H0A0) that includes all securities rated CCC+ and below. These indices are unmanaged, not available for direct investment and do not reflect deductions for fees or expenses. 4. Third-party information contained in this presentation was obtained from sources that Shenkman Capital considers to be reliable; however, no representation is made as to, and no responsibility, warranty or liability is accepted for, the accuracy or completeness of such information. 5. The information and opinions expressed in this paper are for educational purposes only. The information contained herein does not constitute and should not be construed as investment advice, an offering of investment advisory services or an offer to sell or a solicitation to buy any securities. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS This paper, including the information contained herein, may not be copied, republished or posted in whole or in part, without the prior written consent of Shenkman Capital. 461 Fifth Avenue New York, NY 10017 +1 (212) 867-9090 262 Harbor Drive Stamford, CT 06902 +1 (203) 348-3500 49 St James's Street London, UK SW1A 1JT +44 (0) 20 3371 8234 www.shenkmancapital.com Copyright 2014 Shenkman Capital Management, Inc. All Rights Reserved This letter is for informational purposes only. While the data and statistics contained in this letter are based on sources believed to be reliable, Shenkman Capital Management, Inc. does not represent that they are accurate or complete and should not be relied upon as such. Past performance is not a guarantee of future results.