BERYL Credit Pulse on High Yield Corporates This paper will summarize Beryl Consulting 2010 outlook and hedge fund portfolio construction for the high yield corporate sector in light of the events of the past two years. We will first provide an overview of the impact of the global financial crisis on US speculative grade corporate hedge fund managers. Next, we will review the 2008 and 2009 performance of the US high yield bond and leveraged loan markets and compare their results to results from other financial markets. Based on our analysis of market fundamentals and technicals, we will highlight some of the opportunities Beryl sees in the next two years. Finally, we will construct several multi-manager credit portfolios. High yield securities, also known as below investment grade or speculative grade, are rated less than Baa3 by Moody s or BBB- by Standard & Poor s or Fitch. High yield securities can generally be divided in high yield bonds, which typically have a stated maturity and a fixed or zero coupon and leveraged loans, which are floating rate. Prior to the crisis, high yield bonds were typically unsecured; they were not backed by equipment, inventory, or real estate, while leveraged loans were typically secured obligations. The crisis caused disruption in US high yield and leveraged loan markets and resulted in some hedge fund managers suffering large mark-to-market declines and/or large realized losses when investor liquidation requests forced distressed sales of collateral. As a result, a number of hedge fund managers side-pocketed less liquid investments and/or imposed restrictions on client redemptions. Some managers, with less liquid portfolios which were well below their high water marks required to earn incentive fees, closed their funds to new investment and created new vehicles or share classes for future investors. These managers can also have a significant exposure to equity. Often the manager receives an equity position in an exchange for debt as part of a bankruptcy reorganization. 2009 was a year of dramatic recovery in a number of financial markets. The table below shows how returns on global high yield bonds, leveraged loans, investment grade bonds, emerging market bonds and the S&P 500 recovered in 2009. 2008 Returns 2009 Returns JPM Global High Yield Index (26.8%) 58.9% S&P/LSTA Leveraged Loan Index (29.1%) 51.6% JPM Investment Grade Index (1.8%) 17.5% 10 year US Treasury 20.2% (8.8%) JPM Emerging Market Bond Index (10.9%) 28.2% S&P 500 (37.0%) 26.5% Source: JP Morgan 1 The Beryl Consulting Group LLC Credit Pulse, March 2010 All Rights Reserved
High Yield Bond Market The Moody s speculative grade default rate rose from 1.5% at the end of 2007 to 5% at the end of 2008 before peaking at 14.5% in November 2009. Increased defaults and lower recoveries combined with a decline in corporate market liquidity resulted in double-digit losses for US high yield investors during 2008. High yield spreads, which at prior peaks went as high as 1100 basis points over Treasuries, reached a peak of 1731 basis points over Treasuries in December 2008, pricing in around a 30% implied default rate. Starting in 2009, high yield bonds spreads started to narrow to 657 basis points over Treasuries by the end of 2009 with 512 of the 1074 basis points of spread narrowing occurring in the second quarter of 2009. During 2009, as speculative grade issuers began to feel the stress of maintenance covenants in their credit agreements as well as the uncertainty of refinancing short-term obligations due to market conditions, the issuance of senior secured cash bonds started to climb as capital markets began to thaw. The coupon rate on these senior secured bonds was 9-12%, which was expensive for these issuers, but it gave them time to weather the distressed economic conditions. The 2009 rally in global high yield bonds was led by the strong returns on the lowest-rated, not-rated and defaulted bonds as shown in return table below: JP Morgan Global High Yield Index Returns 2008 2009 Index (26.8%) 58.9% Split BBB (19.0)% 47.6% BB (15.6%) 41.0% Split BB (19.2%) 38.1% B (29.1%) 45.4% Split B (35.8%) 68.7% CCC (47.0%) 110.6% Not rated (26.9%) 82.1% Defaulted (59.6%) 179.8% Source: JP Morgan New issuance of high yield bonds was $180.7 billion in 2009, which easily exceeded 2004 s previous record of $158.2 billion. There were only $52.9 billion in high yield bonds issued during 2008. 2 The Beryl Consulting Group LLC Credit Pulse, March 2010 All Rights Reserved
US Leveraged Loan Market The 2009 rally in US leveraged loans was led by the strong returns on the lowest-rated and less-secured loans as shown in return table below. S&P/LSTA Leveraged Loan Index Returns 2008 2009 Index (29.1%) 51.6% BB-rated (24.2%) 35.8% B-rated (34.9%) 61.2% CCC-rated (45.8%) 88.6% 1st Lien (28.1%) 49.7% 2nd Lien (47.6%) 89.6% Covenant-Lite (33.3%) 62.0% Middle Market (25.2%) 34.1% Performing (29.3%) 52.5% Non-Performing (63.2%) 28.6% Source: S&P/LCD The average bid price for leveraged loans rose from 61.7% at the end of 2008 to 87.4% at the end of 2009. Investors were willing to take on additional credit risk as 2008 market prices were reflecting draconian default and recovery scenarios. US leveraged loan origination, which topped $500 billion during the leveraged buy-out peak in 2007, fell to $38 billion in all of 2009, before recovering to $8.8 billion in January 2010. Current Market Fundamentals US high yield and leveraged loan prices peaked in mid-january 2010 and further price declines are likely, creating a fertile trading environment. Current high yield and leveraged loan spreads are still pricing in implied default and recovery rates that are in excess of the current and projected default rates as shown in the table below: Collateral Type 1/29/10 JPM Index Spread to Treasury Current Implied Default Rate Assumed Recovery Rate Worst Observed Default Rate Current Time to Maturity Default Rate High Yield Bonds 670 bps 10.0% 40.0% 13% (2001) 8.1% Leveraged Loans 575 bps 18.7% 75.0% 12.9% (2009) 8.8% Source: JP Morgan/Eos 3 The Beryl Consulting Group LLC Credit Pulse, March 2010 All Rights Reserved
Moody s forecasts that the US trailing 12-month high yield default rate will decline from the November 2009 peak of 14.5% and the January 2010 13.6% to 3.4% by January 2011. In general, Moody s projects a rising trend for business sales and corporate borrowing restraint will abet spread narrowing. Even without further spread narrowing, coupon returns and trading opportunities make US high yield bonds and leveraged loans attractive investments as the US economy recovers. Credit selection on both the long and short side will be an important contributor to returns in 2010 as spreads may widen out again until the US economy shows it can grow without assistance from the Federal government. Once the private sector is capable of sustaining economic growth, Moody s forecasts the high yield bond spread should begin to approach its 473 basis point average from the previous two economic recoveries. Attractive Opportunities for US High Yield Corporate Investing In our view, 2009 s once in a generation opportunities are now behind us. The exceptional arbitrage and valuation conditions associated with credit have now closed. Nevertheless, credit remains a very attractive asset class as liquidity has largely returned. The economic environment is more constructive with the trading environment back to near normal. Even though the recovery is tepid, below potential growth perspectives are not necessarily a negative for the asset class. Robust 2009 issuance demonstrated that those corporate that had access to credit markets have been able to refinance. Those corporate that are restricted to bank lending have ample cash and are even boasting a negative financing gap. For the time being, weak growth is therefore sufficient to allow a decline in default rates. In terms of relative rankings, we still prefer credit over equities. Higher sovereign yields linked to deteriorating balance sheets of countries like Greece present a risk for corporate bonds. However, if the sovereign risk is the same for both asset classes, credit is now less subject to disappointment than equities. Credit is, by nature, a yielding asset. Furthermore, excess return over cash for corporate bonds remains attractive. By comparison, a weak growth environment is not necessarily supportive for equities shareholders. Yield from credit bearing instruments thus offers an attractive support for this asset class in comparison to still high uncertainties around equities dividend payoffs. Hence, we believe that long/short credit managers are therefore still in a sweet spot for the next 12 months. Notwithstanding, we are well aware that a sovereign crisis and renewed inflation fears could temporarily impact long/short credit managers. The main challenge for this strategy will be the speed of the fading stimulus and tail risks for this strategy are linked to public, not corporate, balance sheets. 4 The Beryl Consulting Group LLC Credit Pulse, March 2010 All Rights Reserved
We have identified the following investment opportunities as particularly attractive in this space: Bankruptcies and Restructurings There are more than 100 companies in bankruptcy with well over $200 billion of outstanding debt, with more bankruptcies expected over the next couple of years. The key to maximizing value in a bankrupt security is to understand how certain events can affect the part of the capital structure that the manager is invested in. Post Reorganization Equity As part of reorganization, a significant portion of defaulted debt can be converted into equity. The Chapter 11 process allows companies to restructure their operations and can result in a rapid rebound to better financial performance. This creates significant financial incentives for key employees to improve company performance, in turn providing substantial upside potential for the company s equity. Middle-Market Opportunities Middle-market company loans returned 34.1% during 2009, which was below the S&P/LSTA Index return of 51.6% as these names struggled in a comparatively hostile economic financing environment. There are a number of small companies with less than $500 million in debt that do not have robust access to capital markets. Defaults in 2010-2014 are likely to be concentrated in middle market companies as these names represent a disproportionate number of debt maturities during that period. The investment opportunity includes owning these businesses at deeply distressed valuations or providing secured financing with an attractive upside return potential. Short Selling With high yield spreads starting to widen in 2010 and a reasonable risk that of a double dip recession if the US housing market takes another leg down, managers with a successful track record of short selling can be expected to generate returns in excess of their peers. Conclusion Security selection and trading skill will be the most important determinants of returns during 2010 and beyond, as the easy beta trade is gone. The asset class offers selective opportunities for attractive returns. For 2010 and beyond, fundamental analysis and credit selection will again create value in mispriced idiosyncratic risk as the large market rally in high yield credit has largely passed. When constructing its US High Yield/Leveraged Loan Hedge Fund Cohort, Beryl chose funds that focused primarily in US below investment grade corporate investments and that had managed this type of collateral over the course of several credit cycles. The managers had established franchises with strong operational and credit and risk management infrastructures and their funds were open to new investment. 5 The Beryl Consulting Group LLC Credit Pulse, March 2010 All Rights Reserved
Beryl has constructed a portfolio of US high yield and leveraged loan managers that can be invested in as either a bespoke strategy or in combination with other hedge fund investment strategies. The portfolio can also be customized to meet investors investment objectives and liquidity requirements. The target portfolio, based on historical data and Beryl s due diligence process, is projected to outperform its peer group benchmark with lower volatility. For more information about our selection process and our selected candidate managers please contact john@berylconsulting.com or vidak@berylconsulting.com About the Author: John Sherman is Senior Advisor, Hedge Funds and Structured Products at the Beryl Consulting Group LLC. Mr. Sherman has twenty three years of combined experience in credit analysis, investment manager evaluation and selection, operations, portfolio construction, and risk management. Most recently, Mr. Sherman was a Consultant with the Alternative Investments Group at Silvercrest Asset Management, where he selected hedge fund managers for its funds of funds and private client portfolios and focused primarily on emerging market, corporate credit, and structured finance investment strategies. Prior to Silvercrest, he held positions with the Portfolio Strategies Group at J.P. Morgan Investment Management, Structured Finance Ratings at Standard & Poor s, and Bayerische Landesbank (Bayern LB), where he was a Vice President responsible for its CDO portfolio. Over the course of his career, he has performed due diligence on over 200 managers in the United States, Europe, and Asia. John has a BS in Finance from Lehigh University and an MBA in Finance and International Business from the Stern School of Business at New York University. 6 The Beryl Consulting Group LLC Credit Pulse, March 2010 All Rights Reserved