Following on from Shaun McDade’s popular Weekly Comment, written in December of last year and entitled “Nice label, but what is in it?”, I felt it was again time to re-think the corporate lending / bond asset class more commonly known in the industry as Credit. In Shaun’s article he eloquently recounted how producers in an unloved backwater of France’s Burgundy wine region came up with a cunning plan to rebrand their wine, by bringing forward its release date and calling it Beaujolais Nouveau. This new name was a huge hit and sales soared for many years afterwards.
Back to credit and let’s fast forward a little. The modern “junk” bond market is the highest risk subset of the corporate lending, or credit, space. It was born out of the US Mergers & Acquisitions boom of the 1970’s, as a means of financing takeovers and leverage buyouts with significant amounts of debt, these loans being at the end of the chain for repayment. Hence, the name ‘junk’ was used to finance the parts no one else wanted to. Importantly, as the subset has become more mainstream, the relatively high risk proposition has been rebranded ‘High Yield’. Like the unsuspecting buyers of Beaujolais Nouveau back in the day, one can’t help wondering if these would be quite so popular investment if they were still called junk? Or, as Joanne Baynham remarked in our Monday investment meeting, it is called credit on the way up and debt on the way down!
Like equities, commodities, emerging market currencies and listed real estate, credit, particularly the higher risk “junk”, has fallen quite hard since mid-2015. The yield spread, or premium, investors demand for lending to corporates, over and above what one demands from lending to the US Government, has widened significantly, which obviously means investors who piled in 12 months ago at previous spreads have lost out. Coming up with fair value for high yield bonds is difficult because, unlike shares, each issue has different contracts and legal obligations, which requires massive individual due diligence and analysis.
However, default rates are more predictable in relation to history and clearly need to be taken into account when investing in this asset class. According to Boston-based GMO Research in their latest quarterly, the long term US average default rate in the high yield junk space is 4.6% p.a., but on a discrete annual basis we have seen figures above 15% and below 1%. Clearly, buying at yield premium over US government bonds would give nice returns if 1% default rates transpired, but less so if 15% of the companies default. More predictable maybe, but still very volatile!
Currently the default rate has moved up from very low levels but isn’t even at average levels yet. High yield spreads, meanwhile, have moved back to averages, so appear to be fair value if default rates and the economy don’t go into recession or crisis mode again. But the nature of high yield makes it a usual candidate for over shooting fair value to the downside whenever defaults begin to rise in earnest, particularly now that banks aren’t allowed to make markets in this asset class and illiquidity is prevalent.
Credit Opportunity, or Not?
