Four dangerous high yield credit myths
Many high yield investors assume the past will be a good indication of the future. A failure to correctly understand the past has led to common but dangerous myths about high yield credit.
It is often difficult to distinguish investment facts from myths, with only a subtle difference between the two. Many high yield investors assume the past will be a good indication of the future. This article explains how a failure to correctly understand the past has led to common but dangerous myths about high yield credit, with the actual triggers and warnings signs of a downturn in credit markets explained.
Myth 1: Equity markets lead debt markets, so sell high yield when equities start to sell-off
I can partially agree with the statement that equities generally lead credit, perhaps even the majority of the time. But when times get really tough, it’s all about who gets paid first and that means debt leads equities. In mid-2007 concerns about falling US house prices were becoming mainstream although few had figured out just how widespread the damage from subprime-related problems was going to be. The first of the subprime-linked fund bailouts and closures occurred in June 2007. By July, the cancer had spread from subprime to credit generally. In the space of a few days, the cost of credit default swaps (a form of credit insurance) sharply increased after years of consistently falling. This marked the turning point for credit. The rest of 2007 was a time of increased credit spreads and greatly reduced liquidity.
Equities continued to rise before peaking in October 2007 in the US and November 2007 in Australia. This was some sort of twilight zone, as two correlated assets classes were having completely different experiences. It all changed early in 2008. The credit problems of Babcock and Brown, Allco and Centro were now front and centre for equity investors. Burnt by these three and others, equity investors started to dig for information about the amount and terms of the debt owed by their other equity holdings. In 2007 and 2008 short sellers routinely targeted companies who were suspected of having a substantial portion of their share register backed by margin loans. This pattern has repeated in 2014 with short sellers targeting the iron ore miners and mining service providers, particularly those with a higher cost of production and with higher levels of debt.
Since June this year, US high yield markets have pulled back meaningfully. They are now a fair way from their peaks, unlike US equities which are still setting record highs. Credit investors have become more discerning with a good number of high yield deals withdrawn, repriced or stuck with the underwriters. No one can definitively say whether this is an early indicator for equities like it was in 2007. What can be said with confidence is that fewer companies are now able to make easy gains from dividend recapitalisations and refinancing debt to lower their interest costs. This means that the tailwind for equities of the last two years provided by cheap debt has either stopped or become a headwind.
Myth 2: High yield debt won’t sell-off until default levels increase
The ‘Minsky Moment’ (a sudden collapse in asset prices) is typically not triggered by investors rationally forming a view that asset prices are too high and voluntarily deciding to sell. Rather, it is the withdrawal of the availability of credit that precipitates the collapse. The withdrawal of credit stops new buyers entering the market and turns the most leveraged holders of assets into forced sellers. Once the spiral of forced selling begins, where one round of forced selling pushes down prices and in turn creates more forced selling, it typically takes two or more years to fully run its course.
After asset prices and credit availability begin falling, borrowers find they can no longer rollover their existing debt and the wave of defaults starts to build. Defaults always lag the fall in the availability of credit and debt prices typically decline one to two years in advance of the main cluster of defaults. Those waiting for defaults to increase before selling are likely to find that prices have moved below 90% of face value by the time they begin to contemplate selling. Many holders then become trapped by a sunk-cost mentality, not willing to sell for a loss even if the near term prospects seem grim. Avoiding being caught in this position is a key part of managing the credit cycle. Keeping an eye on the fundamentals of credit and the bullishness of lenders is the best way to be alert for when the availability of credit starts to turn.
Myth 3: Default rates won’t rise until after interest rates rise
Many will point to the rise in the Federal Reserve rate in the US as a turning point for subprime lending as borrowers that were paying very low interest rates reset to much higher levels. There’s two problems with assuming that this pattern will always repeat.
Firstly, as the response to the previous myth makes clear it is the withdrawal of credit that matters most. The counter factual is that if US interest rates had not started to rise in 2004 the boom might have lasted for longer but it would have come to an even uglier end. Interest rate increases can force the hand of leveraged borrowers in the long term, but in the medium term most leveraged borrowers are insulated by fixed rate debt or swaps used to lock in their cost of debt. It is only as debt approaches the maturity date that borrowers must take action. The smart lenders take action early, before either interest rates or credit spreads rise and the hand of borrowers is forced.
Secondly, Japan has had very low interest rates for the last 20 years, yet the pattern of defaults and restructurings has still played out. Asset prices have fallen, even though potential buyers could theoretically obtain finance at very cheap levels. The simplest explanation is that asset prices had overshot fair value and needed to return to levels based on fundamentals. Cheap debt has arguably done little to stop what was an inevitable correction. Investors can take away from Japan’s experience that when the fundamentals are bad, low interest rates might slowdown but cannot stop an inevitable correction.
Myth 4: Lending with easy covenants isn’t a big deal
Some research since the last crisis suggests ‘covenant-light’ loans performed slightly better than full covenant loans. However, there’s a key factor missing from the analysis. Last time around, covenant-light loans were not the majority and were almost always made to companies that had both (1) a low expectation of earnings volatility and (2) a strong sponsor. Lenders were more relaxed about covenants when a borrower was considered relatively stable and had owners with deep pockets. This time around covenant-light lending is the majority and it seems almost any borrower can get a covenant-light facility if they are willing to pay a little more.
Covenant light lending is a big deal as it makes loans act more like bonds when it comes to default timing and recovery rates. Strong covenants lower the probability of payment default (failure to pay interest or principal on time) and increase the recovery rate if a terminal default occurs. From the lender’s perspective these two impacts are both a very big deal.
Covenants are an early warning system on increases in credit risk. Well set covenants force the business owners to renegotiate the terms of their debt with lenders when credit risk exceeds specific tolerances. Lenders have the opportunity to demand a partial or full repayment of debt whilst the business still has meaningful equity value and an ability to attract new equity. Also, underperforming borrowers with covenants lose control of their businesses to bankruptcy or administration processes earlier, reducing the amount of value destruction. Well-covenanted and secured lenders on average recover 60-80% of their debt after a terminal default compared to 30-40% for bondholders.
As with most areas in life, the most believable credit myths are the ones that contain some truth. Savvy credit investors will ignore these myths and prepare for a potentially more difficult future.
Jonathan Rochford is Portfolio Manager at Narrow Road Capital. This article has been prepared for educational purposes and is not meant as a substitute for professional and tailored financial advice. Narrow Road Capital advises on and invests in a wide range of securities.
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