The benefit of the doubt…a phrase that came to mind as I considered how to
characterize sentiment in the high yield marketplace today. To not assume
the worst while there is uncertainty, or said another way, to assume all is
fine until there is clear evidence to the contrary. While investors do appear
wary of valuations today -- and rightly so, given the maturity of the credit/
business cycle, elevated economic (China) and now thermonuclear (North
Korea) risks abroad, political/fiscal output at home underwhelming initial
optimism and significant uncertainty as the Fed ventures to unwind nearly
a decade of monetary stimulus -- they seem willing to give the market
the benefit of the doubt (and take a lot more risk to earn a little extra
yield). This sentiment feels counterintuitive to us as uncertainty would
seem to prescribe caution and warrant sufficient compensation, not the
opposite. Moreover, while evidence to the contrary may not be apparent
on the surface, sector and single name decompression has started to
emerge, specifically in retail, supermarkets, media, wirelines, energy and
transportation services. Just as poor breadth in equity markets is often cited
as evidence of fundamental weakness, performance dispersion in credit
often represents the tremor before the quake (recall early 2015).
MARKET PERFORMANCE
High yield bonds returned a respectable +0.90% in September. With
reflation themes back in vogue, sufficient excess liquidity in the marketplace
and rising oil prices emboldening investors to take incremental risk in the
energy patch, a sustained bid for high yield bonds buoyed prices throughout
the month (and in the case of higher risk energy bonds, lifted prices higher)
despite the dual headwind of rising rates and heavy new issue supply.
Spreads Absorbed a ~20bp Shift in the Belly of the Treasury Curve
Source: Barclays
Across ratings categories, CCCs generated the highest total return for the month, aided by the stark outperformance
of higher beta, lower credit quality E&P and oil field Services bonds. Already tight spreads of BB-rated credits coming
into the month put a cap on further price appreciation for this cohort in the face of rising interest rates. At best, the
healthy bid for high quality paper held prices stable, translating to even further spread compression for BB bonds.
CCC-Rated Energy Outperformed Highter Quality Comps Following
Several Months of Underperformance…
Source: TCW, Bloomberg
....Underpinning the Risk Rally During the Month
Source: Barclays
However, beneath the surface of the positive September performance was a fair bit of sector and single name
dispersion. As discussed, the energy sector, concurrent with rising oil prices, was lifted out of its funk from
the past several months as investor perception of industry trends improved following reports of steady global
crude demand growth by the IEA as well as evidence of lower than expected production growth from U.S. shale
producers. Add in the uncertainty from the Kurdish independence referendum and a little noise from Hurricane
Harvey, and the market was left inspired to bid for oil-linked risk. Away from energy, the fallout from Harvey and
Irma was a mixed bag for different industries. Transportation Services saw car rental constituents HTZ and CAR
recover on expectations for rising used vehicle prices as replacement demand is pulled forward. On the flip side of
the coin, hospital bonds, particularly the unsecured debt of more levered operators THC and CYH, traded heavy as
prices began to embed expectations for earnings cuts compounding an already tenuous situation as Congressional
Republicans made a last ditch effort to salvage ACA reform. Supermarkets were yet again the worst performing
sector (three months running with a negative total return year-to-date), as poor earnings and forward guidance
from The Fresh Market weighed on already rock bottom sentiment towards the industry in the wake of Amazon’s
foray into the space. Secularly challenged wireline bonds were searching for a floor yet again this month after
a large activist holder of Windstream unsecured notes sent a notice of default to the company in regards to its
separation of network assets into Uniti (fka CSAL) in 2015. Another notable detractor from market performance
this month was Bombardier (Aerospace/Defense) which saw its capital structure trade down following news a
220% tariff will be applied to sales of its C-Series aircraft in the U.S. (in addition to an announcement that the two
principal competitors of its railcar business in Europe had reached a merger agreement).
Source: Barclays
MARKET TECHNICALS
Fund flows in the high yield marketplace were generally supportive of asset prices during the month with +$1.7bn
(net) added to already cash-rich fund balance sheets. September’s experience contrasts distinctly with that of
March, when sizeable outflows (-$8.2bn) coalesced with heavy new issue supply, creating a technical imbalance
that sent liquid benchmark bond prices down -3pts in short order. Instead, stable-to-positive fund flows aided the
marketplace in absorbing the calendar without any discernible disruption to secondary trading levels.
Fund Flows were a Stabilizing Force in the Marketplace in September
Source: Lipper, JP Morgan
On the supply side of the equation, the new issue calendar was very active this month with the market clearing
$37bn of USD-denominated bonds, a stone’s throw away from the $43bn that priced in March. The supply was
largely taken in stride, inciting very modest selling of cash bonds (and ETF holdings) by fund managers to fund
the calendar. Any selling that did occur appeared to be easily digested by the dealer community having entered
the month with sufficient capacity to absorb the incremental inventory. Performance of newly minted bonds
in secondary trading was also generally positive, despite clearing the primary market at low absolute and
relative yields.
High Yield Met Supply ($M)
Source: Barclays
FUNDAMENTAL TRENDS
Consistent with benign default activity realized over the past several months, only one high yield bond issuer defaulted
in September, though it grabbed the attention of the entire market. Toys “R” Us had been burdened by declining sales,
a bloated cost structure and an over-levered balance sheet for some time. The company had, until September, stayed
a Chapter 11 restructuring through creative measures permitted by forgiving capital markets. However, as rumors
circulated that the company would have trouble covering its bills, vendors pulled critical financing lines, inciting a
liquidity squeeze that forced the company into bankruptcy in a little over a week. Observing the fact pattern through
the lens of TOY CDS offers a clear delineation of the situation with the cost of insuring $100 of unsecured credit risk
for 3 months jumping from less than $2 upfront to $80 in short order. Financing markets giveth, but can also taketh
away …swiftly. The jump risk represented in the TOY situation is a prime example of why we are reticent to lend at
these low absolute yields and high dollar prices to fundamentally weak credits that are expressly reliant on extremely
accommodative financial markets to remain solvent this late in the credit cycle.
The Cost of 3 Month Insurance on TOY Unsecured Credit Risk
Spiked as the Company was Forced into Bankruptcy
Source: Bloomberg