4% “High Yield” Bonds?

High Yield Credit Update

October 21, 2019

Ten year U.S. Treasury yields were around 3.10% one year ago, 2.70% at the start of 2019, 2.50% in April, 2.10% in July, and at the start of September, 1.50%. Naturally, many people, or homeowners specifically, likely found themselves over Labor Day weekend wondering where they could refinance their mortgage. I would also presume many that actually inquired about a refinancing with their banker, determined they were able to do so at an accretive rate, even after transaction costs/premiums. This was probably the same thought process that went through the minds of the CFOs of companies with sub-investment grade debt heading into September. “At what rate can we borrow for five years, eight years, 10 years?” Carl Icahn was the first mover with Icahn Enterprises partnering with its banker, Jefferies, to test the waters on a 5 year unsecured bond at 4.75%. $500 million cleared the market inside of 5%! The water was warm. From that point on, it was seemingly a race to the bottom (yieldwise). Deal after deal appeared to one-up the last, clearing bonds at lower and lower coupons and longer and longer terms. This exuberance hit a fever pitch when Morgan Stanley launched a deal for a new Restaurant Brands 8 year bond with an eye to raise the $750 million of capital at a sub-4% coupon. Investors acquiesced and the U.S. high yield bond market cleared what we believe was the first 8-10 year sub-investment grade bond this cycle (and quite possibly in its history) with a 3.875% coupon! One week later, Toll Brothers issued a $400mn bond at a 3.80% rate. Ultimately, in September, 48 deals were syndicated into the marketplace, 24 of them carried a coupon of 5% or less. “High yield” bonds indeed.

Risk aversion continues to crowd capital within the high yield marketplace into high quality credits to the point where the all-in “price” of safety has inflated considerably. For our part, while we believe an up-in-credit-quality bent makes sense given the prospective fundamental environment, ultimately as credit pickers our investment process and security selection is informed first and foremost by price / valuations…and the fact is, there are a lot of ways to lose lending to levered borrowers at 4%.

Market Performance

September felt like yet another lackluster month for performance, with high yield bonds generating only modest gains to end the quarter. Indeed, returns during the third quarter were the worst, or more accurately, the least positive for the year. To be fair, it’s not all that surprising we are losing some steam, given how far the market has run this year, with returns over 11% through September. However, beneath the headline +0.36% and +1.33% total return for September and the third quarter, respectively, investor aversion to risk and loss continues to amplify.

Dispersion remains elevated in our market as we have highlighted in recent commentaries. While sector dispersion is evident, particularly with the Energy sector now generating negative returns in an otherwise double digit returning year for the asset class, the real story this year has been one of dispersion across credit quality. BB rated bonds finished the quarter outperforming CCC rated bonds by over 700 basis points (bps), and currently in October the spread is over 800bps! Sponsorship for structurally challenged balance sheets and business models has waned significantly since this time last year as investors appear no longer willing to underwrite optimistic growth/turnaround assumptions in exchange for high “promised” yields. Investors did attempt to venture back into high risky credits twice this year, once in April and again this past month, only to be quickly punished as more fundamental landmines were tripped, confirming prior reservations and reinflating hurdle rates for taking risk. Our focus is less on the existence of quality dispersion in the marketplace and more on what it portends for prospective returns, particularly when valuations of high quality credits offer extremely thin margins for error.

Source: Bloomberg, Barclays

Again, dispersion in the marketplace thus far this year has had less to do with wholesale sector dislocation (save for Energy) than with quality and idiosyncratic/thematic factors. For example, the Energy sector as a whole in September generated balanced returns as early mark-to-market gains, following the geopolitically driven spike in oil prices, were retraced as concerns over global demand overwhelmed the transitory supply side shock. However, the Oil Field Services sector underperformed due to the swift (and total) collapse of the McDermott capital structure. Though the fundamental ails of the construction company and its ballooning balance sheet were known (or at least apparent to discerning investors), it wasn’t until this past month that high yield lenders completely threw in the towel on extending credit to the company. The result, McDermott bonds, which traded at 95 cents on the dollar in July and above par for several months after being issued in 2018, cratered in value down to 20 cents on the dollar (and may recover even less if a restructuring is forced upon the company). Other large idiosyncratic movers included Mallinckrodt (fundamentally challenged pharmaceutical business with a thin margin of safety against prospective opioid related liabilities) and WeWork (prices on its existing unsecured bonds fell -18pts in the aftermath of the company’s failed IPO).

Source: Bloomberg, Barclays

Market Technicals

Negative fund flows in August proved short-lived (as has been the case all year) with capital flooding back into high yield bond funds (both ETFs and actively managed mutual funds) in September. Specifically, the high yield marketplace welcomed +$5.8 billion of new capital this past month, bringing cumulative net inflows for the year to +$19.3 billion. While fundamentals have wavered for a growing swath of the levered credit universe, market technicals have continued to offer ballast to prices overall. This stable liquidity has helped compound dispersion as capital that is being pulled from certain sectors and discrete capital structures still needs to find a home and is therefore crowding into less fundamentally challenged credits (effectively high quality, BB-rated bonds).

Favorable Demand Technicals Have Supported the Overall Market Advance This Year

Source: Credit Suisse, EPFR

Back from summer vacation, the primary market re-opened in September in a significant way. Carl Icahn was first out of the gate with the new bond deal for his Icahn Enterprises l, a $500 million bond with a 4.75% coupon, that set the tone, or more accurately, the hurdle rate for the next month of deals. A full 48 deals, totaling ~$31 billion notional, were syndicated in September. The early success of higher fundamental quality deals began to instill confidence in bankers that the market might once again be open to more marginal borrowers. The reality, however, is the bifurcation that has manifested in the secondary market also applies to the primary, and less creditworthy borrowers found it as difficult to raise incremental capital as their high quality contemporaries found it easy.

Source: Barclays

Fundamental Trends

Only one high yield bond issuer defaulted in September, though the path to bankruptcy for Independent E&P Alta Mesa is representative of a growing list of total meltdowns of marginal borrowers that just one year ago had complete access to funding. High yield bond investors lent Alta Mesa $500mn with a 7 year term at an interest rate of 7.875% in October of 2017. The bonds subsequently changed hands above par for several months and were valued in the marketplace at 95 cents on the dollar one year ago. Today, the bonds are valued at 10 cents on the dollar and likely to recoup de minimis value through the restructuring. The zero-to-no recovery of value for the unsecured bond within the Energy space is not all that surprising. What is notable, is both the velocity at which the tranche lost its once ascribed value as well as the frequency of these collapses (Jones Energy, Sanchez Energy, Halcon Resources, EP Energy, Weatherford International, Foresight Energy – the list goes on).

It Works Until it Doesn’t – Alta Mesa Unsecured Bonds Lost the Near $500 million of Value They “Had” Just One Year Ago

 

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This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2019 TCW