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One Man’s Junk May Be Another’s Treasure – Junk Bonds Market 高收益债券

Many companies rated below investment grade are creditworthy enough and should have access to the new issue market. Weaker companies simply could issue new bonds at higher coupons. On one hand, junk bonds do not correlate exactly with either investment-grade bonds or broad stock markets; on the other, managers can explore different investment opportunities that will generate higher returns and increase interest payments.

Junk bonds fall into two categories: fallen angels and rising stars. The former refer to bonds that were once investment grade but has since been reduced to “junk” status because of the issuing company’s poor credit quality; the latter are those with a rating that has been increased due to the issuing company’s improving credit quality.

On Wall Street, junk bonds in general are not “big” for the reasons that: 1) investors argue that bonds should be included in the portfolio for safety; 2) high-yield bonds are extremely tax inefficient; 3) they are more closely correlated to stocks than investment-grade bonds.

The Strong-Horse Method is a form of fundamental credit analysis that looks for “good junk bond credits” at a cheap price, which is a systematic approach to investing in the bonds of companies that have good value. The approach is equivalent to value investing in bonds. Junk bonds are the closest to stocks in terms of the corporate risk/reward spectrum, so they can be analyzed in a similar way. A common metric used in corporate valuation is EBITDA. It is not generally accepted accounting measure, but analysts use it all the time.

Typically, a high-yield credit specialized investment firm is structured and should include resources of: global credit research, distressed credit analysis, convertibles, bank loans, high-grade corporate, and emerging markets debt searches. Besides a bottom-up credit research incorporating top-down economic framework, best risk/return profile emphasis, a total return approach need to be highlighted, not just yield focused.

Key Factors in Security Selection

1. Business Model

  • Competitive position
  • Corporate strategy
  • Management track record
  • Transparency of financial reports
  • Equity vs. debt market financing strategy

2. Financial

  • Cash flow
  • Source of profitability
  • Balance sheet
  • Leverage
  • Financial flexibility
  • Deployment of capital

3. Structure

  • Place in the capital structure of instrument
  • Covenants/legal
  • Off balance sheet issues

4. Relative Value

  • Risk valuation within industry
  • Risk valuation vs. ratings’ category
  • Associated technical and market volatility
  • Trajectory of credit trends vs. valuation
  • Valuation of credit across various instrument types

Final Thoughts

Since the beginning of 2009, high yield spreads to treasuries have fallen by more than any peak-to-trough period on record. Given the low forecasted default rate, spreads have the potential to follow default rates lower. Even if high yield spreads have declined significantly from their peak, excess spreads still remain well above their long-term average given improved recoveries and market expectations for lower defaults.

In the “junk” universe, both revenues and earnings continue to see improvement year over year. The most recent quarter showed earnings have been resilient. Alongside improved earnings, high yield credits have on average focused on core business, sold non-core assets, and thus reduced leverage. High yield company balance sheets are generally in much healthier shape compared to the last recession in 2008.

Default rates continue to fall from their November 2009 peak and are expected by Moody’s to remain low over the next year. Recovery rates have shifted from late 2009 and currently stand above their long term average as well. The upgrade-to-downgrade ratio by number of issuers and amount of debt is above the long term averages.

Lending standards, which have been a strong leading indicator of defaults, suggest default rates will remain low. With the vast majority of proceeds from the last two years of issuance used for refinancing, high yield credits have been able to reduce near-term credit risk and extend their debt maturities. Ease of refinancing has been the most significant driver of low realized and forecasted defaults.

Due to ease of refinancing and a favorable capital market environment in the past two years, the wall of maturities has been significantly reduced. As a result, there are no major liquidity events until after 2013. A high proportion of debt maturities is from a small number of legacy LBO companies, where default risk is concentrated. Excluding the small concentrated group of issuers, maturity schedules for the broad high yield market become even more manageable, especially in the near term.

In an environment of slow growth, high yield has outperformed equities; in an environment of sub-par growth, high yield returns have been positive whereas equity returns have dropped significantly and have turned negative.

Coupon return will likely continue to drive overall performance: 1) earnings have been resilient and defaults remain subdued, but margin concerns are surfacing; 2) the pursuit of yield amid low interest rates is at odds with risk aversion alongside global economic concerns; 3) limited total return opportunities exist, but spreads still have further room to tighten.

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