Could the high yield market reach a turning point in 2012? The 12% returns year-to-date through September (according to the Bank of America-Merrill Lynch U.S. High Yield Cash Pay Index) have some investors asking whether greater caution may be needed looking ahead, particularly as default rates continue to rise – albeit gradually. While we expect this trend to continue in 2012-2013, we also note that actual default events generally are a lagging indicator when it comes to spread and return performance of the high yield market. More important, we think, is how high yield returns will likely continue to be sensitive to equity markets – even more so now than what long-term history would suggest.
Default cycles tend to lag high yield returns
While market optimists point to current low default rates and forecasts (the current default rate is at 3% as of August 2012, per Moody’s Investors Service), skeptics warn of potential increases in defaults leading to lower returns as a reason to reduce their exposure to high yield. To help illustrate both these views, Figures 1 and 2 show how high yield has performed relative to trailing default rates by plotting monthly total returns from high yield (i.e., price change plus coupon income) vs. Moody’s default rate for 1988 to 2012 year-to-date. A scatter plot of monthly returns (Figure 1) shows very little correlation between the two.
In addition, as Figure 2 shows, historical default rates have tended to lag high yield market performance (not the other way around). In the most recent recession, the trailing one-year high yield default rate peaked in October 2009, almost one entire year after prices and returns bottomed in November 2008. In fact, in November 2008, the one-year default rate was only 3.3%. By the time the default rate peaked at 15.4% in October 2009, the market had already rallied to return 63% from its lows. The 1990–1991 default peak also lagged the cyclical return trough. In general, and with some exceptions, the high yield market tends to rapidly re-price vulnerable credits such that when they actually default, prices have already moved to reflect distressed levels.
It is those exceptions, or “surprise defaults” across an industry or a sector, that have the most potential to negatively affect the market. One example is the 2001–2002 default cycle, when three different default surges came in quick succession: the telecom bubble bursting after WorldCom went bankrupt, the bankruptcies in the utility sector and the accounting scandals. As Figure 2 shows, the default rate peak in the 2001-2002 cycle coincided with the cyclical trough in high yield total returns, unlike the 1990-1991 or the 2008-2009 cycles.
High yield valuations and returns tend to be strongly tied to equities
The high yield market has had a positive correlation with equity markets for many years (see Figure 3, which compares correlation on a 0-to-1 scale for the percentage change in spreads (over Treasuries) for key high yield indices vs. the percentage change in level for both the Russell 2000 small cap equity index and the S&P 500), and this correlation has become even more pronounced since the recent recession.
To understand why these correlations may be increasing, consider how high yield spreads behave with respect to equities, according to the metric Net Debt/Enterprise Value (EV) (see Figure 4). Enterprise value is defined as net debt (gross debt minus cash on balance sheet) plus equity value; it is a common measure of the total worth of the company. For the sake of simplicity, we will use five-year maturity credit default swap (CDS) spreads and focus on the constituents of the high yield cash universe (as represented by the BOA-ML U.S. High Yield Master II Index constituents that have both public equity and tradable CDS contracts). Figure 4 uses a simple average for each of the datasets to plot the chart, and Figure 5 plots the same CDS spread data against default rates.
Figures 4 and 5 highlight some key trends:
- There is very strong coincidental correlation (95% for the period shown) between spreads and net debt/EV over time.
- Default rates tend to lag spreads by six to seven months.
- Net debt/EV levels remain elevated in 2012 compared with the pre-2008 period.
That last observation may be particularly intriguing: Why is the high yield/equity correlation higher now (post 2008) than longer-term history would indicate? Generally, during the recovery phase that follows recessions (when risk assets rebound from trough levels), the upside in high yield bonds tends to peak (get capped) due to the negative convexity of the asset class (i.e., most high yield bonds have call options that enable the issuer to retire the bond before maturity). In contrast, equities can continue rallying if investors believe growth will persist.
Today, however, the slow economic recovery (what PIMCO calls the New Normal) means net debt/EV levels remain elevated and hence spreads are all the more sensitive to changes in equity levels. In fact, by analyzing spread behavior at the individual credit level, we find equity valuations are one of the strongest factors affecting high yield spreads. Figure 6 plots the same set of high yield CDS spreads shown in Figures 4 and 5, but now in detail at a single point in time (31 August 2012) vs. net debt/EV. Notice the increasing slope of the regression fitted line: As the proportion of debt in the enterprise value goes up, or in other words, as the equity cushion shrinks, spreads widen out in a non-linear manner. All else being equal, one would expect increasing probability of default as a company’s debt burden increases in relation to its total worth. This is why at elevated net debt/EV levels, high yield is likely to be more sensitive and more correlated to equities.
Comparing Figures 6 and 7, one can also see that net debt/EV has a meaningfully greater correlation with high yield spreads compared with another commonly used credit metric, net leverage (net debt/EBITDA; EBITDA is earnings before interest, taxes, depreciation, and amortization).
Investment implications of the equity–high yield correlation
The framework linking equity and enterprise valuations to high yield spreads can help inform investment decisions. For instance, if you expect equity valuations to increase for a certain sector or name – whether based on general growth prospects, a changing environment or new information – then, all else being equal, you could expect credit spreads in that sector or name to decrease in the future. A recent example is credits related to the U.S. housing sector, which have seen spreads tighten since 2011 on back of relatively strong performance in their equities given the anticipation of a housing recovery. Conversely, spreads on credits related to metals and mining sectors have widened this year on the back of relatively weak equity performance in the sector, mainly due to decreased demand from China.
This analysis has its limitations, mostly notably the fact that a meaningful part of the high yield universe consists of private companies. However, this can be mitigated to some extent by using public comparables. Investors should also keep in mind that individual credits will have their own idiosyncratic factors. Nonetheless, equity valuations and net debt/EV can be an important first step toward setting up a broad credit relative value framework.
To summarize, when analyzing the high yield market, investors should recognize that while the default rate is an important market metric, it will likely continue to be a lagging indicator of total return performance. Equity market volatility and its associated effects on enterprise value will likely continue to drive high yield spreads, and investors should closely monitor equity markets for signals on where spreads may go in the future.