Recent credit market upheaval has had a significant effect on the U.S. high yield bond market. The result has been a large shift in the risk/reward profile of high yield, and an increasing need for careful credit selection through fundamental research. In the interview below, Mark Hudoff, PIMCO’s lead Portfolio Manager for High Yield, discusses how the market has been affected and outlines PIMCO’s outlook for the sector.
Q: Please give us a brief overview of how recent financial market trends have impacted the U.S. high yield market.
Hudoff: The high yield bond market has certainly seen a broad repricing of risk and tightening credit standards in the wake of the credit market turmoil spurred by the U.S. subprime mortgage crisis. In recent years, yield-hungry investors – emboldened by low default rates and high recovery rates – pushed high yield credit spreads to precariously low levels. Heavy demand from structured products and leveraged vehicles also drove yields lower. In that environment, the tide had been lifting nearly all boats and there was limited differentiation between credits.
More recently, the widespread reassessment of risk in financial markets has quickly increased the premium that investors demand to take risk in high yield. The sluggish U.S. economy is also clouding the outlook for some sectors within high yield. In this environment, caution and careful credit selection are becoming increasingly important. PIMCO sees this market volatility as a potential opportunity for reassessing credits that we had seen as overpriced in recent years, and for carefully seeking opportunities that fit with our long-term and short-term views on the sector.
Q: What are PIMCO’s current long-term and short-term views on the high yield bond market?
Hudoff: For the long term, there are two important characteristics that frame our high yield outlook. The first is that over many long-term horizons, the high yield market tends to overcompensate investors for the risk of default. For example, the average spread over U.S. Treasuries for high yield bonds during the 10-year period ending August 2007 has been 528 basis points, according to Merrill Lynch. Over that same period, Moody’s data shows high yield defaults have averaged 4.70% per year and the recovery rate on high yield bonds has been 41.5% of par. If high yield over compensates investors for the primary risk of default in the market, then spreads should exceed losses. Indeed, by making the quick calculation we find that this is the case: defaults at 4.70% multiplied by the loss rate of 58.5% of par equals 2.75%. This represents the “breakeven” spread needed to offset expected losses. So, over the 10-year period, the average 5.28% spread compensated investors with about two and a half additional percentage points above the loss incurred by defaults and non-recovered assets. This suggests long-term value in the asset class.
The second characteristic framing our long-term view of high yield is the sector’s high level of cyclical vulnerability. Though long-term averages suggest long-term value, actual risk premiums and default rates vary a great deal depending on economic conditions. For example, based on the same 10-year data referenced earlier, spreads have ranged from under 300 basis points to over 1000 basis points and default rates have ranged from less than 2% to nearly 11%. What’s more, there tends to be leads and lags between spreads, defaults and recovery rates. So while high yield over compensates investors for the risk of defaults over the long term, there are many short-term periods when it doesn’t. At PIMCO, this means that high yield is both a strategic and tactical asset class. When spreads don’t compensate investors for prospective defaults and recoveries, it can pay to be underweight. When the converse is the case, a high yield overweight may be appropriate.
Our short-term outlook is currently dominated by the major turning point we are seeing in the credit cycle. We feel that we are looking at classic late-cycle investing patterns, characterized by a tension between relatively solid fundamentals and leverage-induced supply and demand fundamentals. For the past several years, credit picking was not the market’s key consideration – investors moving down in credit quality often beat those that were carefully selecting credits because defaults were declining and recoveries were increasing. At this point in the cycle, we believe defaults are past their bottom point and we expect that recovery rates will begin to fall. With pressure building for these two variables to move in the “wrong” direction, we believe credit selection is becoming increasingly important, and we see opportunities to exercise our strengths in credit research over the short to medium term.
Q: How exactly have the problems in the U.S. subprime mortgage market filtered through into the high yield area?
Hudoff: The subprime contagion is linked to the high yield market in two primary ways. First, the high yield and subprime markets share similar sources of demand from structured products like collateralized debt obligations, so there are parallels in how the sectors are valued. When uncertainty developed in the subprime area, it affected the liabilities of broad swaths of the structured products market. Many leveraged loan-based vehicles were no longer profitable for investors, so naturally the demand for leveraged loans began to wane. This eliminated what had been an almost inexhaustible source of demand for below-investment-grade loans. The very factor that had long been underpinning the high-yield market was suddenly gone.
The second major link between subprime and high yield has been patterns of hedging activity that sent spreads wider in many parts of the below-investment-grade bond market. Financial intermediaries, like banks and brokers, made huge financing commitments for below-investment-grade loans and bonds used to support leveraged buyouts (LBOs). With the demand for riskier products drying up, those intermediaries had to consider the possibility that they would not be able to distribute the loans and bonds they had already committed to financing. This left them holding significant liabilities on their own balance sheets. To hedge these liabilities, many bought credit default protection through credit default swap indices. This surge in demand for credit protection, along with demand from dealers and hedge funds that were also trying to hedge subprime exposure, pushed spreads for the index dramatically wider throughout June and July. Subsequent adjustments pushed single name credit default swaps and cash bond spreads wider throughout June and July, culminating in the highest level of non-credit related volatility in the history of the high-yield market by the end of July.
Q: Will the fallout from the subprime sector continue to affect the high yield corporate sector?
Hudoff: As it stands, we have entered another phase of the systematic deleveraging in the credit markets. If the first phase was about hedging and demand from structured products, this next phase is about contraction and liquidation. News headlines are increasingly telling stories of various types of funds, from hedge funds to commercial paper-based conduits, being forced to liquidate in order to meet margin calls or investor withdrawls. It is still too early to tell if this process will be orderly or spin out of control, but it is likely to persist at least for a few more months. There are positive dynamics that could dampen this risk, namely that the Federal Reserve has started cutting interest rates. This should go a long way toward shoring up confidence, but it also might be second-guessed as a sign of late desperation. Moreover – similar to the Fed’s 1998 response to the collapse of Long Term Capital Management – it may take more than one rate cut to establish the Fed’s credibility when stabilizing a financial system that is undergoing a massive risk reduction exercise.
We also believe that markets are only beginning a major transformation in structured finance rating methodology. We don’t see much of an issue with ratings for individual companies, but there will likely be major implications for the ease with which structures are rated and, importantly, how investors perceive the risks associated with these structures. Ultimately, there will be a damper on demand that will likely be felt in credit markets over in the coming years.
Q: Earlier this year, PIMCO said it was cautious in high yield, and it was minimizing exposure to risky corporate credit in portfolios. Has the recent turmoil in credit markets opened up any opportunities to get back into selected credits?
Hudoff: The high yield market looks much different now than it did just a few months ago, with significantly wider spreads and shifting fundamentals for some sorts of issuers. We remain cautious, favoring higher quality credits within the sector, but the recent volatility has opened up incremental opportunities for PIMCO. Still, when viewing the overall high yield market, we have to pay close attention to the plusses and minuses of the whole sector and each individual credit.
On the positive side, many portions of the high yield market should benefit from relatively benign fundamentals. Corporate profits remain generally high, with median expectations for 2007 year-over-year profit growth centered above 7% as of September, according to ISI.
Balance sheets – although starting to deteriorate due to stock buy-backs and LBOs – are generally still in good shape. The long-term outlook for global economic growth appears solid and, perhaps most importantly, defaults are near historic lows. For example, in August, the Moody's 12-month trailing global high yield default rate stood at 1.42%, well below the long-term average of 4.70%. Recovery rates for unsecured debt in the high yield market have also been running very high at 58% as of August, according to Moody’s, well above the long term average of around 42%. Low defaults and high recovery rates go a long way toward explaining why spreads reached cyclical lows in May of this year.
On the negative side, the supply and demand picture is unraveling after a long favorable period. For the past several years, heavy demand for high yield from structured products and other leveraged strategies severely limited the supply of high yield bonds in primary and secondary markets. Corporate America was on a significant deleveraging binge over the same period, which further compounded the dearth of supply in the high yield market. Against the limited supply backdrop, the emergence of new types of yield-hungry investors from across the globe drove a bull market for the high yield sector, pushing credit spreads to historically tight levels and causing extremely low volatility. But this favorable supply and demand dynamic turned out to be very fragile, underscored by the violent summertime market action this year. The fear of subprime contagion raised questions about the banks’ ability to digest over $300B of LBO commitments without the underpinning that had previously been provided by demand from structured products.
Q: Much has been said of recent years’ private equity boom and the “releveraging” of U.S. corporate balance sheets. Can this trend remain strong in the current environment?
Hudoff: The releveraging phenomenon has, to a large degree, been overstated. While it is true that some areas of the market have seen a releveraging process over the last couple of years, it has really been a tale of two trends. Most of the established corporate marketplace has actually been deleveraging balance sheets from 1999 through 2006. Leverage, measured as a function of debt to cash flow, has declined from a peak of just over 5:1 as of September 2000 to a trough of under 4:1 as of March 2006, according to Merrill Lynch data. The bulk of any releveraging going on over that period has been the use of excess cash flow to buy back stock, and it did not materialize in any systematic increase in leverage on corporate balance sheets because it was offset by gains in profitability.
The one portion of the marketplace that has been unambiguously releveraging has been firms involved in LBOs or management buyouts. Nearly a decade of strong earnings growth and shrinking price/earnings multiples offered the ideal environment for this trend. Through the beginning of 2007, we’ve seen leverage pick up in aggregate. As of March 2007, debt-to-cash flow was slightly above 4:1, according to Merrill Lynch. While leverage itself is not necessarily a bad thing in corporate America, the ways in which releveraging has been carried out has adversely affected the high yield market.
The two releveraging trends that most impacted the high yield market were explosive demand for “bank-loan like” product from the structured products sector, and the fact that bank loans provided an ideal vehicle for LBO sponsors to buy companies. Several years of increasingly easy distribution of bank loans gave banks and brokers confidence to commit historic amounts of balance sheet to fund private equity and sponsor LBOs with “committed” financing. Unfortunately, when the subprime problem spread it had the effect of severely reducing or eliminating demand for bank loans. For investors, this means we’ve been confronted with a huge supply overhang that will likely require further repricing to get dislodged.
Q: What are the investment implications of PIMCO’s outlook for high yield?
Hudoff: We believe that following the widespread cheapening of the market seen in recent months, high yield offers opportunities in the near to medium term. We believe defaults will increase, but only modestly over the next year to a little over 3%. The combination of solid balance sheets, continued corporate profits and global growth will likely offset the default pressures building from releveraging efforts at individual corporations or through the LBO channel.
With credit spreads in the market well above 4% – even if defaults move up to 3.50% and recovery rates decline to historic levels of around 42% over the coming year – high yield still offers over 2% of compensation above the expected losses. This represents value, especially if our credit research efforts and active management style help keep the default rate in our portfolio below the high yield market’s average rate.
Nevertheless, we do think increased volatility is here to stay and expect macro and hedging investors to play an increasingly important role in the technical supply and demand influence on the high yield market. Finally, we’ve just ended a long period of benign market conditions, and now its time to really start thinking about individual credit investing. The days of buying low quality bonds to clip the fat coupon and outperform higher quality credit intensive strategies are gone for now.
Q: Thank you Mark.