One of these investors is Martin Fridson, CFA. At the 69th CFA Institute Annual Conference in Montreal, he asserted that the majority of market participants are regularly projecting the high-yield default rate incorrectly.
“Most projected default rates in the marketplace, and you can read about this in the press, are based on a calculation method that takes the spread over Treasuries and subtracts a fixed illiquidity premium,” Fridson said. “This is wrong for a number of reasons.”
First, the illiquidity premium is not fixed — liquidity varies greatly depending on the issue and environment. Second, the overall spread can be the same on two dates, but with very different concentrations of default-prone issues in the index. The standard method doesn’t have internal consistency and may at times not even make sense. In 2007 for example, it said the market was expecting a negative default rate. In addition, the standard method implicitly assumes the market assesses no risk premium beyond 365 days (e.g., no default premium at all on day 366).
The right method to determine the market’s default rate forecast assumes bonds that will ultimately default are already trading at distressed levels of over 1,000 basis points (bps) over Treasuries. Fridson plotted the historical distress ratio, or the number of bonds trading at distressed levels, against the distressed default rate, or the percentage of distressed issues defaulting within 12 months, for the period 1999–2014. As the graph below demonstrates, the distressed default rate declines as the distress ratio rises.
Sources: BoA Merrill Lynch Global Research, used with permission; Moody’s Investor Service
Based on BoA Merrill Lynch US High Yield Index and BoA Merrill Lynch US Distressed High Yield Index
Using a regression equation, the distressed default rate percentage equals -0.3031 (a declining slope) x distress ratio +35.50 (y-intercept). This rate is then multiplied by the Distress Ratio to produce the market’s true expected default rate.
Using the most recent data as of 8 May 2016, Fridson calculated the distress ratio at 19.8% (14.0% excluding commodities), which yields a forecast for the high-yield universe of 5.8% (4.4% excluding commodities) — exactly equivalent to Moody’s forecast of 5.8%. (Moody’s uses an econometric model incorporating an economic forecast that is usually close to the consensus forecast.)
“Typically when the default rate is 1% or more above the Moody’s forecast, it is a good time to own distressed bonds,” Fridson said. “Similarly, if the bonds are priced 1% or more below Moody’s, then the distressed bonds are priced too tightly (i.e., a signal to sell).”
At the beginning of 2016, investors worried that we were starting down a path of rising default rates and moving above the 4.5% historical average. To determine where we are in the default cycle, Fridson examined the period from 1983 to 2016 and looked for similarities.
Fridson cautioned against comparing the last cycle to today’s environment. “During the Great Recession, the default rate went from near zero to a record default rate of near 14% and back down to about 2% in just two years — a physical impossibility,” he said. “The Fed came in and reliquefied so aggressively that many companies were miraculously saved.”
A more appropriate comparison for today may be the “mini surge” of 1985–1986 when energy prices plunged. “You had a high level of defaults in the energy sector, but not the rest of the economy,” Fridson said. “In the subsequent years, default rates receded then shot up again during the recession of 1990–1991.”
Given the default surges typically coincide with recessions, Fridson looked at the historical length of economic expansions and the high-yield market’s current estimate of the probability of recession.
Historical evidence provides some reason to anticipate a recession in the United States by 2017. The average expansion in the last three economic cycles was 95 months, with the longest expansion running 120 months. Recently former Treasury secretary Larry Summers predicted a 50% chance of recession by 2018. If the US economy reaches December 2017 without a recession, that will represent an expansion of 102 months, exceeding the long-run average.
Fridson used the historical average option-adjusted spread (OAS) of the BofA Merrill Lynch US High Yield Index (1996 to 2015) to determine the high-yield market’s near-term assessment of the probability of recession. Over the period, the mean OAS for high-yield bonds was 1019 bps and 520 bps during non-recessionary periods.
Today, excluding commodities, Fridson noted, the probability of recession is just 9% for the next 12 months (566 bps as of 6 May 2016). Commodities industries are excluded because they are already in recession (with a current OAS greater than 1,019 bps).
“You shouldn’t use the OAS proxy as your only guide for portfolio positioning, but it is one consideration,” Fridson said. “If you think the probability of recession is greater than what the market is predicting, then you may want to underweight high yield.”
Photo courtesy of W. Scott Mitchell
Chief Investment Officer, Lehmann Livian Fridson Advisors LLC
2016 CFA Institute Annual Conference
8 May 2016
Join Martin S. Fridson, CFA, as he discusses whether 2016 is the beginning of a multiyear default rate surge; what default rate the high-yield market expects; what’s the best positioning for rising interest rates — by industry, quality, and maturity; and whether covenant quality will rebound as the credit cycle matures.
Christopher Vincent, CFA: Good afternoon, ladies and gentlemen. This is the 215 fixed-income track, risk and opportunities in high-yield securities with Martin Fridson, CFA. I’m Christopher Vincent. I’m a member of CFA Society Chicago. I’m a fixed-income analyst and portfolio manager at William Blair. And I’m a member of the CFA Institute Annual Conference advisory group. I will be moderating or curating your questions. And let’s get started.
We are pleased to have Marty Fridson here today to talk about the high-yield market. He is the chief investment officer at Lehmann, Livian, Fridson Advisors in New York City. I don’t know that he needs an extensive introduction, and I would have to curate his accolades and we wouldn’t get out of here on time. He matriculated at Harvard, earned his MBA at Harvard, has worked on Wall Street.
And I had a chance to talk to Marty this morning. And I think every charterholder should have a personal narrative. And his of getting the charter early in his career when he was working on Wall Street and how it helped him navigate the investment banking scene is quite a compelling story.
Marty has served on the Board of Governors. He’s served for the Fixed Income Analysts Society of New York, which if you don’t know that, it’s quite an esteemed group. He’s the youngest person to be elected into the hall of fame. I could go on and on. He’s authored several books. But in the interest of time, and the many questions that I know you have, please join me in a warm welcome for Marty Fridson.
Martin Fridson, CFA: Well, Chris, thank you for your very kind comments. And I want to say that I’m optimistic about this being a successful presentation, because it’s based on some questions that were put to me by CFA Institute. And those in turn were derived from questions that were asked by practitioners like yourselves. And I found this is a very good formula.
When I worked on Wall Street, I used to make road trips with our salespeople and visit institutional clients. And very often, as I was returning from that trip, I realized that there was a question that I had not heard before but on this trip, I’d heard in two or three different places. And it occurred to me there were probably many other portfolio managers asking that same question.
So I would get back to the office, and my team developed some research directing at that question. We’d get it out, and then the following Monday morning, as people were going into their meetings, they would find a report which was addressing the question that they had been preparing to talk about at that meeting. And they thought this was really brilliant. But it was really just a matter of listening to what people were saying.
And I was always hoping that my competitors wouldn’t figure this out because it was such an advantage if you just sort of paid attention to what people were curious about and thought was important to them. Because I certainly wasn’t smart enough to come up with all those questions on my own. So it’s worked for me in the past. And I’m very glad to have these four questions, which will help us to find out why this market is different from all other markets.
And these questions, first, is 2016 in which default rates are definitely higher, is this the beginning of a multi-year default rate surge? And I define that as a series of years in succession where the default rate is at or above the average level, which is about 4.5%. And typically, you get to a peak of something over 10% in that cycle.
The second question is, what default rate does the high-yield market expect? And I want to emphasize, this is not really a way to forecast what the default rate will be but what the market’s priced to expect. And that may be an indication that the market is overly optimistic, overly pessimistic and give you some clue into whether it would be a good time to invest.
And I’ll talk a little bit about another method that exists, which can be a reference point for judging whether that market expectation is too high or too low. Then we’re going to talk about positioning for rising interest rates. And one of the things I don’t do is forecast interest rates, on the theory that people tend to have their own views about that if they’re managing money.
And I don’t want my research to be irrelevant to the 50% of the universe that disagrees with my view. I’ll say a little bit about my own view about it, but there certainly are people expecting rates to rise. And it’s a fair question — well, what should I do with my high-yield portfolio if that’s going to happen? And then the final question is, will covenant quality rebound as the credit cycle matures?
As I’ll show, there’s been a deterioration in the strength of covenants. And there’s a question about what drives that and whether, as the cycle matures, as we get into a period where you would think that the bargaining power would be more in the hands of investors as it’s harder to place issues that might result in some improvement in the covenant quality.
So those are the questions I’m going to address. Let me begin the first one — is this the beginning of a multi-year default rate surge? Well, this is a history of the US speculative grade default. And I apologize. I will be focusing on the US, just because of constraints of time. I’ll say a little bit about some of the other markets. And I do work on Europe and emerging markets on a relative value basis, but it’s not one of the topics I was asked to speak about today.
As I say, generally you get a period of several years in a row where the default rate is at or above average the average level of about 4.5%, typically peaking 10% or a little more and then gradually declining. The last cycle, very unusual. You went from a record default rate to below average the very next year. That is physically impossible.
The reason it did happen, though, was that the Fed came in and re-liquified so aggressively that companies that otherwise would have stumbled along and then eventually defaulted in that cycle were miraculously saved. So we have to be a little cautious about using that cycle as a model for future experience.
But the key point that comes out of this graph is that you’ll notice there was a mini-surge in 1985 and 1986 that did not continue to that normal low double-digit peak. And so the question is, are we in that kind of period again? Because that was driven by a drop in oil prices. And at that time, independent oil and gas producers and oil service companies were even a bigger component of the high yield market than they are today.
They represent about 15% of the face amount, a little less than the market value right now. But they’re the biggest single segment. They were even bigger then. So you had a lot of defaults in that industry. But that wasn’t really part of the overall business cycle. The economy continued to perform well. You didn’t have a recession until 1990, 1991. So the default rate receded and then rose again.
And so on this question, are we headed now that we’re on the course of default rates being up last year will be up again this year, over the last 12 months, the default rate has run 4.5%. And this is the percentage of speculative grade issuers there, default rates, as you see, published based on dollar amounts. There are other ways to count it.
But this is as a percentage of issuers. It was 4.5% over the latest 12 months, according to Moody’s. They’re projecting 5.6% for the next 12 months. So the question of whether this is just a temporary surge related to energy or a more general increase is really related to the question of whether we’re going to be in a recession because that’s when you’ll typically see it go all the way to the peak.
One way to address that question is to simply look at the duration of previous cycles. Over the last three cycles, the periods in between recessions have averaged 95 months. If we were to go all the way to the end of 2017 and not have a recession by that time, we would have gone 100 in two months, so more than an average length expansion. But on the other hand, the longest cycle of the last three was 120 months.
So you can make arguments on both sides if you’re looking just at the duration. The former Treasury Secretary Lawrence Summers recently stated that he saw at least a 50% probability of a recession by 2018. And undoubtedly, there are other factors in there. But part of it is simply cycles don’t go on forever.
Now, if you take the view that the Fed will be able to stave off recession perhaps with the help of other central banks, keeping other economies going for an extended period, then it’s a different story. But ordinarily, you would expect a recession to be out there in the not-too-distant future.
Now, you might also consider what the market says about it. And the high-yield market actually has a way of putting an estimate on the probability of recession, if you look at the data in the right way. And it’s based on the just empirical fact that the average spread — this is the option-adjusted spread on the BofA Merrill Lynch US high-yield index, on average, during expansions is 520 basis points.
On average during recessions is 1,019 basis points. So if you look at where the spread is between those two averages, it gives you an idea of how likely we’re headed to recession, because the market is saying, well, we’re fine if we stay where we are. But if we got into recession, we have to give some weight to that possibility that we’ll be at 1,000-plus spread.
Now, this analysis tends to come up with an answer that’s similar to what the consensus of economists who were surveyed on this question say. It’s a question you don’t hear much talk about during expansions when things are going really well. But as the economy starts to falter a little bit, that question gets asked. And the consensus a few months back was around 20%, and that was right around what this market indicator was saying at the time. So what we look at, the option-adjusted spread, and I’ll give you the updated numbers that you can see here, as of Friday’s close, the spread was 648 basis points.
Now, the market is saying that energy is already in recession. The spread there is 1,061. Metals and mining which have included, excluding at the time, was also about 1,019. It’s slipped down to 906 currently. But that’s a much smaller piece of the total market. So I do this analysis currently excluding that commodity component, energy and the metals and mining.
And Friday’s close was a spread of 566 basis points. If you do that little algebraic problem, it translates into a probability of recession of just 9% for the next 12 months. So if you think that the probability is substantially higher than that, it would be an argument for underweighting high yield currently. I wouldn’t go only on the basis of that indicator, but it is one consideration that you can take into account.
The second question: What default rate does the high-yield market expect? And again, this is really a way of finding the market’s expectation. Now, the expectation is sometimes out of line. And that happens typically during bad periods.
You have a sort of a panic, a lot of outflows from the high-yield asset class. And then you get bonds, trading at levels that indicate a high probability of default that really don’t belong there. That’s not an accurate reflection. But really for technical reasons, they tend to get there. So you get an overly pessimistic view reflected in the market.
Now, most projected default rates, if you read about this in the press, almost all of them are based on an objectively incorrect method of doing it. What just about everyone except me does — there’s one similar approach that I know of, what I do — just about every account of this is based on is the spread over Treasuries on the high-yield index. And the idea of it is that the spread versus Treasuries reflects the default risk premium.
But it’s the default loss risk premium, really. In other words, a certain percentage, let’s say, 4% default, they figure, well, you’re going to recover something like $0.40 on the dollar. So the loss would be 2.4% in that instance. And then they say, well, that’s usually less than the total spread. So they say, well, the rest of it is what you’re getting paid for illiquidity.
If the market’s priced properly, the spread will be the default loss rate that’s expected plus what you’re getting paid for the fact that these bonds are not as tradable as Treasuries. You can get these periods where you really can’t get out of a bond that you hold. And you have to be compensated for that. And how do they address that? They say, well, let’s take the average difference between the spread versus Treasuries and the default loss rate.
That must be the liquidity premium. And that tends to work out it’s about 325 basis points or so. And they just take that as a fixed quantity. So they say, all right. We’ll subtract that from the spread versus Treasuries, adjust for the losses, and that will give you the market’s expectation of the default rate. Here’s a partial list of why that method is wrong.
First, the illiquidity premium is clearly not fixed. There are times when high yield bonds are reasonably tradeable, times when it’s almost impossible to get a bid. Clearly, the market is going to differentiate between those two periods.
The second problem is that the overall spread can be the same on two different periods with very different concentrations of highly default-prone bonds. And as I’ll talk about, we use the term “distressed” to apply to bonds with spreads of 1,000 basis points or more. And those are comparatively highly prone to default. So suppose you have a spread of 500, and simplifying a little bit, every bond in the market is priced at $500 over Treasuries.
The expected default rate in those conditions is zero because that almost all of the bonds that default are priced at spreads of greater than 1,000 basis points at the beginning of the year. The market recognizes that they’re in danger. So you don’t see bonds trading at — actually, this would be a little below average 500 of the historical spread.
You don’t see those bonds going to default within a year. Now, they might deteriorate and two years later they might default. But they don’t go straight from that kind of valuation to default. So that’s one case. The other case, the spread is 500, but it consists of 90% of the bonds that are at 422 over Treasuries and 10% that are 1,200.
Well, those 10%, you’re probably going to get about 30% of those defaulting. So you’re going to have a 3% default rate, even though the spread is 500, just like it was in the previous case. Using the spread versus Treasuries doesn’t differentiate between those two cases. So it’s another reason why it can’t be the right way to get to what the market’s expectation of the default rate is.
This method, based on the spread, also assumes that there is no risk premium for the possibility of default on day 366, which is, I think, very unlikely. The market is assessing risk that will default within a year, but is probably somewhat concerned about the possibility of default a year and a half from now or two years from now. And I think the most damning piece of that is that in 2007, the market, according to this method, was expecting a negative default rate.
And I’m pretty sure that is not true. And the reason was because the spread got as low as 241 basis points, which was less than that 325 basis points of the illiquidity premium. So the expected default loss rate component was less than zero. So it just doesn’t have internal consistency, and I just don’t think it’s a useful way to try to get to the market’s expectation about the default rate.
Here’s what I believe is the correct method, and it’s based on the fact that, as I said a moment ago, essentially all of the defaults occur in the bonds that are trading at distress levels. And again, 1,000 basis points over Treasuries is a benchmark I came up with about 20 odd years ago, and it’s become somewhat standard. It’s incorporated into BofA Merrill Lynch’s high-yield index, for example. So those are where the defaults are going to come to.
So you could say, and there is one practitioner who does this, looks directly from the distress ratio, which is the percentage of issues trading at distressed levels, and said all right, that’s what drives the default rate, so let’s just do a direct correlation between those two. The catch is that the percentage of issues at the distress level that default within a year is not constant. If the distress ratio is very low, let’s say 5%, it means that the bonds that are trading at that level are genuinely distressed. And it’s not probably because of the economy but because their business model is failing and they’re likely to default. The market is correctly pricing at that level.
When you get into stress level that’s up 30% or more, and at the extreme level during the Great Recession got to 87%, a lot of those bonds are not really high probability of defaults within 12 months. But because there have been huge outflows, some of them are at depressed levels.
So what we find is that in this graph, if you go to a higher distress ratio moving from left to right, you see that the default rate, the percentage of distressed bonds that default, goes down. So I incorporate that into the analysis and generate here a little regression formula. So –0.3031 represents how rapidly that distress default rate declines as the distress ratio goes down. And then there’s an intercept constant of 35.50 percentage points.
So from that, you can generate the distressed default rate and you multiply that by the distress ratio. And that is what I maintain gives you the real market expectation of the default rate for the coming year. Again, to give updated numbers, which you see the ones that were put together in time to get them included in the program here, as of 8 May, the distress ratio overall was 19.8%. and it’s useful to look at it, as I’ll explain in a moment, excluding commodities, it comes to 14.0%.
Running that through the regression formula there, you find that the high-yield universe is currently projecting a 5.8% default rate for the next 12 months, which is very close to Moody’s forecast of 5.6%. Now, Moody’s is essentially an econometric model. It says, here is the mixed, how many very risky bonds, how many moderately risky and so on. And here is the economic scenario that we project for the next year.
Now, they also have a more optimistic and more pessimistic case. The base case tends to be in line with the consensus economic forecast. So if the consensus economic forecast proves correct, the default rate probably will be pretty close to the Moody’s forecast. And the significance of the market being in line with that is that when you get a market projected default rate that’s about a percentage point or more higher than the Moody’s forecast, it tends to be a good time to own distressed bonds, because it means there are some in there that are unfairly priced at very high risk levels. You’re getting overcompensated for the risk.
And at the other extreme, if it’s a percentage point below the Moody’s forecast, it means that those distressed bonds are priced too tightly and it’s not a good time to own them. Now, for the default rate to continue going and get to that peak level, of course the rate will have to accelerate a lot in the non-commodities, excluding energy in mining and metals. Currently, the market is projecting a 4.4% default rate on that portion of the market based on the distress ratio there.
Now, the third question that was asked is positioning for rising interest rates. And again, I’m sure if we took a poll, there’d be some who are quite bullish about the bond market, expecting rates to remain low, possibly even go lower. It’s surprised most people up until now, and others who think that we’re very close to a significant rise in rates.
And this part of the analysis is addressed to that second group and for other who think of course down the line at some point, rates are likely to rise. So how’s the best way to position your portfolio? The obvious answer to that for fixed-income investors is to buy short-dated bonds. Those are the ones with a shorter duration, less interest rate sensitivity.
And those will outperform when rates rise. The obvious answer is wrong. High-yield bonds are a hybrid of interest rate instruments and equities. And they behave that way, and as a result of that, they don’t perform the same way as higher-quality bonds do. You’ll find the fit between duration and price change at the individual level bond much more scattered.
If you look at Treasury bonds, it pretty much goes in a straight line. The longer the duration, the bigger the price rise when rates drop to with — if you do that same graph with high-yield bonds, which I have done, you’ll just find it all scattered around, because they’re responding partly to the equity, essentially an embedded equity option in the bond.
Now, let me explain and give some evidence about first of all why the maturity strategy doesn’t work very well. This is the yield history going back as far as we have data on the interest rate or the maturity buckets of the high-yield market. So we can talk about which maturities did better or worse. And this is based on the government bond index, so all maturities.
And you can see there were two periods of sustained rises in interest rates during this period, from September 1998 to January 2000 and from May 2003 to June 2006. So that’s our laboratory for testing these different propositions about how you can best position in the event of a rising rate environment. Now, if we look at the first period, it does seem to support this idea that, yeah, the best place to be was in the short maturities, five years and below.
And you can see that both of those segments outperform the return of 2.96% for all maturities. And so it looks like an open, shut. It really is just a matter of buying the short maturities. But you notice something a little unusual at the beginning of that period, which was that the yield curve was very flat. As most of you know, I think the more usual situation is to have shorter bonds having lower yields and longer bonds having higher yields.
But that was really not the case. It was pretty flat, so you had kind of an unusual advantage for the short-dated bonds at that time that their yields started out higher as a result of the flat yield curve, higher than they would ordinarily be at such a time. And in fact, when we then look at the second episode of sustained rise in interest rates, we find that there was no such a factor. The short-term bonds did not do better than the longer-term bonds.
And interestingly, it was the very longest high-yield bonds that did the best. Now, don’t conclude that therefore you should buy the longest bonds in a period of rising rates because they were underperformers in the earlier period. There really wasn’t any consistency. But the reason in part why you didn’t see the shorter-dated high-yield bonds outperform was that you started with a more normal, positively sloped yield curve and the short-dated bonds did not start out with that advantage of being at higher yields than they would ordinarily be at the start of that phase of rising rates.
So where do we stand now? We again have a positively sloped yield curve. So it would be, I think, incorrect to assume that we’re going to see a replay of that first cycle where you did in fact benefit in from more conventional fixed-income thinking of, yeah, let’s just stay with the shortest bonds. Now, I want to throw a little bit of a caution on this. It’s also possible that rates will not rise. And I think based on the fact that the Fed did start to raise rates and longer-term rates went down, you have to say at least there’s a question about whether rates are headed up soon.
If they don’t, actually it may be the case that the shorter-dated bonds will be the better place to be because currently we’re in an environment where the yields on those shorter-dated high-yield bonds are actually higher than on the longer-dated high-yield bonds. And that happens from time to time when the economic conditions are not that good.
And I think a lot of people would be surprised to know that that’s the case right now because they figure, oh, the economy is sort of doing OK. But actually, the slope of that high-yield curve indicates a sort of a bearish feeling about the economy. And during those periods where the shorter-term yields are higher, the shorter-term issues do outperform the longer-dated high-yield bonds.
So again, it kind of depends on your view about interest rates. But as far as the maturity is not really the answer, I think is the bottom line for the rising rate environment. The best solution turns out to be positioning by quality. And here, we can look at the first of those two episodes of rising rates.
And you see that the three main subdivisions, double B, the highest quality had the lowest return, and the lowest quality, the triple C and below, had the highest return. Across the top there, I showed the durations of the different segments. It is a little bit shorter in the triple C and below. But based on the previous evidence related to maturity, it doesn’t seem likely that that was really the factor. It was really the credit quality that caused them to do better.
And if we look at the more recent episode, once again, as rates rose — and this is on the order of 200 basis points or more — the highest return was in the lowest quality segment. The lowest return was in the highest quality segment. Now, this may sound counterintuitive because you say, well, how can rising interest rates be good for highly leveraged companies?
Their borrowing costs are going to go up. That’s going that put them at greater risk of default. And the problem should be the most acute for those with the smallest margin of safety, so to speaking, the ones with the highest leverage, which are the lowest-rated issues. Well, very important keep in mind that high-yield bond companies do not have all of their debt in short maturities with floating rates.
They’re generally responsible enough to realize that they should be funded out and they don’t have a lot of very near term debt maturities typically. So if rates start to rise, the initial impact is nothing. Eventually, as they refinance existing debt, they’ll be refinancing at higher rates, but that’s only going to be a portion of their debt. It’s going to take years for that rise in rates to flow through fully to their income statement.
So what is happening during this period of rising rates generally is when you think about it, why would interest rates be rising? Well, a good reason is that the economy is doing well. There’s increased demand for credit, and that’s driving up rates. Well, if the economy is strengthening, that means that the default risk is declining. And when that happens, the riskiest companies are the ones that do the best because they benefit the most from that decline.
You get some improvement even from the double B companies, but they weren’t at much risk of default anyway. So the triple C’s and below are the ones that rise the most when the risk premiums fall. Now, that I think is the best way to play a rising rate environment. But there is one other, you could sort of say supporting role approach, which is to position according to industry.
And what I’ve done here is focus on the 20 largest industries. There are 37 in total in the BofA Merrill Lynch US high-yield index. But once you get down to the smaller indexes, you really can’t move the needle very much on your portfolio. So I concentrated on the 20 largest ones, but I also included insurance, which is viewed as an interest rate sensitive industry, and simply looked at how they ranked in returns in that first episode of rising rates.
And what we find here is that interestingly, in the ones that were better than the return for all industries, included some cyclical industries like metals and mining chemicals and steel, sort of consistent with the idea of the economy strengthening and benefiting certain companies. The steel industry is actually comparatively highly rated but clearly a cyclical sort of industry.
The diversified financial services, perhaps not surprisingly, performed poorly in the rising rate environment. The banks did well because their loan spreads tend to rise when rates go up. But perhaps counterintuitively, the interest rate–sensitive home builders outperformed in this period. And the utilities were just about in line with the all industries return.
If we go to the more recent episode, again, if you have a printed version — sorry, there’s a misprint in that first line. The chemicals, insurance, metals and mining, steel and telecoms repeated. It says reported, but they repeated as outperformers. So they should be considered as overweighting candidates in the next cycle when you see rates going up.
Utilities — again, we’re just about in line with the return for all industries, as classically interest rate sensitive industry. But health care and super retail were repeat underperformers, and those are to be considered as underweight in candidates. The super retail is the category that includes department stores, specialty stores, variety stores, as opposed to drug or food retailers.
The last question, and then we’ll get to your questions, which I’m very excited about, is will covenant quality rebound as the credit cycle matures? Now, one of the most important innovations of the last decade is Moody’s publishes a series of average covenant quality for all the high yield new issues that come to market per month. The quarterly is a little more reliable, a little less statistical noise. But they have a real measure of this.
And this is very important, because in the past, people would say, oh, covenant quality is terrible. And as soon as we got out of a bear market And started to have some issuance again after a hiatus, I’d hear people say, oh, the covenant quality’s all the way back to where it was in 2006, when everything was euphoric and things were terrible and they were getting away with murder on covenants.
I said, well, you’re basing that on one deal, which is an objectively terrible covenant package. But it doesn’t really tell us whether on the whole, but we didn’t have any data to look at to say whether covenant quality was better or worse than it was at some period in the past. Well, Moody’s started a service where they rated the covenant, the major covenants on each high-yield new issue and then they weighted those to give an overall score.
And I said to them, well, you should take it one step further. You should publish the average for those scores for each month. And then finally, we will have a basis of saying whether covenant quality is better or worse than it was at some period in the past. Now, the series only begins in January 2011, so we can’t go back to previous cycles. But it’s a very helpful tool now and going forward. And we will be able to compare different periods as more data accumulates.
So this is what the index looks like here. And their series is the dotted red line. And it gives an average for all of the issues that came in, in a given quarter. Now the blue line is my own variation on it. They do all the hard work of evaluating the covenants, but the one flaw in the Moody’s series is that covenant quality is partly a function of rating.
The highest-rated issues don’t have to give very strong covenant protection. So the double B’s tend to have weaker covenants. And by the way, this is plotted 1 is the strongest and 5 is the weakest. So it’s an inverted scale in terms of quality the way that their notation works.
So the double B’s have the strongest. So if you have a given month where it just so happens for no particular reason, but just you only have 20 or so issues coming in a given month, if it so happens that there were a lot of double B’s, it looks like the covenant quality went down simply because a lot of higher rated issues came to market.
So I filter that out. I use a constant ratings mix and adjust for those fluctuations from month to month in credit quality. And so I think that my version of it is a little bit more precise. You see some big moves that are kind of spurious and just a function of the ratings mix.
But the key point to take away from both of the series is that there’s been a steady decline. Now, this is a function of the issuers having the upper hand. And of course they want to give away the least protection possible. There have been some fluctuations. There’s some hope that if we get into a more difficult market where it’s harder to place deals, there will be some recovery in covenant quality.
But the long-term trend is definitely downward. And I expect that that’s going to continue. It’s kind of a pessimistic view on it, but here’s the reason. If you look at the economics of it, what you have is underwriters. And what they would like you to believe is that they say oh, we’re just like the referee in a match.
Depending on which kind of football you play, where the ball goes out of bounds or where the runner is tackled, however you say it. But we just mark where it was and then sort of whistle and start the new play. Well, that’s a nice idealistic view of the world. And so, as I say, we’re just honest brokers between the buyers and sellers. We just figure out where the market clears and we facilitate the deal.
The reality is that you don’t get paid by the investors. You get paid by the issuer. And the way the issuer pays you is by awarding you to be the mandate to be the book running manager of the deal. That’s where the real profit is. Now, at one time, it was possible to say our firm is more able to underwrite a high yield deal. We can get you a better rate than the other guy.
At this point, it’s matured to a point where if you’re talking about a single B or better issue in an industry where there are other issues, maybe even other issues of the same company, but at least other issues in the same industry, a lot of reference points, there isn’t much disagreement about what the price, what the appropriate spread on the deal is going to be. And they’re all talking to the same institutional customers.
And so they can’t really differentiate themselves very credibly based on an ability to place the deals better. What they can do is to say, we have some very clever lawyers and investment bankers. We’ve come up with a new gimmick in the covenants that people won’t figure out right away and realize that we’ve left a loophole for you to take advantage of at a later point. So this gives you more value.
And by the way, these covenants are written in an extremely opaque way deliberately to make it hard to figure out what these covenants are, to the point where there are companies that exist solely to help institutional investors who are CFA charterholders like you who know a lot already, but this language is so opaque and difficult that it requires experts to spend time going over the covenants to figure out what these traps are.
So if this is the basis of competition, it’s going to drive things downward. And by the way, I published this study that showed that if you go with the counterargument that you’ll get a better rate if you offer stronger covenants does not hold. There is no benefit to the issuer of offering stronger covenants in terms of the rate that they get.
On the other side, you say, well, why don’t the investors organize and resist this? Well, the problem is they’re very fragmented. So on the other side, you have an oligopoly of about a half a dozen investment bankers, investment banks who do most of the deals. A few get done by the smaller ones, but it’s very concentrated.
And you can’t really — if you’ve got money coming in, a billion dollars comes into the high-yield mutual funds in a week, you can’t sit there in cash and say, I’m not going to buy your deals because I don’t like the covenants, because then your shareholders start to say, I’m paying you a half a percent and you’re buying cash. You do that. Let me make the asset allocation decision.
You just invest it as profitably as you can in the high-yield market. So the option of staying in cash and not buying deals doesn’t exist. So you’re forced to buy what’s offered. The portfolio manager in the high yield acknowledged for the most part that they don’t have any real control. They pretty much have to take a fait accompli as far as what the covenant package is. Kind of a bleak picture of it.
Nonetheless, the returns wind up despite all that being satisfactory over time. But in terms of covenant protection, there’s been a steady deterioration. And I don’t see anything really changing that in the near term. So I would say that you might get a little bit of improvement in a bear market as the bargaining power shifts a little bit toward the investor. But the longer-term trend, not too encouraging.
So with that, let me turn it over — and by the way, here are some suggested additional readings. I think there have been a number of good things. I would highlight last year, the New York Society of Security Analysts brought out a volume which I edited and contributed one chapter to. But we had some of the very best practitioners, academics contribute articles about the future of the high-yield market.
And that is available online. But I think we were able to attract some very, very thoughtful contributors to that. But there have been a number of good books, and I’ve mentioned a couple of recent articles also that I think you would find helpful. So with that, let’s take some of the questions from the audience and from our moderator.
Christopher Vincent, CFA: Thanks, Marty. We will not — I’ve got 2:59:45 on the clock. We have 15 minutes for questions. And since each of you have asked about two questions each, we won’t get to all your questions. However, let me start with a couple that there’s a theme here, maybe, Marty. And that is, double B’s versus single B’s versus triple C’s. You showed the quality returns highest in triple C in the rising rate environments, right? What are the default rates of double B’s versus single B’s versus triple C’s?
Martin Fridson, CFA: Well, double B’s on average, they say the rates vary a lot over the course of the cycle. They’re in, I believe, still under 2% on average in the double B category. In the triple C category, if you’re about now, there are some issues that are subordinated, triple C. And so the default probability’s really based on the senior rating of the company that might be a B.
But more and more, that’s less the case than it was in the past. So the actual triple C one year default rates are considerably higher, I think probably up in the 20% range and the single B’s around 8% or something like that. Those are rough numbers. Those are one year rates over a five-year period.
Considerably higher when you have — for the market as a whole over these default rate elevated periods of default rates I talked about, 30% of all the issues typically default over about a four- to five-year period. So rates are quite high. But there is a lot of differentiation. Again, the spreads are higher, wider and the yields are higher on the triple C’s. So the market does compensate you for that. But the Sharpe ratios do tend to be better at the higher-quality end.
So there is some reaching for yield at the lower end. People are saying, well, I’m getting current yield. I’m getting more volatility. But it’s worth it to me to have that. Or the funds are just trying to offer the highest yield in order to just sell their fund. But for whatever reason, the risk–reward tends to be somewhat less attractive.
Christopher Vincent, CFA: It seems the crossover buyer does not go to triple C’s, which may create an opportunity.
Martin Fridson, CFA: And again, a lot of it has to do with where you are in the cycle. There are times when in the recovery from the Great Recession, you had a 57% return on the high-yield index as a whole, but over 100% on triple C’s for the year 2009. So there really isn’t quite a buy-and-hold strategy.
You can’t really do that in high yield the way you could with stocks, for example, where if you’re talking about Fortune 500 companies, they’re pretty much all going to be there at the end of the period in which you’re buying and holding them. There’s a lot of turnover in the high-yield universe.
Now, you could maintain a more or less constant allocation between the different credit quality, but you have to take it then. If you had maintained that kind of constant mix, you would get better risk-adjusted returns at lower end but a lower absolute return. You have to decide what the objective is.
Christopher Vincent, CFA: Let’s talk about a current event, which the press took note of, the regulators took note of, to look into a certain type of fund. The question relates to the Third Avenue focused fund. And this question is oriented towards, was it really a big surprise?
So would you weigh in on Third Avenue and mutual funds in the broader idea of triple C and concentration, etcetera?
Martin Fridson, CFA: Yeah. I don’t recall — I think there probably turned out to be a couple of negative comments about Third Avenue. I don’t think there was a lot of focus on it. I think if you look closely, when it failed — and basically, for those who are not familiar, they suspended the payments unilaterally, which you really have to ask the SEC for permission to do that. They did it unilaterally and then the SEC came and talked to them and they eventually worked out a way to pay the holders off in time. But they basically had a huge runoff after a very bad performance.
And I would say it is a fair statement. It was really a distressed bond fund rather than a high-yield fund. But the categories that the SEC has specified are finite. And they definitely own below investment grade papers, so that qualified them as a high-yield fund. But the typical high-yield fund has a lot of double B paper, a lot of single B paper, and some triple C paper.
And what they say in the prospectus is typically, if they’re buying triple C’s, it’s because they think they really ought to be rated B. So they’re not really going after bonds that they think are likely to default. That happens, but they’re basically trying to buy bonds that are going to continue paying interest, as opposed to the real distressed buyers are buying bonds that, you say, well, it’s at a low enough price that whether it defaults or whether it continues to pay, I’ll do well.
If it defaults, I’m buying at a low enough price that I’ll get a good recovery. And of course, some of those funds also buy bonds that are already in default. But that’s not something you really see typically in a high-yield mutual fund. So the Third Avenue fund had a lot of triple C and a lot of illiquid paper.
The rules were not tight enough to control that, but it was a very different risk from what you saw in the typical high-yield fund. When they failed, there were a couple of others that looked like they had some of the same characteristics might be a little bit questionable. But I think the market eventually realized that it was not a reflection on all of the funds.
I think it’s a good warning sign for people to be conscious, take a close look at what’s in the funds and to be aware that — I think if you had done a comparison shopping base and looked at one of the sources of data on mutual funds and said, all right. They give a breakdown of the portfolio by quality, by maturity, and some other measures. And if you see one that’s really an outlier, you say, well, let me find out why it is that way.
And I think the answer you would have gotten from a knowledgeable person would say, well, yeah, that is a very different risk from this fund that’s 45% double B, 45% B, and 10% triple C. And also, by the way, Third Avenue fund was also much more concentrated. One of the other numbers you get is what percentage of the total market value is in the top 10 holdings. That was much higher. High yield funds typically would not go much above 2% in any one name.
Christopher Vincent, CFA: Let’s talk about high-yield funds and cash bonds and ETFs. Some of our audience, as I was this morning at breakfast, wanting to engage you in a conversation about how ETFs have changed the market or not, for the better or not, and you would you address that for us?
Martin Fridson, CFA: I think the starting point on this would be, take a deep breath after you read some of the press accounts. The media loves stories that talk about how the world is about to come to an end. And there are always some pundits in the market that love to encourage that, particularly people are not involved in high yield that think this is the devil’s work and say, now they really have done it.
I’ve always hated these junk bonds, and now they’ve really done it with these ETFs. They are risks, and I don’t want to downplay. There have been some cases of redemption problems in ETFs, when they said we’re going to redeem you in kind because it’s not attractive to go and sell the bonds, raise the cash to pay out in cash. So there are some hazards there. And so there’s no point in ignoring that evidence.
The concern is that the liquidity of the underlying bonds has been reduced. That’s clearly true because of the tightened banking regulations, the capital rules, and the Volcker rule, which prohibits the banks from engaging in proprietary trading, which was a big reason why they were involved in secondary market making to have the window and see where the proprietary trading opportunities were. That has reduced the liquidity, and so I think the risk has increased.
So I think that it’s good to be mindful of those risks, get as much information as you can about these ETFs. But I don’t think they’re going to be a total calamity. The other concern about them has been that they’ve added to the volatility because they’re a vehicle that enables people to trade in and out of the market in a very short term basis. And that’s bound to increase volatility, which is not altogether clear, by the way.
Having the ability for investors to come in and say, well, the market’s overheated. We should sell, or the market’s gotten cheap. If there’s an easy way to get in on a short term basis, that may actually be a stabilizing factor. But given the premise that having a lot of in and out traders is a bad thing, it’s not as if everybody was a long term holder before ETFs arrived on the scene.
There have always been players who were interested in getting into the market because it was cheap or because a newsletter had a technical model based on momentum or something else that said this is a good time, and a few weeks from now we’re going to put out a sell signal. And they’re moving in and out. And the vehicle in the past was no load mutual funds that allowed a lot of trading.
Some of those funds had no more than three switches in a year, because we don’t want so much less money going out. It hampers our ability manage the funds. Others said, hey, if we can have your money for six months out of the year, that’s great. It’s better than zero, so we’ll hold a little bit more liquid paper in order to accommodate those flows in and out.
So those no load mutual funds were a vehicle that were used by those active in and out traders and the same effect. I think the ETF is a better vehicle. Makes it more efficient to do it, but it’s not as though it was a total sea change versus the way the market was in the past. I think that’s a little bit of a misconception that I see in some of the reports about the impact of ETFs.
Christopher Vincent, CFA: OK, thank you. Marty, there’s a question here about expected returns. And I don’t know if you frame your thinking in this fashion. But the question is has to do with a base case versus a bull market versus a bear market return for the asset class, I guess, over the next one to two to three years.
Martin Fridson, CFA: Yeah. Well, with spreads at 566, you’re talking about yields in the 6+ range. They’ve been fluctuating between 6 and 7 or so for a while. And if you give back some of that through default losses, there are some premium redemptions that offsets some of those credit losses. But over time, you do have a net reduction. So you’ve got to expect a medium single-digit return in a just sort of ordinary market.
The bull market, again, we’re not going to see, I don’t think any time soon, a repeat of 2009’s by far record return of 57.51, I believe was the exact return on the BofA Merrill Lynch high-yield index. But you’re likely to see at some point in a given cycle a bull market year with a return up in the 30% range. And you’re likely to see bottom of the cycle return that’s at least slightly in negative territory. The losses to some extent are offset by the current yield.
And so you may not be very far negative, but you’ll have probably at least one negative return year during a cycle. So that’s kind of the range. And I think the best way to look at this market is over a full cycle. Because the income is coming in pretty steadily through this period. If you didn’t pay any attention to your statement, you’d say, well, getting my monthly income check here and it’s coming in pretty steadily.
And I’m fine. But given today’s market with long-term Treasury rates at 2%, you’ve got to be taking some kind of risk to get the compensation to get a yield up in the 6% range. And that’s basically it, that you’re going to have some volatility.
Christopher Vincent, CFA: And is it fair you’re giving us a little fair warning about the length of the economic cycle here? Given the length of the growth cycle we’ve been in, you’re giving us a little fair warning about that. Is that fair?
Martin Fridson, CFA: I’m not looking for a recession in 2016. But as you start going beyond that, you’re starting to push your luck. I’m not too optimistic about the Fed’s ability. I think they’re trying hard. They deserve credit. But relying strictly on monetary policy, to me, the likelihood that they can stave off a recession far beyond the normal length of the business cycle, I’m fairly skeptical of that.
Christopher Vincent, CFA: We did not get to several of your questions. As hopefully advertised, we are at the end of our allotted time.