There is no substitute for experience. In all facets of life, experience acts as our baseline when it comes to contemplating the future. This is why revisiting history is such a common practice among financial academics and practitioners. For better or worse, we count ourselves among the practitioners that enjoy a walk down memory lane; we have found the practice to be a healthy exercise flooded with valuable lessons. It has taught us that while no two periods are identical, we should listen to “this time is different” arguments with a skeptical ear—there is a lot to be learned from today’s resemblance to the past. There are elements of the current high yield market that resemble tricky periods of the past. In this newsletter, we will compare today’s market to prior periods to see if we can better inform our judgment of the future.
First, the worst
A few observations stand out from Chart 1, which displays calendar year returns for high yield. Perhaps surprising to some, high yield returns have been remarkably consistent with only a small number of negative years. Notably, 2008 was a tough period for the high yield market and it remains in investors’ minds when contemplating the asset class. The tremendous recovery in 2009 compensated for the difficult year; nonetheless, 2008 is not a period that we would be eager to repeat. With the exception of the commodity-induced carnage of 2015, negative high yield returns have uniformly coincided with recessions.
In this note, we will pay particularly attention to how the current high yield landscape compares to historical periods just prior to recessions. We will view the market through a familiar lens by segmenting the market’s characteristics into three categories: 1) valuation, 2) fundamentals, and 3) technicals.
1. Valuation
Today’s valuations are not very exciting; the financial press argued that today has an eerie resemblance to the two most recent pre-recession periods. As can be observed from Chart 2, these were the only two periods over the past 20 years when valuations were worse off—not a reassuring sign for anyone contemplating new investment in the asset class. These previous periods coincided with robust economic conditions; tight spreads are a contemporaneous indicator of credit cycle health. The important question for high yield investors is how long could tight valuations persist?
2. Fundamentals and Technicals
Many fundamental characteristics of the high yield market act as coincident indicators to market performance. The default rate, for example, rises during a recession and acts as a good proxy for the current health of the market. By the time the default rate is elevated, however, the high yield market has already
retreated. It is not an effective warning sign. The upgrade/downgrade ratio, amount of distressed debt, and even most financial leverage metrics are equally ineffective warning signs—by the time the characteristics reach dangerous levels it is too late. Accordingly, we will focus on high yield market characteristics that have acted as precursors to difficult performance environments. We are grouping fundamentals and technicals together because several of the most effective predictors share elements of both. For example, we generally think of the new issue calendar as a technical factor, but the underlying composition of new issuance can have a meaningful influence on market fundamentals.
The distressed debt ratio, the percentage of the market that is trading at distressed levels (50% of par or less), has been a good short term leading indicator of rising default rates. Chart 3 shows the relationship over the past 20 years. The current distressed debt ratio is less than 1%. This benign level is not a signal of lurking trouble. Like the default rate, the distressed debt ratio can remain low for long periods.
The Primary Market
Our experience has taught us that the primary market, or new issuance, provides useful warning signs. When the primary market gets aggressive, it is time for caution because it is likely that an imbalance is beginning to develop in one form or another (e.g. tech spending in the late 1990s, M&A in 2007). Aggressive issuance can take various forms, several of which we highlight in the following charts.
Chart 4 depicts the amount of low rated new issuance (CCC and below) as a percentage of the total high yield market. It is perhaps more common to view low rated new issuance as a percentage of all new issuance rather than as a percentage of the total market, but this can yield misleading results in yearswhen new issuance was unusually light or unusually heavy. By the end of 1998, low rated issuance from the four prior years accounted for 8% of the total market; by the end of 2007 low rated issuance from the four prior years accounted for 10% of the total market. This form of aggressive issuance adds risk to the market and has accurately prophesized that difficult times lay ahead.
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