This commentary is written by Martin Fridson, a high-yield market veteran who is chief investment officer of Lehmann Livian Fridson Advisors LLC as well as a contributing analyst to S&P Global Market Intelligence.
A high point of last week’s CFA Society New York High Yield Bond Conference was a session titled "A View from the Front Lines." It addressed several current high-yield market challenges as well as today’s best investment opportunities. The panelists were Bill Zox, co-portfolio manager of Diamond Hill Capital Management’s high-yield fund; John Dixon, managing director at Dinosaur Financial Group, with 20 years of experience trading high-yield bonds; and Martha Metcalf, head of U.S. credit at Schroders and lead portfolio manager on the firm’s ISF Global High Yield Fund.
High on the list of investor concerns is the tight valuation on the high-yield market as a whole. Dixon noted a recent report of a two-decade low in spread per turn of leverage. Metcalf and Zox pointed out, however, that the other choices available to fixed income investors are also rich and that U.S. high-yield is one of the few and one of the safest ways to obtain a starting yield greater than the inflation rate. They advocated obtaining more value for risk by reducing risk. That could include cutting back on CCC exposure, shortening duration, moving up in the capital structure, and holding more cash than usual, although not maximum levels.
On a positive note, the panelists observed that the economic rebound has repaired some of the credit damage inflicted by the pandemic-induced recession. The most recently reported upgrade/downgrade ratio was highly positive. Defaults of many weaker names have left behind a comparatively high-quality speculative-grade universe.
MORE FRIDSON: Sharp credit quality upturn projected for high yield in 2021
Credit-conscious investors should not assume they are completely out of the woods, however. Dixon opined that some zombie credits will resume trading at distressed levels once the Fed ceases its unprecedentedly forceful market support. The panelists agreed that crude oil's rebound to $70 per barrel bailed out some credits that were otherwise on track to default.
That panelists also pointed out that some improving credits have already tightened to the spreads at which they are likely to trade post-upgrading, citing The Kraft Heinz Co. as one example. Corroborating that comment, the option-adjusted spread, or OAS, on the Kraft Heinz BB1 Composite Rating 3.80% notes due in 2027 was +109 bps on June 10, the date of the panel discussion. That compared with a median OAS of +126 bps on the same date on BBB3, 2027-maturity senior unsecured issues within the ICE BofA US Corporate Index. (The median for BBB2 senior unsecured bonds due in 2027 was +97 bps.)
Market liquidity is currently low. Many trades are crowded on one side, making it difficult to find a counterparty. Zox linked this problem to “broken plumbing” in the Treasury market that must be repaired before liquidity can return to other asset classes. In addition, a “red hot” primary market is absorbing much of the available liquidity, with many recent new issues trading actively at narrow bid-asked spreads. In this environment, said Zox, investors should maintain diverse sources of liquidity and hang on to their most tradable bonds. Metcalf added that liquidity has been declining since the Global Financial Crisis and that her team has consequently put more focus on sourcing bonds and nurturing relationships with dealers.
Zox explained that his fund’s strategy is to be a provider, rather than a user, of liquidity. His team responds to the market’s demands on any given day, rather than beginning the trading session with a fixed menu of planned transactions. Both he and Metcalf noted that the availability of electronically based, direct trading with other institutions has been helpful in a period of less active market-making by dealers.
Impact of meme stocks
Another noteworthy aspect of the current high-yield market involves spillover effects from the sensational trading in meme stocks. One outstanding example is AMC Entertainment Holdings Inc. As the “stonk” enthusiasts latched onto that troubled stock, the price soared from $1.98 on Jan. 15 to $19.90 on Jan. 27. Over the same span, the company’s subordinated 10.5% notes due June 15, 2026, with a Composite Rating of C, skyrocketed from 29 to 62. That represented a 114% gain over an interval in which ICE BofA US Distressed High Yield Index rose by 3%.
Contradicting the adage about lightning not striking twice, the “to the moon” crowd vaulted AMC stock from $9.00 on May 6 to $62.55 less than a month later, on June 2. The AMC bond rose from $86.75 to $97.625, a 12.5% gain versus 0.74% for the ICE BofA CCC & Lower US High Yield Index. Dixon noted that AMC capitalized on the massive rise in its stock price by raising new equity and now has a war chest with which it can de-lever its balance sheet. Metcalf, though, voiced concerns about long-run prospects for the motion picture exhibitor business. She expressed relief that because AMC is a comparatively small issuer, choosing not to be in the name was not a critical portfolio decision.
Potential alpha generators
As for other pockets of opportunity, Dixon volunteered that he saw further upside in the reopening trade, specifically travel and leisure. Metcalf said, with the caveat that upside in general is more limited than earlier in the year, that she perceived potential for appreciation in rising stars, energy, and banks. She added that she can buy subordinated debt of the leading banks $50 million at a clip, which also helps in dealing with the liquidity issue. Zox saw value in many first-time issuers and specifically cited UWM Holdings Corp. and Angi Homeservices. Among fallen angels, Zox mentioned Seagate as one that his fund has used. Metcalf noted a blurring of the investment-grade/speculative-grade division, with market participants on both sides becoming more active in the crossover zone.
ESG in high-yield
One other topic discussed in “A View from the Front Lines” was client demand for ESG-minded portfolio management. Metcalf noted that working for a U.K.-domiciled company with largely European clients, ESG is a top priority and also represents the biggest opportunity. ESG focus has long been integrated into Schroders' credit analysis, a process that was formalized in 2017.
Metcalf added that the issues are complex, with many edicts coming from countries and from clients within those countries. Zox said that open-end mutual funds are the last in line to be asked to bring ESG into the picture, but it is certainly coming. His fund’s focus is on issuers that are not in the lowest range of ESG practices and are making progress on that front. Dixon commented that as a result of investors’ growing ESG sensitivity, companies in the private prison and coal industries face higher costs of capital as refinancing needs arise. They will not be able, in his view, to obtain their customary bank facilities but instead will have to tap hedge funds.
For further exploration of these topics, see the video replay of the session.
High-yield spread edged closer to Fair Value in May
The high-yield market remains extremely overvalued by historical standards, but edged closer to Fair Value in May. Specifically, the ICE BofA US High Yield Index’s option-adjusted spread, or OAS, moved from -199 bps to -187 bps versus our Fair Value estimate, calculated as described below. That compares with our cutoff of 124.5 bps (one standard error) for deeming the market extremely over- or undervalued. The conclusion would be different if one declared the period of the Fed’s unprecedentedly aggressive monetary policy in response to the COVID-19 pandemic to be an entirely new era and discarded all pre-2020 data. We plan to comment more fully on this subject next week.
To elaborate on the latest changes, our fair value estimate for the high-yield OAS dropped to +516 bps in May from +527 bps in April, putting it at the lowest level since December 2018. Economic indicators improved, with Capacity Utilization rising to 75.2%, from 74.6% and Industrial Production climbing from 0.1% to 0.8%. Somewhat offsetting those tightening influences on the Fair Value spread was a drop in the five-year Treasury yield to 0.78% from 0.86%. Underlying Treasury rates are inversely correlated with the high-yield spread. The default rate, a backward-looking indicator with only a minor impact on the spread, dipped to 4.7% from 5.4%. There was no change in the Fed survey of senior loan officers, which is reported only quarterly. Last month’s update showed that the number of banks easing credit to large and medium-sized businesses exceeded those tightening credit by 15.1 percentage points. Our dummy variable for quantitative easing remained at 1, indicating that QE is in force.
On May 31, the ICE BofA US High Yield Index’s actual OAS stood at +329 bps, up from +328 bps a month earlier. With the Fair Value estimate down by 11 bps from April, the gap between the actual spread and Fair Value moved by 12 bps, from -199 bps to -187 bps, as noted above. By June 15, however, the actual spread tightened to +317 bps, leaving the actual-versus-Fair-Value differential exactly where it ended April, at -199 bps.
Research assistance by Bach Ho and Ducheng Peng.
ICE BofA Index System data is used by permission. Copyright © 2021 ICE Data Services. The use of the above in no way implies that ICE Data Services or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of Lehmann Livian Fridson Advisors LLC's use of such information. The information is provided "as is" and none of ICE Data Services or any of its affiliates warrants the accuracy or completeness of the information.