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Fridson: Determining fair value for the high-yield market

Churchill Downs announces $400M of eight-year notes for debt refi

Judge dismisses Marble Ridge claims over Neiman's MyTheresa transfer

Affinion receives consents for recap, covenant elimination

Revlon delays annual 10-K, details liquidity, ERP-related losses

Fridson: Determining fair value for the high-yield market

This report explains our fair-value model for high-yield. It evolved from an effort to develop a more useful valuation reference point than the historical average spread. With high statistical significance, the model indicates when it is attractive to increase exposure to the high-yield asset class.


Econometric modeling of the high-yield spread-versus-Treasuries dates to research conducted at Merrill Lynch in the mid-1990s (see note 1 below). Within the past year, at least one sellside firm has introduced its own version of the technology.

The path to an econometric model of the high-yield risk premium began with research challenging the traditional valuation approach. In the 1980s, traders judged the market rich or cheap depending on whether the spread was above or below its historical average. Buying and selling on that basis, we found, did not produce better absolute or excess quarterly returns (note 2) than a buy-and-hold strategy.

This result puzzled market participants. Upon reflection, though, it made perfect sense. The spread represented a risk premium. Therefore, the average spread was the correct spread only on the rare occasion when risk happened to be average. When risk was above average and the spread was above average by a commensurate amount, high-yield bonds were not cheap, but fairly priced. Misvaluation occurred only when the risk premium was out of line with risk.

The trick was to quantify the risk. Despite a once-widespread notion that persists even today, default risk is not the whole story. In round numbers, the historical default rate on high yield bonds is 4.5% per annum, and the average recovery rate is 45% of face value. That implies a required spread of 4.5% x (1 -0.45), or about 250 bps. The historical average spread of the BofA Merrill Lynch High Yield Master II Index, however, is approximately 600 bps.

To hear the high-yield boosters of yesteryear tell it, the difference (350 bps) represented a free lunch (note 3). The extra spread supposedly resulted from conventional investors’ irrational aversion to “junk” companies, which the rating agencies systematically underrated. There was just one flaw in this claim of a gross, glaring, and persistent market inefficiency: When analyzed in a Modern Portfolio Theory context, the high-yield asset class landed very close to the Securities Market Line (a graph of mean return versus standard deviation of return), indicating little or no chronic undervaluation.

The possibility remained that in some periods the high-yield market was underpriced or overpriced, relative to its then-prevailing risk. Identifying such episodes necessitated considering not only default risk, but the full risk of owning speculative-grade bonds, including the risk of illiquidity. Rational investors demand to be paid for the fact that they cannot convert their high-yield holdings into cash as readily as they can their Treasuries.

Model specification

To capture as much of the total risk of high-yield bonds as possible, my collaborators and I over many years have tested a variety of potential explanatory variables to incorporate into a multiple regression analysis. The accompanying table details the five variables in the present model, developed in collaboration with Finnerty Economic Consulting. This model explains 82% of the historical variance in the option-adjusted spread (OAS) on the High Yield Master II Index (adjusted R2 = 0.82). For any given month, the spread calculated with this formula represents our fair-value estimate of the high-yield risk premium.

The accompanying chart shows how the actual spread compares, month by month, with the fair-value estimate. If the market is exactly at fair value, that month plots at zero on the vertical scale. Inspection quickly discloses that in most months the actual spread is somewhat greater or less than fair value. Occasionally, the divergence reaches an extreme, defined as one standard deviation (133 bps).

These divergences reflect transitory risk factors. Value-oriented, multi-asset investors will increase exposure when the spread greatly exceeds the level justified by the perennial risk factors listed in the table above. They will reduce exposure when the spread is far below the fair-value estimate. For managers who operate exclusively within high-yield, undervaluation implies an aggressive stance and overvaluation a defensive stance.

Also of interest from a statistical viewpoint is the next chart, a histogram of the monthly actual-minus-estimated data. The computer-fitted curve approximates a bell-shaped curve, suggesting that the monthly differences are normally distributed. This implies that the monthly observations do not suffer from the defect of serial correlation.

Performance of model

While practitioners value reassurance that the model meets a high statistical standard, their primary concern is whether it helps them make money. To answer that question, we analyze 12-month returns versus five-year Treasuries (note 4) following the months from December 1996 through September 2011. Adhering to the principle of conservatism, we exclude the extreme returns of 2008-2009. (Absolute returns were negative 26.39% and positive 57.51%, respectively, for the two calendar years. Calculations that take into account this once-or-twice-a-century experience make the FridsonVision model appear more effective as a timing tool than is justified in ordinary times.)

We segregate the 154 months in our observation sample according to whether the actual spread was:

  • Fair (+132 to -132 bps versus fair value): 126 months
  • Cheap (greater than fair value by 133 bps or more): 15 months
  • Rich (less than fair value by 133 bps or more): 13 months

The mean excess returns over five-year Treasuries during the next 12 months, by beginning valuation, were:

  • FAIR: +1.99%
  • CHEAP: +20.78%
  • RICH: -2.17%

Despite the modest number observations outside the Fair zone, these results stand up to statistical scrutiny. The excess return following cheap months is different from the comparable figure for fair months with 99% confidence. Excess returns following cheap months are also different from excess returns following rich months with 99% confidence.

Rich months are different from cheap months with only 80% confidence, which is below the threshold customarily deemed statistically significant. Note, however, that because of their large yield cushion, it is impossible for high-yield to underperform Treasuries without suffering a major relative price decline. For example, in calendar 2001, high-yield’s total return difference versus five-year Treasuries was negative 3.03 percentage points. In that year, the high-yield index lost 4.76% of its value, versus a 2.52% gain in value for the five-year Treasury index. This suggests that investors who care about capital preservation should cut back on high-yield when the FridsonVision model finds the asset class is extremely overvalued, even though the average total-return difference between fair and rich months is too small to achieve statistical significance (note 5).

Finally, let us underscore the difference between our method, which compares the actual spread with fair value, and the traditional comparison with the historical average spread. On March 31, 2002, the OAS on the Master II was 708 bps, nearly 100 bps wider than the historical average for our observation period. The FridsonVision model nevertheless indicated that the OAS was 176 bps (1.3 standard deviations) less than fair value. This meant that high-yield was extremely rich. The model was vindicated when the Master II outperformed five-year Treasuries by 11.24 percentage points over the next 12 months.

Bottom line: The important consideration is not where the high-yield market is trading relative to where it trades under average conditions. What matters is how high-yield is priced relative to its prevailing risk.

Martin Fridson, CFA

CEO, FridsonVison

Research assistance by Daniel Fridson


1. In 1993, Martin Fridson and Jeffrey Bersh showed that deviations from historical average spreads had no value in predicting quarterly absolute or excess returns on high-yield bonds. The following year Fridson and Jón Jónsson introduced a multiple regression model that explained 72% of the variance in the spread of the high-yield index over 10-year Treasuries. Christopher Garman, also working in the Merrill Lynch high-yield research department, improved upon that model, as subsequently detailed in Garman, M. Christopher, and Martin S. Fridson, 1999. “Monetary Influences on the High Yield Spread versus Treasuries.” High Yield Bonds: Market Structure, Portfolio Management, and Credit Risk Modeling (McGraw Hill), Theodore M. Barnhill, Jr., William F. Maxwell and Mark R. Shenkman, Editors: 251-268. Subsequent work by Fridson and collaborators including Greg Braylovskiy, Vince Kong, and Camille Mcleod-Salmon used the option-adjusted spread.

2. Excess return is the return of the asset class minus the return on ostensibly default-risk-free Treasuries.

3. The most common valuation model in use today compares the spread-versus-Treasuries with the sum of the current default loss rate (defined as [default rate] x [1 minus recovery rate]) and the average difference between that rate and the spread. The difference is taken to represent the high-yield market’s illiquidity premium. Most users of this model fail to adjust for the fact that illiquidity, like other high yield risks, varies over time. In reality, separating default risk from illiquidity risk, as this method attempts to do, is not feasible because the two are interconnected. A sounder approach is to analyze the total high-yield spread as a function of risk determinants like the explanatory variables in our model.

4. High-yield bonds are most commonly issued with initial maturities of 10 years, but are typically retired well before maturity. The five-year Treasury index’s duration tends to be close to the high-yield index’s. On average, during our observation period, the five-year Treasury has ranged from 0.9 years longer to 1.2 years shorter (in modified duration) than the Master II, with a mean of 0.5 years shorter.

5. When the outlier returns of 2008-2009 are included in the analysis, the difference between the excess returns following fair months and rich months is significant at the 99% level.

Churchill Downs announces $400M of eight-year notes for debt refi

Churchill Downs (Nasdaq: CHDN) is in the market with a $400 million offering of eight-year (non-call three) notes, sources said. An investor call for the J.P. Morgan–led deal is scheduled for today at 11 a.m. EDT.

Proceeds will be used to repay existing debt. Existing unsecured debt ratings are B+/Ba3. Additional bookrunners for the 144A-for-life offering are PNC, U.S. Bank, Fifth Third, and Wells Fargo.

Churchill Downs last accessed the bond markets in December 2017, placing $500 million of 4.75% notes due 2028. Trade data show the notes closed the session yesterday at 95.75, to yield 5.36%.

The issuer’s long-term debt also includes a $400 million B term loan due 2024 (L+200, 0% LIBOR floor).

The company in February reported fourth-quarter and full-year results, citing a 22% increase in net revenue for fourth-quarter 2018, at $219 million. Full-year revenue was roughly $1 billion, up 14% over the prior year.

Louisville, Ky.–based Churchill Downs operates as a racing, gaming, and online entertainment company in the U.S.

Judge dismisses Marble Ridge claims over Neiman's MyTheresa transfer

The judge overseeing a lawsuit against Neiman Marcus Group has dismissed claims made by distressed hedge fund Marble Ridge that the retailer’s transfer of its MyTheresa asset to a subsidiary outside of creditors’ reach violated the terms of its indenture.

Judge Tonya Parker cited a “lack of subject matter jurisdiction,” according to a court document filed in Dallas, siding with Neiman's argument that Marble Ridge lacked standing to assert their claim.

“[Marble Ridge] Master Fund is not a creditor of Neiman Marcus based on its alleged holdings of term loans because it is not a lender under Neiman Marcus’ Term Loan Agreement,” Neiman counsel Mike Lynn of Lynn Pinker Cox Hurst argued in the defendants plea to the jurisdiction in December.

To prove an action for fraudulent transfer, Master Fund must be a creditor, the defendants argued. “Marble Ridge Plaintiffs lack standing to bring the claims asserted in their original petition,” Lynn said.

The order dismisses all of Marble Ridge’s complaints without prejudice.

“From the beginning, we have said Marble Ridge’s lawsuit lacked merit. We are pleased that the Court has fully vindicated our position and dismissed all of Marble Ridge’s claims with prejudice,” Neiman Marcus said in an emailed statement to LCD.

The Dallas-based retailer is currently in talks with creditors on an out-of-court restructuring that would give the company a three-year runway on its term loans and unsecured notes to implement its turnaround plan. While the deal would return an equity stake in the luxury fashion brand MyTheresa, 50% would remain out of the reach of creditors in case of a default, Marble Ridge argued.

For further coverage of the proposed restructuring see “Marble Ridge says Neiman Marcus revamp a 'devil's bargain'," LCD News, March 4, 2018, and “Neiman Marcus restructuring sees MyTheresa stake for noteholders," LCD News, March 1, 2019.

The case is Marble Ridge Capital LP v. Neiman Marcus Group Inc., DC-18-18371, in the District Court of Dallas County, Texas. A hearing on Neiman Marcus Group's defamation case against Marble Ridge is still scheduled for 9 a.m. on March 21.

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LCD comps is an offering of S&P Global Market Intelligence. LCD’s subscription site offers complete news, analysis and data covering the global leveraged loan and high yield bond markets. You can learn more about LCD here.

Affinion receives consents for recap, covenant elimination

Apollo-controlled Affinion Group has met the required 98% participation threshold to proceed with its proposed recapitalization plan. In addition to reducing debt by $628 million and extending its maturity profile, the company also received consents to eliminate financial covenants under its indenture.

The restructuring proposal came after the marketing concern failed to make a $22.2 million interest payment due Feb. 19 on its first-lien term loan due May 10, 2022, entering instead into a forbearance agreement with its first-lien lenders through June 3.

If the transaction is not completed, Affinion has warned it could seek to restructure via Chapter 11, obtaining a $55 million debtor-in-possession term loan facility with HPS Investment Partners, Manchester Securities, and Zev Investments for this purpose.

The distressed exchange will swap about $700 million of principal of the company's 12.5%/pay-in-kind (PIK) 15.5% step-up notes due 2022, which were put in place as part of a 2017 restructuring, for equity in the company. Affinion also plans to issue $357 million of 18% PIK unsecured notes due 2024 (unrated) and use net proceeds of about $300 million to repay its full revolver borrowings of $108 million and pay down $153 million of the approximately $872 million outstanding on its first-lien term loan due 2022.

Pro forma for the repayment, $719 million of the term loan will remain outstanding, with the loan's maturity extended to 2024, from 2022. Additionally, as part of the transaction, the total commitment under the revolver will be reduced to $80 million, from $110 million, and the maturity extended to 2023, from 2022, according to S&P Global Ratings.

As of Dec. 31, Affinion had $84.7 million of cash and cash equivalents.

“We believe Affinion's decision to forgo its interest payment is strategic because it proposed a new recapitalization plan and negotiated with lenders to restructure the balance sheet, and not due to insufficient liquidity given cash on hand,” S&P credit analyst Elton Cerda said in a March 8 report.

Prior to the removal of financial covenants, the issuer was subject to a 6.75x senior secured leverage ratio governing the facility, scheduled to step down each quarter in 2019 to 6.38x, 6.25x, 6.00x, and 5.88x, respectively.

Affinion, a provider of loyalty and customer engagement solutions, placed the PIK toggle bonds in 2017 as part of a restructuring that swapped its existing unsecured notes in a deal said to be backstopped at the time by a significant portion of the company's existing senior unsecured lenders.

The loss of a key customer last year, however, is expected to result in a double-digit decline in revenue and EBITDA in 2019, according to a December report by S&P Global Ratings. S&P has since lowered its rating on Affinion, to SD, from CCC–, on account of the missed term loan payment. Moody’s lowered Affinion to Ca, from Caa3, and withdrew all ratings.

Revlon delays annual 10-K, details liquidity, ERP-related losses

Revlon, Inc. has delayed the filing of its annual 10-K report for the fiscal year ended Dec. 31, 2018, saying it has identified a material weakness in its internal financial reporting related to the implementation of its enterprise resource planning (ERP) system in the U.S.

In addition to the company’s dwindling liquidity position, service level disruptions at its Oxford, N.C. manufacturing facility following the February 2018 implementation of the new ERP system have been a key concern for investors in light of the impact on the company's ability to manufacture and fulfill shipments to U.S and international retail customers.

According to preliminary numbers released by Revlon, net sales fell 4.8% to $2.56 billion for the full-year 2018. The company said the performance reflects a net sales reduction of $64 million related to the previously referenced service level disruptions stemming from the ERP system implementation.

Operating losses widened to $85.2 million in 2018, from $23.8 million in 2017, again, driven primarily by lower net sales and costs associated with remediating the SAP disruption at its North Carolina manufacturing facility, as well as a $20.1 million loss related to reacquiring certain iconic Elizabeth Arden trademark rights.

Revlon's net loss came in at $294 million for 2018, compared to a net loss of $183.2 million last year.

The unaudited results showed adjusted EBITDA of $237.9 million for the year, compared to $257.3 million in 2017.

Revlon said the assessment of its internal controls over financial reporting for 2018 is not expected to result in any changes to the disclosed financial results.

In terms of liquidity, the company’s liquidity position had fallen to $118 million as of Feb. 28, from $160 million at year-end 2018. Its current liquidity consists of $75 million of unrestricted cash and cash equivalents, as well as approximately $50 million in available borrowing capacity under its revolving credit facility, less float of $7 million. As of Dec. 31, Revlon had $87.3 million of unrestricted cash and cash equivalents, as well as $96.4 million in available borrowing capacity under the revolving credit facility (which had $335 million drawn at the time), less float of $23.4 million.

Revlon bonds were in the red ahead of the filing, but losses deepened post the aftermarket disclosure. Revlon Consumer Products 5.75% notes due 2021 (CCC/Caa3) traded in clips at 84, down roughly 2.5 points on the day. The notes started the year at 75, before trading up alongside the broad-market rally to peak levels this month on either side of 87.

Revlon earlier this month entered into an amendment to its asset-based revolving credit agreement to extend the maturity date applicable to the $41.5 million senior secured FILO tranche to April 2020, from April 2019. The fully-drawn FILO tranche was placed in April last year to provide for the additional first-in/last-out tranche commitment under its ABL revolver. See “Revlon TL gains on new FILO "liquidity comfort", LCD News, April 20, 2018.

Revlon manufactures, markets, distributes, and sells beauty and personal care products. Corporate issuer ratings are CCC+/Caa1.

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LCD comps is an offering of S&P Global Market Intelligence. LCD’s subscription site offers complete news, analysis and data covering the global leveraged loan and high yield bond markets. You can learn more about LCD here.