The last time that U.S. high yield spreads (the difference in the effective interest rate paid for riskier corporate bonds relative to US Treasury bonds) had widened out to the levels they are at today was August 2011. The S&P 500 index was still at 1120, below pre-recession levels. The price of oil was $110. And Donald Trump’s role in the political arena was limited to espousing anti-Obama “birther” conspiracy theories.
How times have changed.
Default risk is back in the minds of high yield investors. Oil and other commodity prices are down by 80% or more – dragging the energy sector with them. But the U.S. stock index is still in lofty territory after a 7-year bull run, just 9% from all-time highs. Meanwhile, Mr. Trump who incidentally built an empire fueled by high yield bonds – and defaults — is a front-runner to be the next leader of the free world.
So far, 2016 has left investors wondering where to hide.
Increasing risk has been compounded by economic slowdowns in China, Brazil and Europe. That means the Fed is unlikely to raise U.S. base rates significantly this year – which will keep U.S. stocks on life support. On a relative basis, the U.S. economy is well positioned: historically low borrowing rates for corporates and a healthy consumer (low unemployment, the beginning of wage growth, and extra dollars from cheap oil). Within the U.S. economy, we believe that lower middle market companies (companies with less than $100MM in revenu
es which is Lateral’s focus) are the best positioned given they have little or no reliance on exports. Smaller companies in asset-based industries excluding energy aren’t as exposed to the shifting credit/commodity cycles and other externalities. The risks are intrinsic and fundamental (management execution, collateral value, contract veracity), non-correlated and without the volatility costs of mark-to-market pricing.
The changes in the high yield market over the past 3 months have wide-ranging implications, as the spread between investment grade and high yield widen.
First, high yield is still expensive relative to embedded risks and liquidity constraints in the market. Funds and ETFs are vulnerable to correlation and liquidity constraints so there’s still more risk that needs to be priced in. Long-feared liquidity traps inthe bond market materialized in December due to a combination of the Fed’s zero interest rate policies and regulatory changes. The corporate bond market increasingly favors early sellers and “runs” on illiquid bonds that beget selling in unrelated but more liquid bonds. As a result, bond prices didn’t then and don’t now adequately reflect risk.
Since August, high yield spreads have widened by 275 basis points and prices have dropped by 30% but default risk is going up significantly. Mutual and hedge funds are experiencing redemptions and outflows–most notably the gating of the Third Avenue Fund. The result is further illiquidity. High yield issuance this month is on pace to be down 90%, year over year,
according to Citi analysts. Analysts have been steadily increasing its expectations for defaults, particularly in the energy sector, driven by the plummeting price of oil.
Second, the sponsor-backed private debt model is getting less compelling to investors. More than $100 billion was raised for private debt funds and business development companies (BDCs) last year. The 8-10% target returns from covenant-light loans to private equity-backed companies no longer makes sense in an environment with rising high yield spreads and declining public equity comparables. Steep competition in this market has resulted in highly leveraged transactions with limited covenant protection and generic pricing divorced from the underlying risks. For private debt funds, the illiquidity to investors is much less justifiable given the 5-10 year locked structures with no upside. Furthermore, these funds often employ 1-2 turns of leverage, adding to the risk which investors must consider.
For BDCs, which are theoretically liquid instruments and publicly traded entities that participate in middle-market private and syndicated loans, the trouble has already started. Or as the Wells Fargo BDC analyst put it: “Winter is coming.” BDC stocks are trading on average at 69% of their portfolios net asset value and portfolio write-downs are just starting. Because of their discounted values, BDCs are unable to raise new capital in the public markets. Every new $1 invested by the BDC is effectively marked down to 69 cents. As a result, the effective yields on some of these discounted portfolios are in the high teens even though their underlying portfolio yields no more than 10%. The market believes that more write-downs are in order for BDC portfolios.
Third, private equity deal-making is increasingly hamstrung as the cycle turns. Sellers of private companies believe their companies are worth what they were last summer when transactions were being closed at a premium to public market values. Now with the public market in correction territory, private equity investors must justify paying even steeper multiples to close deals. As noted above, private debt investors and high yield issuance are starting to pull back, leaving private equity firms to overpay and reduce debt/equity leverage ratios, a double whammy on target returns, in order to get transactions done. Anecdotally, this has resulted in numerous broken transactions as sellers decide to wait for a better market. PE investment committees are also pulling transactions which no longer make sense and must instead evaluate portfolio write-downs.
At Lateral, we are encouraged by the recent changes in the high yield and private equity markets which have improved our position in several live transactions and clarified our differentiation to investors in delivering low volatility, defensively structured portfolios with attractive returns independent of credit, commodity or economic cycles. By focusing on lower middle market U.S. companies we avoid global risk factors and address a structural dislocation in access to capital for a key segment of the healthy domestic U.S. market. By focusing on collateral and event-driven growth catalysts, we underwrite to the fundamental performance elements of our borrowers with an emphasis on capital preservation, consistent baseline returns and uncapped potential upside. By exclusively lending to non-sponsored companies, we maintain direct visibility into company performance, customize and enforce covenants and help highly incentivized owners to grow and build successful companies.
We are still only at the beginning of a slow end to the Fed’s low rate regime. For investors looking for a compelling risk-reward in today’s volatile m
arkets, yield opportunities remain scarce. High yield still doesn’t pay enough for the embedded risks. Correspondingly, illiquid sponsor-focused private debt funds need to keep up – and do better than incremental outperformance of comparable risk in the public markets.