In recent discussions with financial advisors and other clients, we've often heard questions about the high yield market, now that the economic cycle has more clearly turned from the recovery phase to a more stable-growth oriented one. Much like equities, high yield bonds' performance tracks the economic cycle: In both markets, more speculative, beaten-down securities enjoy a "pop" at the initial recovery phase, before they settle in to a more stable period of moderate returns, which, history has shown, can go on for years. While it's true that the "easy money" was made when the high yield market enjoyed significant narrowing of credit spreads as a result of the recovery, the arena continues to appear attractive for its relatively high source of current income as well as the potential for appreciation due to credit upgrades, merger activity, and other special situations that occur in the growth phase of the cycle. Of course, opportunities now require careful security selection, unlike the benefits that were enjoyed by virtually all during the narrowing of spreads from near-historic highs.
With that said, questions remain as investors seek to balance out the high yield market's upside potential with its downside risk: While we agree that significant rate rises would diminish the risk/reward profile of high yield bonds, we also see enough strength in the underlying economy for the other possibility: a sustained period of stable growth, providing high yield bonds with upside opportunities noted above. Of course, since we cannot predict whether—nor when—rates will rise precipitously, we continue to monitor our positioning, but currently see the risk reward among our high yield universe (composed of straight high yield, convertible and synthetic convertible securities) to be in line with the relative opportunities. In the paragraphs below, we will walk through our reasoning. A good place to start is by understanding how high yield bonds are currently priced, given where we are in the market cycle and relative to other opportunities.
At some point in the business cycle, "high yield" bonds become more deserving of the term "junk bonds." We don't believe we are at that point in the cycle, but we remain watchful. The turning point typically occurs after a number of years of credit expansion culminating with speculative offerings that border on the insane. During the late 1980's, I remember bonds being issued by companies that had virtually no business infrastructure and less annual revenue than the annual interest payment on the debt they were issuing. Bonds like these were truly "junk" despite the market's willingness to buy them. Not surprisingly, such issues led to the wash out in high yield—or rather, junk bonds—during 1989-90, and helped expose the market's lack of any margin of safety. Only after the fall did the market shun this arena, dubbing the market "junk" when, by our assessment it was truly "high yield:" with much wider credit spreads, we were more than compensated for the equity risk component. But less than a decade later, the market repeated the insanity during the dot com and telecom booms, reminding me of the quip that sometimes the market has a short memory, and sometimes it has no memory. Once again, capital was available to all, leading to junky deals, overextension of credit, and, ultimately a difficult period for high risk investing and high yield bonds.
Today, access to capital has increased, high yield spreads are narrow, and issuance is very brisk. A sane investor might be inclined to ask if we are back in the "junk bond" phase of the high yield market, following the economic recovery phase, when such debt was more clearly "high yield." Although issuance has been very strong and the deal quality has deteriorated somewhat, I would not sound the alarm yet. Many deals being done today could or would have been done via secondary stock offerings or convertible offerings were the overall environment a bit different. However, with interest rates near 40-year lows, management has been choosing not to give up equity at this level, making a straight debt offering more attractive. That's not to say we have not seen some real stinkers issued—just not nearly at the level as in previous peaks. Our investment team has largely passed on recent deals, because we do not feel that the yield is compensating us for the "equity risk" inherent in most of these positions. Still, new issuance does not reflect the complete opportunity set of the market, where we see more reasonably priced possibilities. To clarify this statement and to better understand how we see the high yield market, we can apply some rules of thumb to various valuation methods.
One rule of thumb to determine fair value estimates for the high yield market divides the security down to its two components: equity risk and government bond risk, and calculates an estimated return for each. We use this rule of thumb to assess the current return of the high yield market relative to the returns of other asset classes. Historically, the high yield market has typically returned 30 cents on the dollar in the event of default, while the remaining 70% recovers nothing and is thus like equity. To assess if we are being properly compensated for these two types of risk, we can assume that 30% of the high-yield market's return should roughly match government-bond risk, while 70% of the return should track returns based on equity risk, using some basic equity and bond market return assumptions.
The S&P 500 has grown earnings at a compound annual rate of approximately 7% since 1945. If we assume earnings grow at 7% annually for the next five years and interest rates stay the same, we can estimate we would receive a 7% return on the market plus roughly 2% dividend yield for a total return of 9%. What can we expect for high yield bonds in this environment? Since we have learned that 70% of the average high yield security is equity-like, then we should receive 6.3% (.7 x 9) of the market's return plus the return earned from the government bond-like component: We can multiply the 5-year Treasury rate of approximately 3.75% times the 30% of the high yield market that is akin to government bonds and come up with a 1.13% (.3 x 3.75) return for a combined return of 7.43% (6.3% + 1.13%).
Today, at 7.68%, the yield to maturity (YTM) for the high yield market is slightly higher than this estimated return, but given the "normal" assumptions indicated here, the high yield market looks reasonably priced. Assuming a single-digit return world for equities, then high yield bonds should return single digits as well. Of course, changing your assumptions in these long term growth rates in EPS or the recovery rate of defaulted debt will change the results, but these standard assumptions provide a decent grounding for asset-allocation assessments.
Another rule of thumb of assessing the rationality of the high-yield market is by taking credit quality into account, using the historical default and recovery rates for different tiers of the quality spectrum. Determining a basic bond value mathematically is not difficult. It is the present value of all future coupons to be received and the present value of par value over the life of the security. However, determining the appropriate discount rate in this equation is the key factor, and it varies with credit quality: as quality declines, the factor weights change dramatically. Credit spreads relative to the Treasury curve (the discount rate) reflect the market's current assumptions about an issuer's probability of bankruptcy, expected recovery rate in the event of bankruptcy, time to maturity (or potential event), liquidity, and overall sentiment. So how does the high yield market look today based on these factors?
The table below segregates the high yield index today based on credit quality. The historical 5-year default rates for each credit grade as well as the historical recovery rates are indicated. Given the mix of credits in the market today, we can use a rule of thumb valuation to understand what is implied in the current market valuation. The weighted average 5-year probability of default is 24% and the weighted average recovery rate for the market is roughly 30 cents on the dollar (see bottom row).
Armed with this knowledge, we can use a very basic tree structure (below) to estimate the market's reasonableness. Although the average time to maturity in the market is 7.6 years, the realized time is much shorter as many issues are redeemed early because companies are flush with cash.
For simplicity's sake, I will use a 5-year-to-maturity bullet bond to price the market. Using the historical ratios from the table, there is a 76% probability of the bond paying off at par in 5 years using the historical realized rate and a 24% probability of recovering 30 percent of par. Discounting these facts back at the 3.75% risk free rate implies a 7.64% YTM. This is very close to today's index YTM of 7.68%. This indicates the market is pricing in past experience into the current market and expecting problems out in five years. Of course, the Achilles heel in this situation is the assumption that the 5-year Treasury note rate remains at the current 3.75% level and the bankruptcy rate does not accelerate more rapidly than 5 years.
So, if historical relationships hold and interest rates hold, the high yield market appears rationally valued. What this analysis also indicates is that if mid- and long-term interest rates rise, high yield bonds are no more overpriced than other asset classes. That's to say, if the return assumptions for equities were more negative, upside and downside assessment of high yield would be indeed be less attractive, but in line with the decline of equities' upside/downside. Thus, for those declaring the high yield market as currently unattractive, logic dictates that they would declare the equity and bond markets unattractive as well.
Indeed, these rules of thumb demonstrate how valuations across asset classes are interconnected, and that opportunities should be assessed based on the relative opportunities in the marketplace. Where often we see investors often get into trouble is by trying to time market moves too abruptly, often on short term information. Without taking into account how current opportunities in one asset class compare on a relative basis to overall opportunities across all asset classes, such moves smack of market timing, and have been shown to subtract value over the long term. Instead, we believe in continually assessing the relative opportunities, and tailoring portfolios over longer periods of time, trying to stay six to 18 months ahead of the market cycle. We currently remain focused on the selective opportunities among our high yield universe, as valuations are in line with the risk-reward balance of the equity market, especially with the potential for an ongoing expansionary period. For now, we're still finding "high yield" opportunities rather than "junk" bonds.