Where is High-Yield Risk Today?
Verdad specializes in companies with debt on the balance sheet. Most of our companies issue some portion of their debt in the high-yield bond market. Our strategy’s returns are, as a result, highly correlated with the high-yield bond market. As long as the high-yield bond market is healthy, our strategy significantly outperforms broader public equity markets.
But every three to five years, the high-yield bond market goes through a downturn and the premium that investors demand for taking credit risk spikes. There was a downturn in 2003 driven by problems with telecom debt, in 2008 during the financial crisis, in 2011 during the height of the Eurozone debt crunch, and in 2015 when plummeting oil prices sparked fears of mass defaults on energy bonds.
The key question for us is: when will the next high-yield crisis come and what will cause it? We monitor the high-yield market very closely and are alert to any rise in bankruptcy or refinancing risk.
To assess the current state of the high-yield market, we looked at the underlying constituents of the high-yield index and built up a picture of the aggregate risk of the index. We focused on three key metrics:
The ratio of net debt to EBITDA. This ratio compares the total amount of debt to the total amount of EBITDA. The higher the ratio, the higher the risk. A ratio of 6x is generally considered the threshold for high risk.
The ratio of free cash flow to net debt. Free cash flow is the amount of cash a company generates, after all expenses and investments, that can be used to pay off debt or return capital to shareholders. Companies that are generating positive free cash flow are more creditworthy than companies that are burning cash, so negative free cash flow is a sign of elevated risk.
The percentage of debt rated C or below. Over the long term, over 25% of C-rated bonds have gone bankrupt. When greater than 10% of a sector’s debt is trading at is speculative rating, we consider the sector to be at elevated risk.
Below is a table that groups these underlying constituents by industry and then shows the total for the high-yield market. I have shaded in red areas of elevated risk.
Figure 1: High-Yield Constituent Risk Assessment
Source: CapitalIQ
The only sector that is high risk on each of the three metrics is the sector that caused the last high-yield crisis: oil and gas. These risks are well understood and priced into the market as a result of the 2015 downturn, so we don’t see this as overly concerning.
Problems have typically arisen in the past when certain sectors became disproportionate in their weighting of the total market. Prior to the telecom bubble bursting in 2003, the sector accounted for over 40% of the total outstanding high-yield debt. Prior to the collapse in energy prices in 2016, energy accounted for over 20% of the high-yield bond market. No sector has a comparable weighting in the index today. The higher-risk sectors (hospitals, casinos, broadcasters) all represent 3-4% weightings in the market, a level easily contained even if default rates spike.
As a result, we continue to see limited risk in the current high-yield market. We continue to believe that we are in the early stages of this credit cycle. We agree with Bridgewater’s Ray Dalio, who recently wrote: “we see no major economic risks on the horizon for the next year or two.”
As we have noted earlier, the typical cycle lasts about 39 months, and we are now about 15 months into this cycle. The quality of issuance is high. And, looking at the constituents of the broader index, there seems little imminent risk of large-scale defaults outside of energy, which is a well-understood risk that we believe is largely priced in. As a result, we believe the rally in leveraged equities has a ways to run.