Wednesday, January 30, 2008

Easy? You call that easy?

Markets like this one are the enemy of solid fundamental analysis. It can cause otherwise good traders to start just guessing, resulting in either panic selling or simplistic buying (you know the old, “if you like it at $30, you love it at $15!” trade.)

One area where the value proposition is relatively simple is high-yield bonds. Bonds offer a very straight forward fundamental risk-reward situation: the reward is the yield, the risk is defaults. As of 1/25, Lehman’s High Yield Index yields 10.08%, or 672bps over Treasuries. That’s your reward in hard numbers. So what about defaults?

The following chart shows annual credit losses (that’s defaults less recovery) for high-yield bonds since 1982. The data is from Moody’s 2007 Default Study, and includes all Moody’s rated high-yield bonds.

I've labeled the recessionary periods of 1990-1991 and 2001. So in 1990, if you had owned the entire universe of Moody’s rated high-yield bonds, you would have suffered credit losses of 6.3%. The greatest credit loss rate of the last 25 years was in 2001 at 8.3%. So if the 2001 experience were to repeat itself in 2008, investors would earn 10.08% in interest versus 8.3% in credit losses. Determining the exact total return would depend on the timing of the defaults, but the number would almost certainly be positive.

So could defaults be worse in 2008 vs. 2001? Remember that the 2001 recession was all about over-investment in technology and telecommunications. There were also some very large defaults that were due to unique circumstances, namely Enron, Worldcom, and various airlines. If there is a recession in 2008, it will be about over-investment in housing. Very few high-yield issuers are involved in the housing market. Virtually all banks, brokerage firms, mortgage insurers, etc. are investment grade.

Of course, its possible high-yield spreads move even wider. According to Lehman Brothers, the high-yield index spread got as wide as 1036bps in 2002 vs. only 672bps today. Perhaps spreads will widen further, but don’t get caught fighting yesterday’s war. In 2001-2002, the corporate bond market suffered from a series of accounting scandals, which resulted in investors questioning the veracity of financial statements in general. That fear hit the high-yield market directly. Today the fear is related to mortgage lending, a business dominated by investment-grade companies.

For that matter, the 1990-1991 period was also unique, in that it saw the demise of Drexel Burnham Lambert. Drexel and its star banker Michael Milken created the modern high-yield market, and for several years was the primary market maker. Drexel’s fall from grace put the future of high-yield in serious doubt.

If we do have a recession in 2008, high-yield default rates will certainly increase. But at today’s valuation levels, high-yield already has a recession priced in. Given that there is good reason to believe credit losses will be no worse, or perhaps even better than the last two recessions, high-yield looks fundamentally attractive.


Anonymous said...

You should have included the disclaimer that past performance does not predict future returns.

I think the missing element in your analysis is what would cause defaults in these bonds?

Specifically, would a large, sustained downturn in consumer spending cause defaults to skyrocket to percentages unknown heretofore?

Accrued Interest said...

Obviously anything is possible, but what we have now is a certain segment of consumers who find themselves in a weaker situation: recent home buyers. But the majority of consumers are really no different: longer-term home owners and renters. So while its clear that consumer spending will weaken, its not clear that it will be weaker than during other recessions.

Anonymous said...

""well in this environment...." I'd love to know the annual credit loss %-age for 1974, 1975 and 1980, if you've got 'em.

Thanks very much for your "The credit market had already priced this [recession] in" of 23 Jan, reinforced by today's "at today’s valuation levels, high-yield already has a recession priced in". Last week I took a look at my brokerage's High Yield mutual fund, and at Vanguard's too. Both NAVs were close to October 2002 lows. Since the stock market has yet to price in a recession, and the High Yield funds looked like they were at least trying to, I was able to take an initial position with more knowledge and confidence than I could've without your and Hymas' help.
Disclaimer My decision, based on my judgement. Just wouldn't've thought to look and think about it without your blog posts.

Accrued Interest said...

Moody's has default rates (but not credit loss rates) for that period. The average recovery rate from 1983-2006 was 37%.

70: 8.74
71: 1.14
72: 1.94
73: 1.28
74: 1.34
75: 1.74
76: 0.87
77: 1.34
78: 1.79
79: 0.42
80: 1.61

Now here is the problem. Basically all HY bonds in the 1970's were fallen angels. That may render this period less comparable to today.

Unknown said...

I've been reading your blog for some time (referred from CalculatedRisk), to learn more about bonds as they pertain to the current housing / mortgage crisis. I hadn't pondered investing, but your post certainly is interesting. So, I must ask a naive question: if one were to take your post and act on it (past performance of course not predicting the future), how would one do it? I assume Lehman has an index, not a fund, so how would a naive investor go about reaping something out of this? Does someone run a mutual fund based on the index, or an ETF?

Anonymous said...

Timely post (for me anyway) as I was thinking about taking a half position in ishares HYG based on similar considerations (no financials). Figure if spreads widen closer to 1000 bp, then maybe the other half, if not then stand pat.

Anonymous said...

I wonder how the issuance of covenant light debt with PIK toggle features during the credit insanity (at least in '06 and '07) will affect the default and recovery rates this time around.

One the one hand, it will allow some shaky companies that would have busted through ratio covenants to avoid default for as long as they can make payments on the debt.

On the other, that this type of debt was available as broadly as it was (and at the extremely high multiples of EBITDA that it was) may mean that what we have out there right now can't be compared to what was out there in the past.

Accrued Interest said...

HYG is an easy way to play this. The per-name percentage in HYG is relatively high. I've picked two mutual funds, which shall remain anon, based one 1) Expense Ratio, 2) Lack of bank loans, CLOs, and CDO exposure, and 3) Beta near 1 to HY index.

Most of the PIK toggle bull shit was in loans, not bonds, so if you avoid funds with loan exposure, you have a good chance of avoiding that stuff. You also have a good chance of avoiding a lot of the LBO debt, which was mostly done with bank loans.

Again, HY wouldn't be at 600+ spread if there weren't risks, but I think the risks make more sense in HY than in other areas, including stocks and financial bonds.

Anonymous said...
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Anonymous said...

This is off-topic from your post, but I was wondering if you could tell those of us who don't understand the bond marker the significance of this:

Nevada, Georgetown Univ say muni auctions failed

Is it a fluke? Is it some sort of market breakdown? Does it mean these institutions are screwed?


Anonymous said...

Are you sure about "most of the PIK toggle bullshit was in loans and not bonds" I was almost positive it's the other way around. Do you happen to have any hard figures you could easily pull up?

Secondly, given your example of the spreads vs default lost, wouldn't those companies with the largest yields also be the ones more likely to default? Thus, the average yield vs default is overstated by the more distressed outliers who were more likely to default and thus provide none of that juicy yield?

PS Love the blog. Please keep it up! Any other bond-market blogs u read?

Anonymous said...

Felix Salmon has a reply to this: the large amount of covenant-lite debt issued during the bubble means it's a different ball game this time around.

Accrued Interest said...

To Felix's points: that's why I'm avoiding loans. The cov lite situation should alter recovery, not defaults, in my opinion.

Many of the bad loans (by this I mean, the poorly structured ones) went into CLO's. As I've posted in the past, CLO's had many of the same bad incentive problems that mortgage CDO's had. (CLO's don't have the structured squared problem but that's another post for another day.)

Its not that I'm dismissing cov lite as meaningless, but covs were always a secondary or even a tertiary protection for bond holders. The primary protection is the solvency of the business. So I don't think its wise to overweight the problem of poor covs.

As for the PIK toggle thing, the only thing I can say is that I don't see very many bonds offered with PIK toggles. I see structured products (CDO/CLO) that have PIK features. So I'm speaking from my own experience, not from statistics.

As for the Nevada thing, its a facinating problem, if you are as big a bond geek as I am. I'll try to post about it in the next day or so. Suffice to say that its a weird quirk in the auction rules that is having the opposite effect that was intended.

Anonymous said...

Dear Mr. Graf,

It is premature to suggest that the high yield market is sounding the all clear bell. Yes the spread data you present is accurate as I have lived through several of those cycles.

The problem I have is with the linkages underpinning your logic. You seem to suggest the possibility that we may or may not be headed into a recession. Further you seem to suggest that because housing is a small part of the high yield universe - the integrity of the high yield markets will somehow be preserved and thus offer an attractive option.

Mr. Graf, we are in a recession and it will be deep and long and it is not one that will be solved by a 50 basis point rate cut or a half turn less on leverage. The problem is one of solvency across our financial institutions and the integrity of the paper issued by these institutions for their own account and for others.

Housing is but one example of the lack of credit quality that pervaded the go go financial culture of the last 7 years. It is an important one to be sure as no doubt you are aware that several that nearly $1 trillion was extracted by consumers from their homes during this period with most of that spent. The "spent" portion (e.g. debt) was the fuel for our economy. Now that that fuel is gone the engine is grinding to a halt. .6% GDP growth sort of comes to mind.

The high yield market is a second derivative if you will on consumer and industrial demand. To suggest that housing is a small part of the HY universe and and that spreads are attractive therefore HY is attractive is specious.

Spreads are widening because of the recognition that we are facing a global credit crisis of epic proportions not just in housing but throughout the entire economy. Your readers no doubt understand that the very solvency of US financial institutions is at risk. Why else would we need the soverign wealth funds Mr. Graf?

FAter years of lax credit standards and excessive credit it is time to pay the piper. O follow 400 companies in the leveraged finance universe. Yes spread are widening but business conditions and profits are deteriorating at a more arpid clip. That is the most importnat point for your readers, The consumer is spent and that's bad news for leveraged capital structures. Very bad news indeed. And unlike 1990 a period in which I profited - the scope of this problem appears to be in the trillion dollar range vs $250 billion for the then HY/S&L crisis. The magnitude is far far greater.

So yes - spreads are widening and look appealing. But looks can be deceiving. Stay tuned Mr. Graf. The night is young The party is just starting. Patience.

Anonymous said...

@fallen angel
1) AI is no Zeppelin

2) the financial institutions over which you obsess can be replaced more easily than you lead us to believe. The more insolvent, the more rapid the replacement.
"the very solvency of US financial institutions is at risk"
We can dump them faster than we dump old Fords and replace with better. Just watch how orderly Citigroup's disappearance will be.

Anonymous said...

Psycho Dave,

Not really sure about your comments. One doesn't replace financial institutions with ease as you say. The US and Europe are facing a massive solvency issue in banks, monoline insurers among others.

To whistle past the graveyard is generally not a profitable exercise. Thereis a small thing called a credit contraction afoot here.

But keep whistling. As I said earlier we have a solvency issues. Assets of all types are going to get cheaper - even high yield bonds and bank loans. And that will make CDO/CLO managers very fearful. And where there is fear there is money....

Patience... The night is young...

Accrued Interest said...

I'll say this. High Yield is a contrarian play right now. When you make a contrarian bet, you can't be too afraid of timing. Otherwise you'll never actually buy. I mean, if its a contrarian bet, that means sentiment and headlines are wildly against you. So its entirely possible that you'll buy in too early. But if your fundamental bet is right, then the short term pain turns into long-term reward.

Anonymous said...

Accrued Interest,

There is a difference between being a contrarian and catching a falling knife. One is noble and perhaps profitable. The other is suicidal.

In the stressed and distressed securities game, timing is everything. All assets are facing a massive repricing due to the absence of tradtional and disciplined credit standards. While it is true some high yield bonds offer compelling value - most do not.

Being deep levered cap structures in an environment in which there is (1) declining unit demand, and
(2) rising input prices is a dangerous place to be.....

One has to question broadly whether one is being paid for the risk understaken. Timing question.

Let's face it we have vast solvency issue in the US and european financial institutions, the monolines are bust, Option ARMs are next.

This is the time to be patient. Not to buy, but to build one's shopping list....

Now there's a novel concept for US investors: patience.

Squints said...

"Very few high-yield issuers are involved in the housing market."

Heh. Yet.

Squints said...

Tom, just seeking clarification here:

"The per-name percentage in HYG is relatively high."

Do you mean concentration in issuer names? Or concentration in fund contributors of the holdings underlying the ETF?

Anonymous said...

I think Zidane's makes a good point about covenant light and how it might avoid some defaults, thus making HY funds very attractive in the near term. What I am concerned about is that the majority of HY issuance from 2003 to summer 2007 were for LBO's and thus highly levered. Also, most HY issuance tends to be for companies with hard assets, though the HY's don't have a 1st lien on them, there is some type of collateral coverage. Furthermore, these companies tend to be more linked to consumer and business needs. So though it is a good thing that they have some type of collateral coverage, the fact they are more levered and more linked to the economy is troublesome. If I were investing in a HY fund, I would definitely took a quick look through the top 10 holdings and make sure I don't see companies such and equipment manufacturers, home builders and what not.

Anonymous said...

I know the news media is clinically obsessed with the housing market, but they are always the last ones to figure things out. The problem is that people/companies got massively over-leveraged. Housing (arguably) blew up first, but credit cards aren't without problems. Consumer credit, expressed as a percent of GDP, is at or near all time highs. Commercial real estate (office space or strip malls) are massively overbuilt. There was way too much credit sloshing around, and no real economic use for it. People built because they could get the financing, not because there was real demand for construction -- no, house flippers don't count. Even if the house gets flipped, someone has to live there for it to be economically needed. And 50,000 empty condos in Miami alone tells you a lot of this stuff was never needed.

For those of us who have been saying all along (check my posts) that this is an insolvency crisis, not a liquidity crisis -- the ineffectiveness of the Fed dumping more credit is no no suprise. Many people who don't wamt it- because they are being smart and deleveraging. The only people who want credit now are the people who can't pay it back.

Yes, I have to say I told you so; and here is why: there are still people claiming this is a liquidity crisis, one that can be solved if only the Fed will lower Fed Funds to 4%, no 3%, no 2%, no 1%... Guys, we already played this game in Japan, and it doesnt work. Highways to nowhere, financed by cheap money, does not solve anything.

What exactly do you plan to accomplish by lowering interest rates? You can't be seriously thinking a builder "needs" to build another empty condo.

As for refinancing outstanding mortgages: even if rates are zero, you still must pay (at least) the loan amount divided by 360 (12 months times 30 years)... The loan amount is still a lot more than the property is worth, and if we have house price deflation (which is the one thing people seem to agree on) -- the home value will not catch up with the loan amount for many many years.

So a lower mortgage rate doesn't fix the problem.

Joe Average, demonstrating far more smarts than the Harvard MBAs on Wall Street has already figured this out: more and more people are turning in the keys and walking away from their loans.

Maybe Joe Average cannot articulate it quite this way, but here is the reality: these loans are crap, and they need to be written off. I am not talking about a mark to market loss on some bank balance sheet. I mean, tear the loan up. Maybe give a new loan for half the original amount (and at a risk based interest rate) -- but the original loan is garbage.

Wall Street is always saying to take your loss, live to fight another day. Ride your winners.

So why is Wall Street riding its loosers? Take the loss, write them off, and get on with rebuilding the economy.

Sooner or later, we will all be forced to do this anyway- dragging it out just means more people end up in default (bigger losses).

Lower rates are not effective, and they do have a cost. At minimum, it cuts the income of the elderly, who generally live off bond income. It has a serious danger of kicking off yet another, bigger, asset bubble. And most importantly of all, it sets off inflation.

If a worthless currency really fixed things, banana republics would be the envy of the world.

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Anonymous said...

Past cycles had more fixed rate traditional bonds, whereas now 80%+ of the leveraged finance market is floating rate loans. Falling rates make these less attractive and spreads will have to widen massively to clear the hung lbo pipeline and make these attractive relative to fixed rate and equity alternatives. Defaults may be lower but th technicals here are horrendous and with clo's dead, it will take years to clear these. Yes they are fundamentally attractive but my gut view is that for anyone that has to live with the mark-to-market, all these loans and bonds are going lower.

dmandman said...

that might not be too easy...but, is damn easy! For all of your verification of income needs! get the new car or home of your dreams!!!