“So, where’s the fizz?” asked a colleague recently as we discussed conditions in the global high yield bond market. High yield is often considered a risky segment of the financial market, and so my colleague assumed – that after nearly a decade of quantitative easing, and with signs of aggressive behaviour across a wide range of asset classes – that the high yield bond market might be close to bubbling over.
It is a reasonable assumption. Students of financial history will know that a number of the biggest bubbles of the last few decades have been funded using high yield bonds. These include the leveraged buyout booms of the 1980s and the early 2000s, the telecommunications bubble of the late 1990s, and the US shale energy boom of the 2010s. In each case, investors who passively invested in the broad high yield bond market near the peak subsequently suffered substantial losses.
In which areas can we see financial exuberance today? I would argue that prime suspects include: Cryptocurrencies; certain technology companies; equities valued as “bond proxies”; and real estate in “super-prime” markets. In each of these cases the high yield bond market is neither a primary or even a peripheral source of financing.
A key signal of impending trouble in the high yield bond market is the volume of aggressive issuance. We can identify whether a new issue is aggressive in three key ways:
1) by the credit risk of the borrower – a CCC credit rating is a good proxy for this;
2) the use of proceeds – a debt issue to fund acquisitions or dividends is more aggressive than a refinancing; and
3) the structural quality of new issues – bonds that don’t pay cash interest are particularly aggressive.
So far in 2018, CCC-rated securities make up only 11% of new issuance, which compares to 33% in 2007 (and an average of 19% during the 2004-06 period). Use of proceeds has recently been relatively conservative too, with new issues to finance acquisitions and dividends representing less than 20% of total volume. This is far below the peak of 50% reached in 2007 (and an average of 35% during the 2004-06 period). In addition, in 2007 12% of all new bond issues did not offer coupons in cash. 2018, by contrast, has seen no new issues of non-cash pay bonds.
A key feature of the high yield bond market is its relatively short maturity structure. A consequence of this is that the composition of the market is always changing as different issuers, in various sectors, with evolving credit metrics, are regularly issuing and redeeming bonds. As a result, the risk profile of the market is not constant over time. We would argue that the quality of the high yield bond market is much better than it has been in the past. Therefore, valuation models that use historical risk metrics may be unduly cautious with regard to high yield bond allocations.