With Bonds, It Pays to Be in the 'Middle'

With the high-yield bond market falling about 1.25% from its recent highs (based on the Markit HY CDX index), I'm adding a bit to credit. But as I've said in recent columns, you have to choose your spots. The high-yield bond market is becoming increasingly segmented, with certain companies enjoying low yields, easy terms, and ample access to financing. Other companies (and not just energy) are finding a cool reception from the market. Historically, this has often occurred at the end of the credit cycle, just before default rates rose. There is considerable stress in the market today. The chart below shows a distribution of high-yield companies by the dollar price where their debt is trading. We compare today on the left with June 30, 2014 on the right. Source: Bank of America The blue are bonds trading over par (i.e., 100% of the loan amount). These companies are seen by the market as perfectly healthy. Notice that this percentage has dropped substantially from mid-2014, where over 90% was trading at this level. Today that is down to 51%. The percentage trading below $90 (the gold, blue, and green segments), which is what I'd call stressed is now 20%. That was under 2% in 2014. In an efficient market, we can say that company debt trading more than 10% away from its face value suggests a distinct possibility of a default. Since the average recovery for debt holders in bankruptcy is around 30% of the original loan amount, we could crudely say that a company trading 10% down from par has about a 1 out of 7 chance of defaulting, according to the market. Here is where access to market becomes crucial. Perhaps a company whose outstanding debt is trading at $90 can sell new debt -- it just has to do it a bit more expensively. The market effectively says that while this company has some troubles, there is a yield at which the risk is worth the reward. The thing is that the market usually has trouble digesting new debt from companies of a certain level of stress. Here's why. Say you participate in a new debt transaction for a company under some considerable stress. The deal comes with a yield of 12% but is priced at $100. What is your upside? Ultimately, it is no more than 12% per year. What is your downside, though? If the average recovery is 30% of par, then it is around 70%. And since the company is under stress, there is a very real chance that a default happens in a relatively short period of time, so it isn't like you can even count on getting many of those 12% payments before the company goes bust. To prove this point, so far in 2015, only nine companies have been able to come to market with debt yielding 12% or more, or a total of $2.9 billion in debt. By contrast, there is $195 billion of bonds trading at yields of 12% or higher within the Merrill Lynch high-yield index. Now many of these companies do not have any debt maturing immediately that they need to roll over, or else they have access to other forms of capital. But all of them likely need to right their ship soon or they will find themselves in a debt restructuring. What does this mean for that large chunk trading above par? Can't you still buy those bonds? Sure, but there you need to watch out for what we call gap risk. For example, take D.R. Horton (DHI), a Ba1-rated homebuilder. It's a solid company in an industry that is doing well, but its five-year bonds are just under 200 basis points over Treasury bonds. At that level, the market is assuming it gets upgraded to investment grade, which may well happen. But there isn't any upside even if it does. Whereas if the homebuilding market were to turn mildly weaker and suddenly the market no longer assumes an upgrade is imminent, the bonds could sell off substantially. Right now, the average Ba1-rated bond has a spread of +350, which would imply around a 7% loss on this bond if it were to trade in that range. So where do you want to buy? I like bonds in the middle. I'm referring to where there is some challenge, some difficulty facing the company, but it is something that I believe the management team can handle. Bonds like that are trading at yields that provide a better on-going return, and even some upside should management successfully mitigate whatever problem exists. But the challenge is something management can control, which excludes companies pressured by falling energy prices or weakness in China. A few good examples include Dollar Tree (DLTR), Carrols Restaurant Group (TAST), Isle of Capri Casinos (ISLE), and Ineos Group. Those bonds should do alright in a slow growth economy, and can survive a downside scenario. But they aren't so tight that they need perfection to perform.

With Bonds, It Pays to Be in the 'Middle'

In 2015, only 9 companies have been able to come to market with debt yielding 12% or more.

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