The Default Outlook
By: Heather Rupp, CFA, Director of Research for Peritus Asset Management, the sub-advisor to the AdvisorShares Peritus High Yield ETF (HYLD)
On April 1st, TXU/Energy Future Holdings skipped their interest payment due that day, immediately triggering a default by some reporting mechanisms. While the company has a 30 day grace period to pay the coupon payment, most expect them to use the grace period to work further on a restructuring and ultimately file for bankruptcy at some point over the next 30 days. If the Texas Competitive Electric unit is the only entity that ends up filing for bankruptcy (and not the Energy Future unit), this will impact $8.2 billion in par amount of bonds and $19.5 billion par institutional loans, making this the largest high yield default on record and will send April default rates up for both bonds and loans.1 J.P. Morgan estimates, “Including the April 1 default of TXU, the high-yield bond and leveraged loan default rates will increase to 1.22% and 4.14% in April, respectively, up from 0.61% and 1.37% today. For context, this would bring the loan default rate to its highest level since August 2010 (4.74%).”2
There are other names that have been long-time issuers in the high yield space facing challenges, either on the brink of default, missed coupon payments, or already in the midst of reorganization. This includes names like James River Coal (a coal company), Momentive Performance Materials (a chemicals manufacturer), and Global Geophysical Services (provider of seismic data to the energy industry). Rather than any sort of systemic concerns for the high yield market, we see this as the weeding out of the weaker players to the benefit of the remaining, stronger companies in the respective industries.
In looking a three names mentioned above, understanding both the company specifics and the broader industry matters. For instance in the coal space, Patriot Coal previously faced bankruptcy and now James River appears on the verge, so it seems that the marginal players will restructure and the industry rationalize, ultimately helping the rest of the players in the coal industry. And it is also important to recognize that all “coal” is not the same. There is thermal coal (used largely for electricity generation) and metallurgical coal (used for steelmaking) and pricing depending on the geography. So analyzing the differences has been important and we have determined that thermal coal companies in certain geographies appear to have a much better demand profile than metallurgical coal going forward, and hence pricing. So it appears that painting the entire coal industry the same way is unjustified in this case, yet this can allow active managers to take advantage of undervalued, stronger players in the space. Likewise, with the seismic data space, we see strong dynamics for the industry but Global Geophysical ran into company specific liquidity issues, hence there need for a restructuring. Furthermore in the Momentive situation, it appears to be a case of an LBO that was done in 2006 leaving the company with an elevated debt load complicated by the fact that earnings/EBITDA have fallen in recent periods. In this case, an over-levered LBO and company specific issue, not an industry wide problem.
Barring TXU because of its massive size, we certainly don’t see any significant move up in default rates or systemic issues on the horizon. J.P. Morgan continues to project that high yield bond default rates (excluding TXU) will stay below 2% through 2015, well under the historical average near 4%.3 So a very benign default environment will remain for the foreseeable future. However, investors need to make sure this does not make them complacent. Weaker players exist in a variety of industries and thorough analysis is needed to determine which are the solid companies, potentially set to benefit at the expense of others. This is one of the dangers we see of passive, index-based investing: nothing is done to make these identifications, and we believe investors are left to face the consequences all in their effort to save a little on fees. If you could spend the time doing the work to differentiate the marginal players versus the stronger industry participants, and make your investment decisions accordingly, wouldn’t you do it? We certainly see this as the best approach to investing and view active management as absolutely essential in the high yield bond and bank loan markets.
1 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.. “High-Yield Default Monitor.” J.P. Morgan, North American High Yield and Leveraged Loan Research. April 1, 2014, p. 2.
2 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.. “High-Yield Default Monitor.” J.P. Morgan, North American High Yield and Leveraged Loan Research. April 1, 2014, p. 2.
3 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.. “High-Yield Default Monitor.” J.P. Morgan, North American High Yield and Leveraged Loan Research. April 1, 2014, p. 4.