Thoughts on the High Yield Space
Thoughts on the high yield space from Peritus in response to this article. The insight is helpful.
It is very interesting as the misnomer remains that it is an all or none trade. First of all we agree that JNK and HYG should be avoided because they are thoughtless indexes in an asset class that requires thought. But bonds are not stocks. They do not require markets to go up and expectations to get beat. They require the lender to pay the interest rate and refinance at maturity or call date(s). There is an exit strategy built in. We have written chapter and verse about the A to E (amend to extend) issues in the very large LBO’s from the 2006-08 vintage. These loans will be coming due in the coming years and these companies will have to deal with these capital structures that in our opinion are unsustainable. Meaning bonds in these issuers will default. This does not mean that high yield bonds are bad or good, it means that you need discipline to avoid the silliness that comes with money flows and good times. Use of proceeds is one flag. Refinancing debt, general working capital and/or acquisitions have to be analyzed but generally pass the first smell test. When you see large dividends taken out by equity sponsors, it’s a flag. Even if the dividend does not destroy the credit metrics, you may be creating a problem down the road. Private equity sponsors tend to be good partners because when companies run into problems, they generally put more equity in to keep them alive and provide their investors a hope certificate so they can continue to confuse investors about their rates of return (i.e they don’t mark their holdings down). However, if they have already extracted their dough, what incentive do they have?
Bottom line is that the high yield asset class needs to be viewed as a permanent asset class in a portfolio not a “trading vehicle.” High yield bonds and leveraged loans are a $2.5 trillion asset class combined. After 30+ years of data high yield bonds provide better or equal returns to equities, provide immediate and tangible returns through cash flow and have less than half the risk of equities. Why do they continue to be viewed as a trading vehicle? Actively managed high yield provides investors what they want. Tangible cash flows with manageable and knowable downside.