The market reaction from last week’s dovish FOMC statement took many by surprise, including BofAML's HY Strategy team, but as they say the High-Yield Emperor has no clothes, warning that the underlying commentary provided by Chair Yellen shows the vulnerability for high yield issuers to longer-term growth trends. Couple the deteriorating fundamentals for HY issuers with downgrades outpacing upgrades by a ratio of 3.5:1 and a worsening of global growth potential, and they believe the recent rally, though boosted by strong inflows and cash generation, will ultimately fade.
Bad news is bad news, until it’s suddenly good
The market reaction from last week’s dovish FOMC statement took us by surprise. Due to risks stemming from global economic and financial developments, Chair Yellen kept the target range for the federal funds rate unchanged at ¼ to ½ percent. And although this outcome was largely expected by markets, the Fed also cited global growth concerns and subsequently reduced their growth and inflation forecasts for this year and next. Under normal conditions, the mentioning of global growth concerns by the Fed has been met with a market selloff as a negative economic outlook brings concerns of lower corporate earnings. In fact, the last two times the Fed indicated global risks to the domestic economy, while holding rates steady, high yield declined 4.5% and 4% over the next 13 days (Chart 1).
However, the prospect of lower rates for longer dominated investor sentiment in the 2nd half of the week, causing high yield to return 1.23% in just 3 days. While in the short term lower rates spells risk on and may be good for high yield, we believe the underlying commentary provided by Chair Yellen shows the vulnerability for high yield issuers to longer-term growth trends. Tighter financial conditions, slower global growth, and a strong dollar will all negatively impact future earnings from high yield issuers, in our opinion. And with ex-Commodities YoY EBITDA growth running negative in 3 out of the last 5 quarters (the worst in a non-recessionary period since 2000), we question how much further balance sheets can deteriorate before investors question the overall health of the high yield market. And as we discuss below, when looking at measures other than EBITDA, the fundamental picture becomes even less compelling for the asset class.
We also believe it is telling that bank stocks moved significantly lower after the rate decision. Though the price action in banks makes sense - a lower for longer rate environment reduces these companies’ net interest margin – typically the moves in bank equity and high yield spreads are very well correlated (-48%). In our view the challenging bank environment could be a canary in the coal mine for high yield. As financial volatility increases, bank earnings decline, and unease about the global economy heightens, banks pull back on risk and lending and the ability for corporates to access funding in times of need is compromised. Note the latest Fed survey on lending standards as a prime example of declining risk tolerance for loan officers.
Ultimately, we believe markets are currently responding to a major influx in cash and ignoring the fundamental backdrop for high yield- and this could continue for some time, likely until a negative catalyst takes the market lower. Case in point, in the past 4 months non-commodity spreads have been 85% correlated with crude oil prices (Chart 2). Such a high correlation suggests to us that investors have taken their eye off the ball with respect to non-commodity balance sheet health- something that is likely to lead to a surprise increase in defaults and negative price action later this year.
To this end, we wonder how long asset allocators will continue to focus too intently on transitory risk-on signals while ignoring the weak macro credit environment. Couple the deteriorating fundamentals for high yield issuers with downgrades outpacing upgrades by a ratio of 3.5:1 and a worsening of global growth potential, and we believe the recent rally, though boosted by strong inflows and cash generation, will ultimately fade.
Conviction tested, but not shaken
On November 24th, 2015 the opening paragraph of our Year Ahead report read as follows:
One year ago we wrote that 2015 would mark an inflection point for high yield; that there was a paradigm shift in the making that would alter the way high yield traded. This view led us to a bearish disposition for the year, one that we continue to maintain heading into 2016. In fact, as we re-read last year’s outlook, much of the same themes remain. Just like our position in late 2014 we make the case that Q1 next year will be seasonally strong, particularly with el niño creating a warmer weather pattern that will likely help the US economy. Coupled with higher than normal cash balances and a market that has sold off meaningfully in the back half of this year, we envision a scenario where accounts look to put money to work as they feel re-assured by seemingly underlying fundamental strength and optically wide spreads. To this point, we believe we could see high yield tighten beginning with the New Year, as the hope for earnings growth and the ability for leveraged credit to grow into its capital structure buoys demand for the product. We would not advocate buying but would take the opportunity to sell positions in crowded BB paper, accumulating dry powder for a better entry point later.
Although it took nearly 11 weeks to play out, our thoughts for Q1 now seem to be prescient, as the market is tighter on the year for the first time (1bp as of March 16th). As market participants we believe our job is not done well if every day we don’t test our thesis and conviction, try to find information that may change our view, and adapt appropriately. And there has been no time where we have done that more since the weeks following February 11th.
However, after digging into the macro and fundamental data, analyzing the technicals created by more easy central bank policy and breaking down our thesis as to why this is the end of the credit cycle and not some overblown year and a half selloff bound to snap back, we conclude that our bearish disposition for the remainder of the year remains just as well justified as late last year. In fact, although the rally we have recently experienced has been significant, at its basics the reasons for it are exactly what we expected when we wrote our 2016 outlook.
Bolstering our view that investors should not be lured into the temptation of throwing caution to the wind is that from our perspective, there still seems to be very heavy headwinds blowing directly into the path of the global and domestic economies. In fact, though the manufacturing and production portion of the economy appears to have bottomed out, the consumer now looks to be experiencing unexpected - if only modest so far - weakness. And as capital markets continue to remain challenging for the lowest quality issuers, we are concerned of the potential pitfalls of a tightening credit market in the context of a world where revenue growth and share prices were boosted by easy monetary policy and cheap debt. Although our economists wrote last week that they are not seeing signs of economic deterioration through the credit channel, we still worry that an elongated period of tight credit markets could ultimately weigh on hiring over the course of 2016 and 2017. And although it seems that for the time being investors are willing to overlook some signals suggesting a weaker consumer, we believe eventually renewed concerns of a global and US slowdown will overtake any reach for yield activity. Whether the concerns are justified or not is likely to define the shape of the cycle (slow and exaggerated, as the last 18 months have been, or shorter and steeper, as in 2009) but not whether the cycle has turned.
When fear turns to greed
Our economists believed in the beginning of the year that recession concerns were overdone. And although we are more bearish than they are on the longer term prospects of the economy, we agreed. The market clearly got ahead of itself in thinking we were currently in a recession or headed toward one within the next few months. However, we stress, it doesn’t take a recession to have bad markets (4.95% yields to 10% yields in 20 months can attest to that) and the study of recession probabilities should only be viewed in determining the shape of the cycle, not whether the cycle has turned or not. In other words, a recessionary environment is likely to bring a peak default rate while a non-recessionary environment is likely to bring exactly what we have experienced over the last year and a half: a rolling blackout. Not exactly a time period most credit investors will look back fondly upon and very reminiscent to 1998 – 2002.
Having said the above, we think it’s necessary to break down the economic data; not only to show that a) our economists were correct, but b) to show that markets have reacted just as irrationally on the way up as they did on the way down.
Digging into the details, BAML finds debt loads and impairments flashing bright red...
Not only has the ratio of tangible to intangible assets fallen markedly since 2013, but by further adding back “1-off” impairments to EBITDA, companies are inflating cash flow while also not taking into account the decreases in asset values that have direct consequences to the value of the firm. Because the ability of a company to finance itself through debt markets is (or at least should be) a function of the firm’s value in addition to its cash flow, the amount of debt a corporation has relative to its tangible assets becomes more and more important as the credit cycle wanes. In fact, as we are seeing from the commodities sector today, as well as some other idiosyncratic businesses that have recently run into trouble, debt to asset value is as important a measure as any when a firm realizes problems and needs to liquidate holdings. And the trend in total debt to tangible assets has been troubling, as companies have increased debt on asset values that have stagnated or begun to decline.
The increase in debt to tangible assets concerns us particularly when we see situations like Valeant Pharmaceutical, an example of a company where the value of its assets will prove pivotal to its ability to tap capital markets and ultimately service nearly $30bn in debt. The go-to story for Valeant has been the strength of its properties, namely Jublia and Bausch and Lomb, as the firm has been able to fall back on the idea that should its debt become too onerous, selling off assets to pay down a large capital structure would not be a problem. Should Valeant begin to write down some of the value of these assets, not only would these charges be added back to its Adjusted EBITDA, inflating its cash generation, but would also limit its ability to pay back its debt. Although just an example, this scenario can be applied to any number of companies in high yield. For this reason, as we look at tangible assets, impairment charges can’t be ignored when determining the underlying health of a business. And as we consider this crucial input that is often ignored by high yield investors, we see troubling signs of fundamental corporate deterioration as the amount of asset impairments to tangible assets (excommodity) for US high yield has increased sharply since reaching a low in March of 2015.
Which leaves BAML warning, "it's not a pretty picture"...
Bearing these assumptions in mind, when considering our universe of 397 high yield issuers we find that 79 or 20% of them are unlikely to generate enough cash to service their 2016 bond and loan payments, when also taking into account a company’s cash on hand. Expanding this analysis into 2017 and 2018, we find that 27% and 38% would potentially be unable to meet all upcoming debt maturities. While it is true that roughly 62% of these companies are commodity-related, that still leaves 14% of our ex-Commodity universe that absent asset sales or new debt financing would not be able to make all debt payments between now and 2018.
Of course, companies can find alternative methods to generate liquidity such as accessing the capital markets and selling assets on their balance sheet. However, if all companies were to sell 20% of their tangible assets at 75% of book value, 6% will still have negative cash generation by the end of 2016 and 27% by the end of 2018. What’s more, given the constant need to invest and grow through capex, likely requiring investment rather than divestiture, any company that is forced to sell 20% of the assets on its balance sheet to meet debt obligations will simply be kicking the can down the road and eroding bond holder value. Though negative cash flow is in and of itself not a reason for default, and in fact many companies for a variety of reason chose to run their business negative for a period of time, in an environment where asset values are declining and access to capital markets is difficult, we think the large negative numbers could be concerning. Given the high percentage of companies continuing to burn a quickly diminishing stockpile of cash, we believe investors should be more concerned about the possibility for significantly wider spreads on new issue (and hence secondary paper) as investors allow the firm to buy time so they can realize the value of the assets, or at worst, end up in default.