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Reconnecting with the High Yield Market

  • Author: Luis Sanchez
  • Published On: February 21, 2024

After several years working in machine learning and AI, I decided to venture back into the high-yield bond realm by attending the 34th Annual High Yield Conference at the CFA Society in New York. My days as a Quant at Lehman Brothers' high yield trading desk felt like a lifetime ago, and I was curious to see how this market had evolved.

Over two packed days, I soaked up insights from the top fund managers, analysts, and economists in the field. I have to admit - I was blown away by the structural credit derivative opportunities now available. The sheer scope of innovative new products got my quant wheels spinning. Either the trading prospects have massively expanded, or I've just been heads-down in tech for too long without appreciating the opportunities in structured credit. Maybe both! In any case, the conference lit a spark. I'm excited to dust off my structured finance skills and dive back into this fast-paced market, at least from the analysis point of view. Here are some initial areas I'll be posting about after my high yield re-orientation:

  • Understanding the High Yield Market: A comprehensive overview of the market's fundamentals, dynamics, and recent trends.
  • Credit Analysis and Valuation in High Yield: Techniques for evaluating the creditworthiness and value of high-yield bonds.
  • Investment Strategies for High Yield: Approaches to investing in the high-yield market, including diversification and risk management strategies.
  • High Yield Market Outlook: A forecast of the market's future performance based on macroeconomic and market factors.
  • Private Credit: The growing role of private credit in the high-yield market and its investment opportunities.
  • Sector Values in High Yield: An analysis of the performance and valuation of different sectors within the high-yield market.
  • Portfolio Management in High Yield: Considerations and strategies for constructing and managing high-yield bond portfolios.
  • Legal and Regulatory Aspects of High Yield: An overview of the legal and regulatory framework surrounding high-yield bonds, including covenants and the corporate bankruptcy process.

The Origins of High Yield Bonds: startup funding?

While often associated with the "Junk Bond King" Michael Milken, the high yield bond market has a history that stretches back over a century. Its origins can be traced to the early 1900s, with issuers including household names like General Motors, IBM, and U.S. Steel.

In the 1970s and 80s, Milken popularized the use of high yield bonds while at Drexel Burnham Lambert. He recognized that the higher yields on these below investment grade bonds provided attractive returns that compensated for default risk. Under Milken's influence, the high yield market surged from $10B in 1979 to $189B in 1989, providing capital for companies including Turner Broadcasting, MCI Communications, and McCaw Cellular.

However, it's a common misconception that these bonds only benefitted startups. The high yield market has always funded a diverse range of issuers - both established corporations and pioneering upstarts. For over a century, it has served as a versatile financing vehicle for companies seeking funding for expansions, acquisitions, refinancing, and more.

Far from straying from its roots, today's high yield market continues to provide crucial capital access to companies across the corporate landscape. Both household names and disruptive startups leverage high yield bonds to accelerate growth. The market’s storied history speaks to this broad appeal.

Understanding the High Yield Market

To start, it's important to clarify exactly what constitutes a high-yield bond. Also known as "junk bonds," high-yield bonds are debt instruments issued by companies with lower credit ratings, typically BB+ and below by Standard & Poor's or Ba1 and below by Moody's. The "junk" moniker comes from the higher risk of default tied to these securities. But with higher risk comes higher yields—the tradeoff that attracts investors to this asset class.

The high-yield bond market provides critical funding access to companies that do not qualify for investment-grade bond issuances. These are often smaller or highly leveraged companies. The market is also a key source of finance for private equity sponsors and their portfolio companies. By offering higher yields and playing a crucial funding role, the high-yield market helps fuel economic growth and business activity.

Key Drivers of the High-Yield Market

Gaining exposure to the high-yield market requires deep knowledge of the macroeconomic factors and market technicals that drive its risk and returns. Some major drivers discussed at the conference included:

  • The Leverage Cycle: The high-yield market is heavily impacted by the leverage cycle, which refers to the cyclic pattern of companies and financial markets taking on increased debt during economic expansions and then deleveraging during downturns. At the CFA conference, we debated whether we are currently in a deleveraging phase.
  • Commodities: Commodities like oil and metals are pivotal for many high-yield issuers in the energy and metals/mining sectors. Commodity price fluctuations can thus significantly sway default rates. The market is watching for impacts from factors like OPEC policy changes, China's infrastructure buildout, and Russia-Ukraine conflict (as a side note, Ukrainian sovereign debt is, in my opinion, one of the best HY opportunities out there).
  • Retail Outflows: One notable 2021 trend was heavy retail investor outflows from high-yield mutual funds and ETFs, partly driven by rate hike fears. However, the start of 2022 saw retail inflows resurge back into the asset class—a tentative positive sign.

As with most markets, Fed monetary policy shifts––especially rate increases––are top of mind. Conference participants focused on analyzing the pace and magnitude of coming policy changes.

Evolving Credit Quality Dynamics

Today's high-yield market faces a unique set of credit quality challenges. The proliferation of covenant-lite deals over the past decade has tightened bondholder protections. This issue entered the spotlight recently with high-profile bankruptcies like Hertz showing the power a company retains over its bankruptcy process.

On the ratings front, the market has seen an influx of issuers downgraded from investment-grade into the high-yield space. This "fallen angel" dynamic creates a blended ratings landscape. It also raises portfolio construction challenges as these fallen angels may retain less liquidity than traditional high-yield issues. All eyes are also on distressed ratio trends, which measure the proportion of bonds trading at distressed levels. After spiking in 2020, distressed ratios fell back to just 4.2% as of January 2022. However, aggressive Fed tightening could quickly send more companies into distress.

Navigating an Evolving Market

While higher yielding, the risk/return profile in the high yield market remains extremely dynamic given shifting macro and credit trends. As the experts at the conference emphasized, careful active management is essential to navigate market cycles, select appropriate risk exposures, and capitalize on value opportunities as they emerge.

Defaults and Yields Outlook for 2023-2024

Conference attendees also closely analyzed expected default rates and yields over the next two years. S&P Global Ratings projects the high yield bond default rate to rise to 4.75% by December 2024, with a peak earlier in 2024 followed by a decline in Q4 1. This signals a slight increase in defaults from 2023 levels.

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In terms of yields, as of mid-February 2024, the ICE BofA BB US Corporate Index Effective Yield was 6.33%. While not specified for all high yield issuers, this index level and recent yields on certain bonds (e.g. 11.75% yield-to-maturity on Dish Network 2027 bonds) give a sense of the premiums still available.

These yield and default forecasts for the next two years illustrate a high-yield market stabilizing from increasing distress in 2023, but with above-average risk/return profiles compared to historical norms.

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From the perspective of retail investors, the importance of education before venturing into the high-yield bond sector cannot be overstated. This is where the untapped potential of technology in the financial markets, particularly in the high-yield bond sector, becomes evident. Despite the significant advancements in FinTech over the past two decades, the high-yield bond market remains remarkably untouched by technological innovation, lagging far behind other financial sectors in terms of automation and digital transformation. The glaring "lack" of technological integration in the high-yield bond market presents a golden opportunity for innovation for a well capitalized player.

The sector is ripe for disruption, with technology poised to revolutionize how investors access, analyze, and invest in high-yield bonds. By embracing digital platforms, automated trading, and advanced analytics, the high-yield bond market can enhance efficiency, transparency, and accessibility for all investors. This shift towards technology-driven finance could democratize investment in high-yield bonds, making it easier for a wider audience to participate in this traditionally complex and opaque market segment.

Finally, the insights shared at the conference underscore the evolving dynamics of default rates and yields in the high-yield bond market, pointing towards a period of stabilization after the distress observed in 2023. For institutional managers, these insights offer a strategic edge, while individual investors can use this information to make informed decisions about their portfolio positioning.

Stay tuned for the next post, and please comment/share if you found this useful, I am looking forward to insights from different points of view.