With yields near all-time lows, and bond issuance near an all-time high, is the U.S. economy approaching a credit bubble similar to the one that preceded the 2008 financial crisis?
Despite the hand-wringing among some fixed income investors, we believe that as it relates to high yield, the answer is no. The reasons are numerous; for example: The Fed remains accommodative; private equity firms generally are not using the kinds of excessive leverage they did before the financial crisis; we believe the quality of high yield issuance remains reasonable; and corporations are generally being more cautious with their cash given the uncertain business and political enviroments worldwide.
In assessing where we are in the credit cycle, we see credit conditions are constructive for high yield, with current spreads being compensatory relative to risk, embedding a 4-5 percent default rate versus the Last Twelve Month (LTM) default rate of 1.87 percent as of August 2012, according to Barclays High Yield Credit Research. And while spreads between the BB and B credit tiers have tightened inside the historical average of 200 basis points, they are still above their historically tightest levels.
Various companies continue to engage in refinancing activity to strengthen their financial positions and lower their interest rate obligations. The recent memory of the financial crisis is still fresh in the minds of CEOs, and management teams are prioritizing liquidity, realizing they should borrow when they can rather than when they have to.
Additionally, the most recently announced round of quantitative easing by the Federal Reserve may bode well for high yield in the short run. If these actions are successful in stimulating economic growth then company fundamentals should improve.
As companies continue to cut costs and deleverage from the pre-crisis era, engagement with leveraged buyout activity is limited.
For the buyout transactions that have been completed, deal quality and structure are much better than in the environment that defined 2005-2007. However, like in most credit cycles, covenant quality is gradually eroding.
While we believe the credit cycle is currently in a phase of stability, the high yield market tends to gradually misprice risk, and we would expect that to happen over time. High yield should generally perform well in a positive growth environment, albeit a slow one, because it has the spread cushion to withstand a parallel shift higher in the yield curve and can also provide an income cushion via the coupon in a low yield environment.
From an asset allocation standpoint, advisers and retail investors who are considering investing in high yield should view a strategic investment as a complement to a core fixed income portfolio. In addition to potentially providing a more substantial income stream, a high yield allocation should reduce the duration risk inherent in a core portfolio, supplanting it with what might be more manageable credit risk. While defaults do indeed happen, through careful bottom-up, fundamental analysis, asset managers can more easily gauge, manage and underwrite credit risk.
As investors have allocated billions of dollars to bond funds in 2012, yields have naturally lowered. While we expect inflows to continue, we do not expect yields to move down in step fashion in the short term. Despite contrarian talk of a bond "bubble," we believe that the current state of the credit cycle and improved corporate fundamentals bode well for high yield in the coming years.
High yield, lower rated securities involve greater price volatility and present greater risks than high rated fixed income securities. All investments involve the risk of loss of principal.
Edward Meigs, CFA and Sean Slein, CFA are Portfolio Managers of the First Eagle High Yield Fund, which seeks to provide investors with a high level of current income. Ed and Sean have managed portfolios together for more than 10 years, through two full credit cycles. They employ a bottom-up investment approach and focus on fundamental research, seeking to maximize risk-adjusted returns by modifying risk exposure throughout the high yield credit cycle. They are also Co-Portfolio Managers of the First Eagle Global Income Builder Fund along with Giorgio Caputo and Robert Hordon, CFA.