NN IP: History doesn’t repeat itself, but it often rhymes
There’s a saying that’s frequently attributed to the American author Mark Twain that explains how investment managers build their expectations about the future, “History doesn’t repeat itself, but it often rhymes.” In other words, in the future we can expect to see similar things to what we’ve seen in the past.
Currently, we think that many global high yield bond managers and strategists are using narratives from the past to construct an inappropriately gloomy view of the future. Their past experience from prior credit downturns has convinced them that high default rates, and thus large credit losses and weak returns, are coming, and that high yield positioning should be defensive. Our research has led us to the opposite conclusion. We believe the default rate will fall over the coming year, leading to solid returns as the market reprices for lower credit losses, and that investors should select mutual funds that are overweight credit risk to benefit from this dynamic.
In the three credit cycles that high yield has experienced since its birth as a category in the 1980s, exuberant market conditions have fueled issuance from aggressively financed companies, resulting in high levels of defaults for multiple years as these overextended issuers faltered. These periods of climbing high yield defaults were accompanied by poor high yield bond and equity returns, and were characterized by the economy contracting as market-fueled bubbles deflated. In general, high yield bond returns are weak as the default rate climbs, and turn positive when bond prices have fallen enough to compensate for expected default losses.
Prior downturns have been characterized by one sector cracking, followed by fear of contagion and lack of funding for other sectors, causing them to crack. The lead horse was the savings and loan crisis in 1990, telecom in 2002, and housing in 2008. In the case of 2002, a huge amount of high yield bonds were sold to finance the buildout of wireless networks and the internet. Investors funded companies based on business plans that promised tremendous profit growth with the increase in data usage. Needless to say, the profit growth failed to materialize and telecom defaults escalated. Defaults then spread to the utility and airline sectors as investors lost their appetite for aggressively financed companies, and defaults increased further as the economy went into recession. The “shale revolution” seems to rhyme with the telecom bubble.
Since the end of 2008, energy issuance has grown rapidly in the high yield market, fueled by higher oil prices and easy access to capital. The weighting of the energy sector in the US High Yield market increased from approximately 7.5% at the end of 2008 to over 15% in 2014. Recently, low oil, natural gas, coal and iron ore prices, coupled with banks and market investors being less willing to lend to these companies, have caused a large number of high yield companies to default.
Consequently, the default rate has increased sharply. For global high yield investors, this is most visible in US high yield, as the very large US market has much more energy and commodity exposure than the smaller European and Asian high yield regions. Defaults in the US have climbed from approximately 2% of outstanding principal last year to approximately 4% for the trailing twelve months; most strategists expect the default rate to climb to 5% or higher in 2016 and remain elevated for another two years. There isn’t a similarly overextended industry in Europe, and defaults are expected to remain low there while the economy improves.
We think those strategists who expect the default rate to continue to rise and remain elevated are forecasting a similar sequence of events. First, they are assuming that the weak energy and commodity prices will cause more principal value in these sectors to default than has already defaulted in the last twelve months. Second, they are assuming that investors will become more reluctant to invest in struggling companies in other sectors, as they view energy and commodity sector turmoil as symptoms of a broader illness in the high yield universe. Third, they are assuming that the global economy will weaken as the long expansion in the US fades into contraction through the tightening of lending standards. All three assumptions “rhyme” with prior experience, and we believe all three will prove to be incorrect.
We see the US default rate falling during the next year. Why? Our bottom-up fundamental analysis shows that the weakest issuers in the energy and commodity sectors have already defaulted (in late 2015 and year to date 2016) and the survivors have bolstered their credit profiles by issuing equity, selling assets, refinancing debt and adding hedges, thereby reducing their probability of defaulting. Even if financial conditions tighten, we see little contagion to other sectors with very few issuers in need of immediate refinancing. As well, the problems in the energy and commodity sectors are actually good for most other sectors! Lower energy prices reduce corporate expenses and increase consumers’ disposable income. We also think the chance of a recession within a year is low, as the prudent debt usage and consumer de-leveraging in this very tepid and disappointing expansion have not created the dramatic imbalances seen in the prior three cycles.
The impact of lower defaults on global high yield performance could be powerful. Expectations of increasing defaults have pushed the price of the average global high yield bond below par, creating the conditions for good performance if our default forecast proves to be correct. We believe taking more risk than the global high yield benchmark in this current market environment will prove to be the correct strategy.
By the way, there is no evidence that Mark Twain ever said or wrote those words.
Tim Dowling, head of Credit Investments and lead portfolio manager Global High Yield at NN Investment Partners