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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is a bond portfolio manager at Barksdale Investment Management and editor of The Credit Investor’s Handbook
Back in the 1980s, when Michael Milken helped foster an appetite for higher risk-reward corporate bonds, junk bonds became the fun asset class with volatility and bankruptcy workouts featuring sharp elbows and big egos.
Credit cycle after credit cycle, if you were on the right side of the trade on stressed or lower quality debt, you hoovered up bonds at pennies on the dollar and made big profits if they bounced back in value; if you were on the wrong side, you rode your holdings through the workout process.
But the financial crisis resulted in changes to the high yield or junk bond market that took more than a decade to manifest. Increasingly, the high yield category of bonds has moved closer in overall quality towards investment grade.
The average spread of securities in the Bloomberg US high yield index — that is the incremental yield over Treasury rates — is a substantial 3.5 percentage points. But you would be hard-pressed to find many individual bonds that trade at that average. Instead, you’d find BB-rated bonds inching towards lower investment grade spreads, and borderline distressed credits, often with CCC credit ratings, trading at double-digit yields.
Importantly, more of the high-yield universe is now made up of better quality bonds. While issuance of BB and even high B-rated credits is robust, the issuance of CCC-rated bonds has dwindled.
This lowest quality end of the ratings spectrum had its heyday in the lead-up to the financial crisis. According to data from JPMorgan, lower-rated (any bond with a CCC from at least one of the agencies) bonds represented 24 per cent of high-yield bond issuance from 2004-2007. In parallel with the trend, the broadly syndicated loan (BSL) market came into its own, as banks found insatiable demand for the loans they used to hold on their own balance sheets.
Everyone knows what happened next: risk appetite evaporated, the banks stopped making markets in the bonds and loans they had underwritten, and credit investors experienced equity-like returns (in a bad way).
Lower-rated bond issuance subsequently declined, a trend that accelerated recently with the quantitative tightening era as interest rate rises meant less need to search for yield. CCC-rated bonds accounted for only 6 per cent of the last 18 months of high-yield bond issuance.
So if you’re waiting for a huge default wave to trash the high-yield bond market, you could be disappointed, as the low percentage of CCC issuance over the past few years is likely to cap distress. While ratings downgrades are inevitable in a recession, the high-yield bond market is starting from a position of (credit) strength.
In the next credit cycle, private credit may bear the brunt of the defaults and distress that used to characterise downturns in the public market. Highly leveraged companies didn’t stop issuing debt in recent years; instead, they turned to private credit, which does not typically require that borrowers obtain a credit rating.
Private credit investors tout their indifference to credit ratings as a positive. These agencies do get things wrong on ratings but data from Moody’s shows that over long periods of time its ratings of industrial corporate bonds are broadly predictive — that is, roughly a third of bonds rated CCC at issue can be expected to default within five years of issue versus 8 per cent of BBs.
But since private credit investors have greater access to information by virtue of being “private side” — along with the ability to renegotiate terms on the fly that permit issuers to skirt bankruptcy and prevent crystallising losses at the trough of the cycle — this transition might dampen corporate bankruptcies overall and improve risk-adjusted returns for leveraged credit.
And the “unitranche” structure used in many private credit transactions, which features only one debt instrument in the capital structure, should enhance recovery values for the deals that do end up defaulting. This is because that eliminates the riskiest (unsecured) portion of the capital structure.
Private credit is still too small to accommodate the mega deals that rely on the junk bond and broadly syndicated loan markets. But it would not be a surprise to see a $25bn leveraged buyout get done entirely in the private credit market within the next few years.
The market Milken made is in some sense coming full circle, as the quality complexion of the high-yield bond market looks more like investment grade, and riskier deals return to the shadows.