It is often difficult to distinguish investment facts from myths, with only a subtle difference between the two. In trying to understand the investment risks, many high yield investors look to the past for guidance assuming that the past will be a good indication of the future. This article explains how a failure to correctly understand the past has led to the development of common but dangerous myths about high yield credit. Four such myths are highlighted with the actual triggers and warnings signs of a downturn in credit markets explained.
Myth 1: Equities lead debt, so sell high yield when equities start to sell-off
I can partially agree with the statement that equities generally lead credit, perhaps even 90% of the time this is true. But when times get tough, it’s all about who gets paid first and that means debt leads equities. In mid-2007 concerns about falling US house prices were becoming mainstream although few had yet to connect the dots and figure out just how widespread the damage from subprime related problems was going to be. The first of the subprime linked fund bailouts and closures occurred in June. In July 2007 the cancer spread from subprime to credit generally. In the space of a few days, the cost of credit default swaps (a form of credit insurance) very sharply and suddenly increased after years of consistently falling. This marked the turning point for credit. The rest of 2007 was a time of increased credit spreads and greatly reduced liquidity.
Equities continued to rise before peaking in October 2007 in the US and November 2007 in Australia. I can remember thinking this was some sort of twilight zone, as two correlated assets classes were having a completely different experience. This all changed early in 2008. The credit issues of Babcock and Brown, Allco and Centro were now front and centre for equity investors. Burnt by these three and others, equity investors started to dig for information about the amount and terms of the debt owed by their other equity holdings. In 2007 and 2008 short sellers routinely targeted companies who were suspected of having a substantial portion of their share register backed by margin loans. This pattern has repeated in 2014 with short sellers targeting the iron ore miners and mining service providers, particularly those with a higher cost of production and with higher levels of debt.
Since June this year US high yield markets have pulled back meaningfully. They are now a fair way away from their peaks, unlike US equities which are still setting record highs. Credit investors have become more discerning with a good number of high yield deals withdrawn, repriced or stuck with the underwriters. No one can definitively say whether this is an early indicator for equities like it was in 2007. What can be said with confidence is that fewer companies are now able to make easy gains from dividend recapitalisations and refinancing debt to lower their interest costs. This means that the tailwind for equities of the last two years provided by cheap debt has either stopped or become a headwind.
Myth 2: High yield debt won’t sell-off until default levels increase
This myth is one I’ve heard from otherwise intelligent investors, who typically have strong experience in equity or property investing but limited experience in debt investing. The “Minsky Moment” (a sudden collapse in asset prices) is typically not triggered by investors rationally forming a view that asset prices are too high and voluntarily deciding to sell. Rather, it is the withdrawal of the availability of credit that precipitates the collapse. The withdrawal of credit stops new buyers entering the market and turns the most leveraged holders of assets into forced sellers. Once the spiral of forced selling begins, where one round of forced selling pushes down prices and in turn creates more forced selling, it typically takes two or more years to fully run its course.
After asset prices and credit availability begin falling, borrowers find they can no longer rollover their existing debt and the wave of defaults starts to build. Defaults always lag the fall in the availability of credit and debt prices typically decline one to two years in advance of the main cluster of defaults. Those waiting for defaults to increase before selling are likely to find that prices have moved below 90% of face value by the time they begin to contemplate selling. Many holders then become trapped by a sunk-cost mentality, not willing to sell for a loss even if the near term prospects seem grim. Avoiding being caught in this position is a key part of managing the credit cycle. Keeping an eye on the fundamentals of credit and the bullishness of lenders is the best way to be alert for when the availability of credit starts to turn.
Myth 3: Default rates won’t rise until after interest rates rise
Historically there is evidence to support this assertion, but it is by no means a guarantee. Many will point to the rise in the Federal Reserve rate in the US as a turning point for subprime lending as borrowers that were paying very low interest rates reset to much higher levels. There’s two problems with assuming that this pattern will always repeat.
Firstly, as the response to the previous myth makes clear it is the withdrawal of credit that matters most. The counterfactual is that if US interest rates had not started to rise in 2004 the boom might have lasted for longer but it would have come to an even uglier end. Interest rate increases can force the hand of leveraged borrowers in the long term, but in the medium term most leveraged borrowers are insulated by fixed rate debt or swaps used to lock in their cost of debt. It is only as debt approaches the maturity date that borrowers must take action. The smart lenders take action early, before either interest rates or credit spreads rise and the hand of borrowers is forced.
Secondly, the experience of Japan in the last twenty years is pertinent in illustrating that it is not always about interest rates. Japan has had very low interest rates throughout this period, yet the pattern of defaults and restructurings has still played out. Asset prices have fallen, even though potential buyers could theoretically obtain finance at very cheap levels. The simplest explanation is that asset prices had overshot fair value and needed to return to levels based on fundamentals. Cheap debt has arguably done little to stop what was an inevitable correction. Investors can take away from Japan’s experience that when the fundamentals are bad, low interest rates might slowdown but cannot stop an inevitable correction.
Myth 4: Covenant light lending isn’t a big deal
There’s been some research following the last crisis that shows covenant light loans performed slightly better than full covenant loans. However, there’s a key factor missing from the analysis. Last time around, covenant light loans were not the majority and were almost always made to companies that had both (1) a low expectation of earnings volatility and (2) a strong sponsor. Lenders were more relaxed about covenants when a borrower was considered relatively stable and had owners with deep pockets. This time around covenant light lending is the majority and it seems almost any borrower can get a covenant light facility if they are willing to pay a little more.
Many credit investors simply don’t grasp the importance of covenants. Covenant light lending is a big deal as it makes loans act more like bonds when it comes to default timing and recovery rates. Well set covenants lower the probability of payment default (failure to pay interest or principal on time) and increase the recovery rate if a terminal default occurs. From the lender’s perspective these two impacts are both a very big deal.
Loans with proper covenants are less likely to suffer a payment default as covenants are an early warning system on increases in credit risk. Well set covenants force the business owners to renegotiate the terms of their debt with lenders when credit risk exceeds specific tolerances. Lenders have the opportunity to demand a partial or full repayment of debt, whilst the business still has meaningful equity value and therefore still has an ability to attract new equity. By having an early warning system, the likelihood of a payment default occurring substantially falls.
Well covenanted lending will also have higher recovery rates compared to lending with few or no covenants. Underperforming borrowers with covenants lose control of their businesses to bankruptcy or administration processes earlier, reducing the amount of value destruction that occurs. Well covenanted and secured lenders on average recover 60-80% of their debt after a terminal default compared to 30-40% for bondholders.
Conclusion
As with most areas in life, the most believable credit myths are the ones that contain some truth. Equities do lead credit but not when it matters most. The price of high yield credit does fall after default rates increase, but it first starts to fall when the availability of credit falls. Increases in interest rates do help bring on increases in default rates but are not the main reason for those defaults. Covenant light loans performed fairly well last time, but were much lower risk than the current vintage so past performance is not a good predictor of the future. Savvy credit investors will ignore these myths and will instead be preparing for a potentially more difficult future.