Not Your Father's High Yield Bond Market May 3, 2012 Michael Lewitt, Vice President and Portfolio Manager
In a zero-interest-rate world, high-yield bonds are one of the last refuges for investors looking to earn a decent return on their capital. Today, the average yield on the Barclays High Yield Bond Index is about 7.3%. This is about 6.3% (630 basis points) higher than 5-year Treasuries.
Within the high-yield universe there are several different ratings classes: BB, B, and CCC. For the most part, BB-rated bonds yield about 5.5% today (457 basis points over 5-year Treasuries), B-rated bonds yield 6-7% (613 basis points over 5-year Treasuries), and CCC+ rated bonds yield significantly higher, depending on the issuer (1100 basis points over 5-year Treasuries, or about 12%). While this is a helpful guide, it must be remembered that each bond must be analyzed individually from a credit perspective.
Current yields and spreads are discounting a 5% default rate, but the actual default rate in 2012 is unlikely to be that high. Most likely, no more than 3.5% of high-yield issuers will default. Therefore, investors are being overcompensated for the risks they are taking by investing in this asset class.
The most attractive opportunities are bonds that are trading at wider spreads than the average spread of their ratings category. Here are some examples of bonds purchased in the last month:
Moody's/ S&P
Dollar Price
Yield-to-Worst
Current Yield
Spread to Rating Median
NRG Energy, Inc. 8.25% due 9/1/20
B1/BB-
$96.75
8.80%
8.53%
+204
Sprint Capital Corp. 6.9% due 5/1/19
B3/B+
$87.50
9.35%
7.89%
+259
Harrah's Opco/Caesar's Ent. 5.625% due 6/1/15
Caa3/CCC
$74
16.64%
7.60%
+651
A quick word about the Harrah’s/Caesar’s Entertainment bonds. While they obviously have a very low rating, it should be noted that the company has repurchased $650 million of this $1 billion bond issue financed by the two private equity firms that own the company. Further, this is a short-maturity bond (3 years) and most of the company’s debt matures after these bonds. The combination of the private equity firms’ multibillion-dollar investment in the company and the short maturity of these bonds, coupled with a steadily improving gaming market, strongly suggest that these bonds will be paid off at maturity, providing a 16.64% total return. This bond is illustrative of a number of bonds that were issued by large LBOs that have low ratings, high yields, and a low likelihood of default.
The US economy remains sluggish and is likely to struggle in the months and years ahead, until wiser heads prevail in Washington DC and adopt pro-growth policies and bring some discipline to the federal budget. Such an environment will make credit analysis particularly important in the high-yield sector. But a combination of wide spreads, low defaults, and a significant number of bonds trading at wider spreads than their ratings category offer investors the opportunity to earn attractive risk-adjusted yields on their money in a zero-interest-rate world.
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