By Mark Hudoff, PIMCO | 2 July 2008
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Q: Given PIMCO’s expectation for a U.S. recession over the cyclical horizon of six to 12 months, what is PIMCO’s view on the high yield market?
Hudoff: The big picture is that there are two cycles at work: a financial cycle and a real economy cycle. Usually, the financial cycle is a hostage to the real economy cycle, in a situation where excesses in the real economy feed through to excesses in the financial economy. During the typical end-of-cycle period, the real economy deteriorates, and the financial economy deflates and is forced to deleverage. High yield spreads typically reflect the movement through these two cycles: spreads will widen as defaults increase (real economy cycle), and liquidity diminishes as balance sheet repair takes hold (financial cycle). The coincidence of these cycles usually amplifies the violence of credit spread volatility during these end-of-cycle periods.
This time may be different. It appears that the traditional concurrence of the real economy–financial cycle has broken down to a degree. The excesses of subprime mortgages, structured products and leveraged buyout (LBO) lending, accelerated realization of the need for balance sheet healing in the financial economy before traditional real economy influences could be fully transmitted.
The U.S. Federal Reserve signaled a commitment to facilitate this healing process with extraordinary measures like backstopping the Bear Stearns takeover by JPMorgan and providing brokers with access to the Fed lending collateral programs. In effect, this "put option" to the financial system was intended to prevent a complete collapse in the disintermediation function. So far, the Fed and other central banks’ actions appear to have stabilized the financial system. Moreover, the actions have made it easier for the financial system to deleverage through re-capitalization.
The open question is whether the healing will be sufficiently advanced in the financial economy to dampen credit spread volatility when the traditional real economy cycle slowdown arrives. It is an important question because entry points are important in high yield. In the past, the optimal entry point in high yield had been associated with periods of realized defaults rather than those periods that involve only mounting expectations for defaults. We witnessed the volatility that increasing expectations for future defaults can have in high yield over the first three months of this year. The Fed’s actions unwound much of that in recent months. Nonetheless, we are still concerned that the real economy may slip into recession.
At this point, we view high yield as bounded by the following considerations: Fundamentals are deteriorating and access to new lending remains strained. The balance between supply and demand in high yield, while much improved compared with the daunting LBO overhang of last year, is at best neutral. Valuation, however, has greatly improved. As such, we are cautiously optimistic about prospective opportunities for high yield investors. We think we are approaching the point where realized defaults will translate into wider high yield spreads, and this in turn makes high yield a potentially compelling risk-reward proposition.
Q: Are you seeing any deterioration in corporate fundamentals yet?
Hudoff: We have started to see some signs that things are getting worse. Earnings have begun to decelerate sharply, going from expectations of modest year-over-year growth to year-over-year declines in the first half of this year. We think earnings will continue to be under pressure and full-year earnings will be flat to lower. That will likely translate into vulnerability for the stock market.
Although corporate fundamentals are starting from a relatively solid basis today compared, for example, with the late 1990s, we expect them to continue to deteriorate in lock-step with the macro economy. We also think the housing problem in the U.S. will continue to weigh on growth. It remains to be seen whether the Fed will be able to put a bottom in the housing market in the near term or if it will be a more protracted process.
Q: Corporate balance sheets have been in good shape leading up to the financial crisis. Will that help soften the blow?
Hudoff: Heading into this period of turbulence last year, corporate fundamentals were the best they’d been in over a decade. We saw some excesses develop— for example, with the frantic pace of LBOs— but in general, companies pre-funded many of their liabilities. Cash was high, debt maturities low.
The healthy state of balance sheets has certainly softened the blow of the credit crisis for many firms so far. However, with a combination of balance sheet repair for financial firms and broad de-leveraging that is translating into tighter lending standards, many corporations that need access to market-based liquidity cannot find suppliers. As a result, we think default rates are going to rise.
Q: How high do you think defaults will go?
Hudoff: In January, Moody’s reported a global default rate of 1.1%. By April, the global default rate had risen to 1.75%. We think defaults will continue to march higher over the year and reach about 5% within 12 months.
We have some models that suggest it could be higher than 5%, but those models do not accommodate the number of "covenant-light deals" which are a characteristic of this market that is different from past markets. There were a lot of bank debt and capital structures created with very loose covenants because investors were flush with cash and there was a lot of competition for yield. In fact, according to S&P, covenant-light deals accounted for about 25% of the new issue market in 2007. We think these could help stave off a rapid acceleration in defaults because the trip wires, or triggers for default, do not get thrown until later— when the company has to prepay or faces amortization or another event.
Historically, 5% is about the average default rate, according to Moody’s. So we should move from well below the average to about average within 12 months.
Q: Markets seem to be pricing in much higher defaults than the long-term average. Why the discrepancy?
Hudoff: At the depths of the market uncertainty in March, spreads in the high yield market implied default rates that were about three percentage points higher than what we expected for 2008, according to PIMCO’s calculations. The main reason was the uncertainty regarding the trajectory of the economy and how successful the Fed would be in stemming the housing and subprime mortgage problems. Effectively, before the "Fed Put" was extended to the financial system in March, the market was increasingly discounting the full real economy–financial cycle paradigm that I already discussed. Now, the markets are discounting a roughly 5% default rate, according to our model.
Q: Is there a scenario in which defaults would rise to meet market expectations?
Hudoff: If the U.S. economy slows more than expected or the disintermediation problem doesn’t get solved in the next six months or so, the risk is that defaults will get worse than we expect. Those trip wires for covenant-light deals could start to get thrown earlier than expected, in the latter part of 2008 and 2009. Under those circumstances, defaults could pick up beyond 5%.
Q: The market for new high yield issues has been very slow. What are the supply and demand dynamics right now?
Hudoff: I would characterize the technical supply and demand picture in high yield as fragile. Usually, there is a rough equilibrium in the high yield market that is established on one side with new issues and credit migration from investment grade into high yield that is reasonably offset by flows into the asset class, bond maturities or retirements and credit migration out of high yield. This balance usually translates into annual new issuance averages between $120 and $150 billion. In concept, if supply exceeds this range, spreads have to increase to draw new investors into the game.
The problem we had last year was that we had a lot more supply than demand. The LBO calendar had produced more than $200 billion in loans and about $100 billion in bonds that had to be absorbed by the high yield market given the lack of structured product and other alternative sources of demand. That represented well over two times the annual new issue supply, according to JPMorgan.
Over the last few months, through a combination of cancellations, restructurings and placements, this overhang has been reduced. We currently think there is roughly $65 billion in bonds and $95 billion in loans that still need to be distributed. This still represents a very large calendar compared to historical periods.
This supply overhang must be worked off before a sustainable rally can take place, and the process will take some time. Volatility over the past few months has prevented supply from coming to the market. In fact, the first three months of this year saw the lowest supply in the high yield market in a decade, according to Merrill Lynch data.
On the demand side, market turbulence has continued to keep the marginal buyers for bank loans— structured products— completely on the sidelines, and it is unclear when they will come back. For now, the only bidders for bank loans and high yield bonds are traditional mutual funds and real money accounts. But even those buyers are mostly sitting on the sidelines with a lot of cash, trying to preserve their capital during this volatile time.
Q: How long before buyers come back and the excess supply is absorbed?
Hudoff: We think it will take at least six to 12 months.
Q: With both fundamentals and supply/demand dynamics fairly fragile right now, have there been any positive developments in the high yield market?
Hudoff: The good news is that valuation has improved. In the high yield market, investors are compensated for taking risk by credit spreads. When spreads widen, at a certain point the spread will properly compensate an investor for taking on the risk. That is when valuation dominates fundamentals and technicals.
Q: Is it time to buy high yield?
Hudoff: Almost. The weakening fundamentals and the technical supply overhang we discussed will continue to put pressure on spreads. So the question is, when will valuation dominate the equation and compel us into high yield because we’ll be compensated for the risk? In other words, when will spreads hit their peak for the cycle?
We have gone through the math, and all of our indicators point to the second half of this year. Looking at history, the recessions in the early 1990s and the early 2000s suggest that the latter part of the year is when spreads start to turn around.
Q: Is there a potential negative scenario that could delay a turnaround in the high yield market?
Hudoff: I think about downside scenarios a lot. In its least negative form, I think the most obvious scenario involves the emergence of another downward leg to the credit crisis. The most obvious source of this would be consumer finance–related exposures and a return to balance sheet uncertainty that tests all the progress made by the Fed in shoring up confidence in the financial economy. A more difficult iteration of this scenario would involve knock-on real economy effects that translate into a deeper and more protracted economic slowdown.
Q: Given PIMCO’s outlook for high yield, how are you investing today?
Hudoff: We will remain cautious and mindful of preserving our clients’ capital, because there is still a considerable amount of uncertainty. So we will try to focus on credits— either sectors or individual securities— that may benefit from the volatility or are immune to it.
We like sectors like utilities and healthcare and names that are relatively defensive. We would try to limit our exposure to companies that are very exposed to discretionary income, such as consumer cyclicals. We are a little concerned about cyclicals overall, including heavy cyclicals, because a moderating economy is not necessarily great for a levered cyclical company.
In general, we are focusing on credits that have good asset coverage so that our downside risk is limited. We like seasoned, big, liquid names that have more proven credit histories and which we have seen pay down debt in the past. Our sweet spot is high single-B, low double-B rated securities, and although that part of the market has been under pressure lately, we believe that is just the ebb and flow of valuation.
We will be very selective in the LBO pipeline. Many bank loans and bonds that were part of leveraged buyout commitments made last year have been sitting on the balance sheets of investment banks. Those that were sold in the third and fourth quarter of last year have since declined in value. We have not really bought any new LBO issues— either loans or bonds— although we have bought some in the secondary market after their prices fell.
This is the time when a cautious approach, with a heavy asset coverage requirement, could potentially pay off.
Q: What is your view on the bank loan market apart from LBOs?
Hudoff: We like bank loans, and we have increased our allocations lately. Why? First, the sector underperformed in 2007. We have never seen this kind of volatility in the loan market. At the same time, bank loans are a higher-quality part of the high yield universe. What we have experienced in the leveraged loan markets over the last few months could be called a "black swan event"— it has been way beyond the realm of normal expectations— and we are happy to take advantage of the opportunities that this dislocation has created.
Second, we like bank loans because they tend to be the first to benefit from a turnaround in the economy. As the economy starts to improve, investors typically start to bid up bank paper. Also, when banks come back to the market as investors, bank loans will most likely be the first kind of paper they buy, and that could provide a technical boost to the market.
Finally, bank loans are priced against LIBOR and eventually LIBOR should go up. The Fed cannot cut rates forever, and the forward curve is not going down at the front end in perpetuity. At some point, the process will reverse.
Q: So bank loans would be a potential long-term investment?
Hudoff: Yes, but bank loans could also benefit sooner than we expect. If the Fed manages to restore confidence in the financial markets quickly, everyone will then become concerned about inflation. In that case, there’s a very good chance that the Fed will take back all of the easing quickly. So the same forces that pushed floaters down and made them appear very unattractive on a yield basis will make them attractive again.
Q: Thank you, Mark.
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Normxxx
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