Distressed Debt Investing: The High Yield Market is "Completely Out ...

The title of this post comes from a quote from a buy side friend working at one of the largest hedge funds out there. I 100% agree with his assertion. Howard Marks also agrees (see his most recent letter here: http://www.oaktreecapital.com/MemoTree/Ditto.pdf). He writes:

"Regardless of the reason, things are happening again today - especially in the credit world - that are indicative of an elevated, risk-prone market:

• Total new issue leverage-finance volumes - loans and high yield bonds - reached a new high of $812 billion in 2012, according to Standard & Poor's, surpassing by 20% the previous record set in pre-crisis 2007.
• The yields on fixed incomes securities have declined markedly, and in many cases they're the lowest they've ever been in our nation's history. Yield spreads, or credit risk premiums, are fair to full - meaning the relative returns on riskier securities are attractive - but the absolute returns are minimal. I find it remarkable that the average high yield bond offers only about 6% today. Daily I see my partner Sheldon Stone selling callable bonds at prices of 110 and 115 because their yield to call or yields to worst start with numbers - 'handles' - of 3 or 4 percent. The yields are down to those levels because of strong demands for short paper with perspective returns in that range. I've never seen anything like it.
• As was the case in the years leading up to the onset of the crisis, the ability to execute aggressive transactions indicated the presence of risk tolerance in the markets. Triple-C bonds can be issued readily. Companies can borrow money for the purpose of paying dividends to their shareholders. And CLOs are again being formed to buy leveraged loans with heavy leverage."

I find it interesting: Many many people realize the market is heavily overvalued in terms of compensation of return versus risk, but they still are buying. Maybe they NEED to buy because they are an insurance company or pension that can't find yield anywhere else that high yield bonds. Or maybe they NEED to allocate capital because they are getting inflows from retail/new investors. Maybe they think all is clear for the foreseeable future and hence are happy to clip a fat coupon for the interim period. I am hearing primary markets are simply a food fight amongst large funds trying to get whatever allocation they can get a hold of to put money to work for coffers that seem to be only growing from demand in the asset class.

In all honesty, it is very very hard to be a mega fund in high yield credit. How many times can you look at TXU or CZR/HET? Accounts were a little busy at the end of the year getting up to speed on Mittal but that too has been a buying frenzy. Where the value lies, in small, off-the-radar, thinly traded securities, is marginally off limits to these funds because 1) They can never get size on a position to move the needle 2) If they did get the size they wanted, they'd be a huge % of noteholder base, a position a lot of funds do not want to be in when everyone is running for the exit.

From talking to people on the syndicate desks it looks like issuance will continue to ramp throughout the month, especially considering some of the macro concerns (debt limit being hit, more negotiations on grand comprise) that await us in February / March context. I wouldn't be surprised if we also saw a big M&A issuance calendar as we move throughout the year.

In September 2012, I wrote a post entitled "An Open Letter to CFOs Across America." It seems like many CFOs / corporate treasuries read my post and took the advice to heart. We've seen a significant amount of refinancing,? dividend deals, M&A (to a lesser extend than I would have thought). For those that were around in 2005/2006, you may remember this exact feeling you are feeling today. Probably less so because absolute yields are just so low now relative to that time period.

The problem of course is bullish behavior which turns into recklessness continues until it doesn't. A very good friend and mentor of mine once said "Liquidity in the market, just in general, it can change on a dime." I often tell this story but in 1Q 2007, I met with a number of CSFB salesmen about the current market environment at that time (crazy). One of the quotes I wrote down, and still remember to this day: "It seems overdone, but its hard to imagine what's going to stop this." We know how that turned out.

Howard Marks, in his letter, also wrote:

"Equities are still being disrespected, and equity allocations reduced. They they are not being lifted by comparable income-driven buying."

A tenet, never proved, but often said in passing among the buy side is that the credit guys lead the equity markets. When credit gets shaky, soon after equities do as well. Its hard to tell if the forced buying, i.e. yield chasing, will spill over into the equity market in the form of stretched valuations. In theory though, when credit is robust, investors start pulling out things like the LBO calculator, or sum of parts valuation - in evaluating spin offs, that almost inevitably lead to higher equity values.

What excites me? The next cycle. Even assuming a modest default rate of 5-6%, given the amount of high yield and leveraged loans that have been issued in the past few years, the notional values are enormous, especially if you thrown in a few wildcards of huge complexes that file (Maybe not another Lehman, but another behemoth that will keep distressed investors busy). Add to this any opportunities that comes out of Europe and distressed investors will stay more than busy.

In the interim, companies are still filing for bankruptcy (THQ, Penson, etc). As distressed investors our job is to source, evaluate, and analyze those situations as they come across our desk and look to allocate capital where the return is much more commiserate for the risk, while offering downside protection in a margin of safety. That feels MUCH better than buying CCC bonds with a 6 handle.

Source: http://www.distressed-debt-investing.com/2013/01/the-high-yield-market-is-completely-out.html

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