From my friend David Kotok:
High Yield Bonds in a Quantum Universe
August 16, 2012
Michael Lewitt is a portfolio manager and heads the opportunistic credit section of Cumberland. His bio can be found at www.cumber.com. His email is michael.lewitt@cumber.com.
Zero interest rate policy has created a quantum universe in which bonds and other financial instruments are, more than ever, difficult to value. Traditional value metrics are no longer sufficient tools for investors seeking to protect their capital and still generate reasonable risk-adjusted rates of return.
The high yield bond market is currently trading at its lowest yield in history. At 6.84%, the Barclays High Yield Index is trading at 604 basis points (one basis point equals 1/100th of 1%) more than 5-year Treasuries. Spread represents the risk premium that investors demand for owning these bonds, and it is measured against the yield on what are considered to be riskless Treasury securities. It is important to recognize that spread measures relative values while yield measures absolute values. Investors who pay too much attention to spread and not enough attention to yield leave themselves vulnerable to large losses when the market reverses, as it inevitably will.
The manner in which most high yield investors rely on spread and Treasuries as a riskless benchmark is flawed.
Spread is a fixed income measurement tool being applied to a hybrid debt/equity security: a high yield corporate bond. The weaker a bond’s credit quality, the greater risk of loss it poses. Lower rated bonds pose a risk of loss that is more akin to equities than to investment grade bonds. For that reason, spread becomes less useful as a risk measurement tool as one moves from BB-rated bonds down to B-rated and CCC-rated bonds.
Treasury securities are considered riskless because the world believes that the United States will never default on its debt. This belief persists even after last year’s loss of America’s AAA rating. But today’s low interest rates on Treasury instruments point to the fact that the economy is extremely weak. Moreover, while the U.S. will certainly not default, it actively engages in the process of “disguised defaults” through policies that encourage inflation and currency devaluation. For these reasons, Treasuries may not be risk-free in the way that they used to be, and using them as the benchmark understates the risks associated with below investment grade bonds. Because high-yield bonds are priced off Treasury rates, they offer an unduly low yield that is lower than justified by these types of bonds and the economic environment.
Today’s spreads are about 300 basis points wider than they were in May 2007, when the high yield bond market traded at its lowest spreads in history (+238 basis points). Yields, however, are about 50 basis points lower. The reason for this is that 5-year Treasuries were trading at 4.85% in May 2007 while today they are roughly 0.70%.
In order to earn appropriate risk-adjusted returns in high yield bonds – and to avoid succumbing to the trap of focusing on relative returns – an investor must seek out bonds that are trading at appropriate absolute valuations. This requires a greater focus on yield rather than spread.
Interestingly enough, some of the best absolute values in the high yield bond market are in short maturity lower rated bonds that remain low rated due to high leverage but that are otherwise unlikely default candidates.
One example of this type of bond is First Data Corp., a credit card processor that was taken private by KKR prior to the financial crisis. First Data Corp. 11.25% Subordinated Notes due 3/31/16 pay more than a 12% yield despite the fact that most of the company’s debt matures after 2016, KKR is heavily invested in and strongly supportive of the company, and the business is slowly but steadily improving. These bonds are rated Caa2/CCC+, yet the odds of the company defaulting and not repaying them are extremely low. In this case, as in many cases, the low rating is attributable to the company’s high leverage but drastically overstates its default risk.
The lesson is that investors must learn to think for themselves and not blindly follow conventional valuation measures or credit ratings. Thinking like the rest of the market only allows an investor to see what everybody else sees. The key to successful investing is seeing what nobody else sees. The path to higher risk-adjusted returns and the ability to avoid the large losses that are inflicted on high yield bond investors with near biblical regularity requires the ability to think differently than the consensus. This is particularly important in a quantum investment universe in which zero interest rates are distorting the value of all financial instruments.
Michael Lewitt, Vice President and Portfolio Manager
Humanities 