I came across this piece from the Business Insider. Their post talked about one of the more surprising aspects of this recession: the low default rate in high yield credit. I’ll openly admit, in the words of Frank Vitchard, “I did not see that coming!”
They referenced a Fitch report, “The Extreme Credit Cycle – Making Sense of a 1% U.S. High Yield Default Rate”, which talks about this development. According to Fitch, the high yield default rate went from 13.7% with 151 defaulters last year, to a forecasted 1% default rate for this year. A stunning drop, to say the least. But let’s a take a look at the following chart, which comes out of the report:
The thing I note is the divergence in growth rates between TTM revenues and TTM EBITDA we’ve seen since ’07. In ’05 and ’06 you can see the growth rates tracked pretty closely together, but in ’07 as the economy started wobbling, TTM EBITDA started turning negative. Plus, EBITDA went lower, farther and sooner than revenues. But EBITDA growth is slowing down, possibly peaking. Not much of a surprise since we knew companies were cutting costs via layoffs and forgoing cap ex. But what are we talking about when we refer to EBITDA? From WikiInvest:
EBITDA = Income before taxes + Interest Expense + Depreciation + Amortization
Ah, yes…. Earnings Before I Trick the Damn Auditor… actually it’s Earnings Before Interest, Taxes, Depreciation and Amortization. I don’t particularly like the metric because the things it leaves out are, well, kind of important. But the metric is supposed to reflect a relatively clean cash flow measure. I guess to me, aside from the drop in income (which is obvious), the thing I’m most curious about in the high yield space is which component had the biggest impact in the second half of ’08 as well as the second half of ’09: was it interest expense? Or depreciation and amortization? The answers we get there can help explain why we’ve seen such a dramatic drop-off in default rates.
My theory is interest expenses have taken such a dramatic cliff-dive it has only served to help high yield companies in managing interest costs and as a result their weighted average cost of capital. This differs from Fitch’s conclusion that it’s the cap ex piece. How did I arrive at that? Let’s take a look at the chart:
The coverage metric EBITDA less CapExInterest feel further going from a peak of just over 3 times coverage to roughly 1.5 times coverage – about a 50 percent drop in a coverage metric. Yet the EBITDA/Interest only fell from a peak of near 5 times coverage to a low just under 4 times coverage. So I don’t buy the reduced CapEx story all that much. I think the story is really in the reduced interest expense.
And on the heels of that, we read this from Bloomberg:
Investors are returning to junk bonds after the worst month since 2008 on speculation the economy is growing fast enough to avert corporate defaults without sparking inflation.
“High yield is the place to be,” said Manny Labrinos, a money manager at Nuveen Investment Management who oversees $1.8 billion of fixed-income assets. “Sub-par growth is somewhat of a Goldilocks scenario because it means rates stay low and people are still going to reach for yield.”
High-risk debt has returned 1.76 percent in June, almost double the gain of investment-grade corporate bonds, Bank of America Merrill Lynch index data show. Underscoring demand, CNH Global NV, the Fiat SpA unit that makes tractors and harvesters, boosted the size of its speculative-grade offering by 50 percent to $1.5 billion in the largest junk-bond sale since April 20.
So the paper is exceptionally well-bid, but what would you expect in a rate environment like ours? Indeed, as one of the more astute people I follow on twitter said:
The reason I worry about it is the same reason I worry about sovereign deficits. The amount of debt worries me not because I think there’s some magic debt/GDP number from which there’s no point of return, but because low rate environments are highly convex and rate shocks can kill. Especially when growth rates for GDP, earnings, etc. grind lower. At some point, you’re bound to have a problem. I’m going to cover more on the sovereign-related stuff later.
In the meantime, chew over the idea that with rates so low and liquidity being so excessive, defaults in high yield will continue to surprise to the downside, grinding returns lower still.
Seems we have started another feedback loop, just like the Japanese did, 20+ years ago…