Value Investing

Hotchkis & Wiley: The Bear Case For High Yield In Today’s Environment

In Hotchkis & Wiley‘s 2015 High Yield 2Q Newsletter, Ray Kennedy, Mark Hudoff, and the rest of Hotchkis & Wiley’s high yield team point out that an important part of their risk assessment is an exploration of views contrary to their own, i.e. evaluating “the bear case”.

They write:

“With this in mind, we thought it would be interesting to evaluate the case against high yield. Previous newsletters have highlighted what we viewed as the most compelling reasons for investing in high yield bonds. In this newsletter, we will flip that approach on its head and highlight the most frequent and compelling objections that we observe from clients, prospects, and various members of our industry network, imparting our views on each.”

Hotchkis & Wiley’s 2015 High Yield 2Q Newsletter

“One must dig deeply into opposing points of view in order to know whether your own position remains defensible. Iron sharpens iron.”

– Francis Collins, American physician/geneticist and Director of the National Institutes of Health

Hotchkis & Wiley – Point counterpoint

During the normal course of our research process, an important part of our risk assessment is an exploration of views contrary to our own, i.e. evaluating “the bear case”. We would like to believe that people who see things our way are highly intelligent and those who disagree are simpletons but we have learned from our experience that this is hardly the case. Reasonable, levelheaded people frequently disagree with our judgment. Occasionally they will convince us outright or bestow enough uncertainty to alter our course of action while other times we agree to disagree—either way, considering their viewpoint with an open mind is a worthwhile and enlightening exercise.

With this in mind, we thought it would be interesting to evaluate the case against high yield. Previous newsletters have highlighted what we viewed as the most compelling reasons for investing in high yield bonds. In this newsletter, we will flip that approach on its head and highlight the most frequent and compelling objections that we observe from clients, prospects, and various members of our industry network, imparting our views on each.

Hotchkis & Wiley – We are too late in the credit cycle

A typical business cycle comprises an expansionary period followed by a contractionary period. Specific to credit markets, expansionary periods are associated with deleveraging, earnings growth, and spread tightening while contractionary periods are associated with releveraging, earnings deceleration/declines, and spread widening. Perhaps the most common objection we receive regarding the high yield market’s prospects is that the end of the credit/business cycle is approaching. Leverage has crept higher, spreads have widened from trough levels, and earnings growth has decelerated. Also, the current cycle is getting long in the tooth. Based on information from the National Bureau of Economic Research (“NBER”), Chart 1 highlights the duration of various business cycles going back more than 150 years sorted from longest to shortest. The average cycle is just under five years, and we are already nearly six years into the current cycle.

Hotchkis & Wiley

First, we agree that the end of the credit cycle is approaching. We expect financial leverage to increase before it decreases and we expect earnings growth to decelerate. We have been saying that it feels like we are in the eighth inning; however, innings can last a long time—particularly in contemporary business cycles. The asterisks in Chart 1 highlight the eight most recent business cycles (those since 1960), which have an average duration of close to seven years (seven and a half if you exclude the 1.5 year outlier). The reason recent business cycles appear to be longer than in the past could be due to market integration, central bank intervention, or some other factor but the point is that the current environment could persist.

Importantly, the end of a credit cycle does not inevitably equate to a disaster for high yield investors. The NBER has a committee that selects exact dates that business cycles begin and end, but in reality, cycles typically progress gradually. Fundamentals can deteriorate without causing a rampant increase in defaults. So long as the market offers a spread sufficient to cover defaults adjusted for recovery rates, high yield investors should out-earn high grade alternatives.

The exception would be severe recessionary environments. Such environments are most often preceded by plummeting long term treasury rates resulting in an inverted yield curve. As shown in Chart 2, the yield curve has flattened from unusually steep levels but remains a long ways from inverted. In sum, we do not observe warning signs that a severe recessionary environment is inevitable any time soon.

Hotchkis & Wiley

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