Tremors: The Evolution Of A Short High Yield Strategy by The TradeX Group
The current high yield (HY) bubble can be thought of as an impending earthquake that is severe in magnitude and warning local inhabitants with foreboding tremors. We have been discussing the state of the HY market with investors for approximately two years now, shooting up flares and ringing alarms, like these communications in December 2013 and March 2014 (before and when our short strategy launched). The basic investment thesis has been that there are hundreds of companies that have had near unfettered access to capital markets due to unprecedented easy-money policies. Many of these companies did not merit this access, but nevertheless it was still cheap and easy for them to find refinancing or to issue new debt. These companies probably knew that at some point capital markets would become much harder and more expensive to access. The tremors are now much closer to each other and carry much more force, as we wind down a year that will result in the first annual HY loss since 2008. The “worst-of-breed” HY companies that we target are becoming easier to find, because there are so many of them. In this blog, we will review the evolution of a short high yield bond strategy in recent years.
City-life is bustling – 2009 to 2012: The Financial Crisis is over and companies that barely made it out of 2008 have licked their wounds. Helicopter Ben is QE’ing like crazy and capital markets are open for business. High yield companies have access and can raise large amounts of low-cost debt. What do they do with it? They extend their Ponzi-schemes by refinancing prior debt, by paying out dividends, by initiating expensive share buy-back plans and by making ill-advised acquisitions and LBOs. In CCC’s, less than 10% of new bond issuance is used for corporate purposes, CAPEX or project finance.
Seismic activity deep underground – 2012 to 2014: CCC’s that hung on in 2008 and levered up afterwards are seeing their businesses grind slower, with huge amounts of new competition, negative revenue trends, volatile EBITDA, declining and negative free cash flow and rapidly increasing levels of leverage. Refinancing activity reaches fever pitch levels in 2014, accounting for 33% of all CCC new issuance activity by purpose. The companies need breathing room and they need it fast. Yield-to-worst in the JPM US HY Index hits 5% as the Fed has indirectly forced investors into taking undue, credit-agnostic risk. Some HY companies secretly hope that they find a seat before the music stops. Seismic activity is starting to be registered, some small tremors are felt and some early adopters reduce exposures and start to prepare for the coming quake.
A tectonic shift occurs – 2014 to 2015: Macro headwinds persist and are being recognized and pointed out by many well-known market participants. The inevitability of the cyclical nature of markets looms large – equity markets are tired and overextended, commodity markets are shaky and need EM growth to sustain, high yield markets are frothy. Famous market mavens are warning the masses. An interest rate hike is imminent and the Fed’s level of conviction is not confidence-inspiring. Over the last 43 years, on average, 56% of CCC issuance defaults within 7 years of issuance. The time is up. As flows turn negative, volumes recede, new issue activity slows, liquidity dries up and performance turns negative, can this time really be different? As Mark Twain famously said, “History does not repeat itself, but it rhymes”.
Evacuation plans are put into effect – 2015 to TBD: The tremors are no longer subtle and the fault lines are apparent. The collapse in oil prices has global impact, effecting commodity pricing across the spectrum, threatening employment gains, failing to positively incentivize the consumer to spend more and raising geopolitical tensions. Bankers, who have plenty of choices for raising debt, recognize that capital markets are no longer quite as accommodative and choose safer borrowers to bring to market. Risk reassessment occurs overnight, repricing certain sectors such as telecom, cable and chemicals (ie. Sprint, Cablevision/Altice and Olin/Dow Chemical, respectively).The constant push and pull between bulls and bears is starting to shift to the bear side and liquidity is tested.
Destruction followed by rebuilding – TBD: The inevitable earthquake occurs swiftly, and companies will be torn down. Default rates have spiked and distressed players start looking for reclamation projects. This is a great time to be a long distressed buyer, but before that becomes a viable option, there will be lots of pain taken.
There is still time to get short of high yield bonds at asymmetric price levels. But, once the tipping point is crossed, market dynamics shift quickly and these bonds can no longer be borrowed. We have already established shorts near par in preparation for the earthquake in HY. This strategy is clearly an opportunistic one, and now is the time to protect a portion of your portfolio. Good luck out there. #shortHY
Partner, Director of Research