Marty Fridson: Risks And Opportunities In High-Yield Market
June 7, 2016
by Marianne Brunet
If you think there is a greater than 9% chance that we will be in a recession in the next 12 months, you should avoid high-yield bonds. But if you think the economy is recovering and interest rates will rise soon, you should invest in the lowest-quality bonds in the market.
According to fixed income expert Marty Fridson, there are risks and opportunities in the high-yield market that you should consider whether you’re a bull, a bear, a hawk or a dove.
Fridson is the chief investment officer at Lehmann Livian Fridson Advisors LLC and a widely respected fixed income analyst. He spoke on May 9 at the 69th CFA Institute Annual Conference in Montréal on high-yield investment strategies.
I will review his analysis of default rates, his strategy for investors expecting rising rates and his explanation for the recent deterioration in covenant quality.
High-yield market – Is 2016 the beginning of a multiyear default-rate surge?
According to Fridson, “Default rates in 2016 are definitely higher,” but whether this is the beginning of a multiyear default-rate surge depends on whether you think we are heading into a recession.
Fridson explained that default rate surges typically follow the pattern of economic cycles, and to illustrate his point he presented the graph below.
The data shows that surges in U.S. speculative-grade default rates throughout the last 33 years have typically coincided with economic recessions. But Fridson did not just present the graph to show a general trend; he introduced it so he could point out an important subtlety.
He stated, “The key point that comes out of this graph is that there was a mini-surge in 1985-1986 that did not continue to that low double-digit peak. So the question is if we are in that kind of period again. Because that was driven by a drop in oil prices.”
He explained that in 1985-1986 there was a mini-surge driven by defaults in the oil and gas industry, but that those defaults weren’t part of the overall business cycle. The economy continued to perform well even though the energy sector was faltering, so the default rates receded and didn’t rise again until the recession in 1990-1991.
“Whether this is just a temporary surge related to energy or a more general increase is really related to the question of whether we’re going to be in a recession,” Fridson said.
One way to answer this question is to look at the average length of economic expansions, according to Fridson. He explained that the average length of the last three cycles was 95 months, and the longest of the last three cycles was 120 months. Therefore, because it will have been 102 months from the end of the last recession to December 2017, he concluded that there is some historical evidence that supports expecting a recession in 2017.
Fridson said, “The former Treasury Secretary Lawrence Summers recently stated that he saw at least a 50% possibility of a recession by 2018,” and that part of this view is based on the fact that expansions don’t go on forever.
But high-yield investors should consider whether the market is priced according to this bearish outlook.
Fridson deduced the high-yield market’s estimate of the probability that we will enter a recession in the next 12-months, excluding data from the energy and metals because the commodities industries are already in recession.
According to his calculations, the high-yield market estimates the probability of recession as just 9% over a 12-month horizon. “If you think that the probability is substantially higher than that, it would be an argument for underweighting high-yield currently,” Fridson said.