Leveraged credit: the dawn of a new golden age?
The new market regime has led to enticing yields and an environment in which the pendulum has swung back in favour of credit holders for the first time in years, with leveraged companies being forced to take creditor-friendly action.
In 2023 there’s been a banking crisis, default rates have doubled from their cycle lows and interest rates have continued to rise.
Surely this made for a tough time for investors in high yield bonds and loans?
Actually, not so much. High yield (HY) bonds are having a great year. Up 6.3% over the last 12 months in Europe, while leveraged loans are up 9.75%.
So, what’s going on and what does it tell us about returns looking forward?
Turning tide of cashflows
The bond sell-off in 2022 was undoubtedly brutal and went beyond what most market participants thought possible. However, for credit investors it represents a year of transition to a new regime in which the cashflows of leveraged companies are no longer being directed principally to equity holders but instead to creditors.
Let’s take the case of Italian paper producer Fedrigoni - a classic, private-equity led, leveraged buyout (LBO) of a successful business from the founding family.
A bond was issued in 2018 to finance the buyout which paid Euribor+4.125%. With Euribor negative for much of the life of the bond this meant a yield of less than 4%. In late 2022 the company changed hands again, this time, though, the bond issued to finance the buyout paid a coupon of 11%. Same company. Comparable leverage. Different coupon.
The pendulum has clearly swung in favour of creditors and this is by no means an isolated case. We see a broad range of opportunities to put money to work in performing high yield credits today in the 7-11% yield range.
It wasn’t so long ago that we were referring to 7% yielding bonds as ‘stressed’.
Impact on firms of higher financing costs
It is true that this world of higher financing costs will lead to increased default rates as some firms find they cannot live with the new interest burden. These over-levered firms, though, will be a small minority and, for stock pickers who can dodge the bulk of the losers while buying into credit stories where default fears are overblown, there are healthy returns to be made. For freshly minted LBOs, this will mean harvesting the cashflows that previously flowed to equity.
Importantly, this also changes the equation for sponsors and asset operators. No longer are they incentivised to run businesses with as much leverage as possible. As low coupon bonds come up to maturity and companies consider refinancing into current market rates, there is a clear incentive for them to find ways to reduce indebtedness. This means creditor-friendly actions are becoming more commonplace. Asset sales, dividend cuts, equity injections and the reduction of growth capex are some examples of this.
The implications for investment returns
Now let's look at what this new environment means for returns.
Over the past 12 months there hasn’t been yield compression in the European HY bond market and yet total returns have been strong. This is because around 70% of the returns have been from carry. The asset class has a yield-to-worst of 7.5% today, which is actually 0.2% higher than this time last year.
Chart 1: Global high yield market valuations - Despite strong YTD returns, the entry point is still excellent
So, the lesson from the last 12 months is that the current carry of high yield leaves investors with margin for error on the macro front. To put it simply, there's been no rally in yields and yet returns have been strong. But let's go further and look at what returns may look like over a given 12-month period in a more adverse scenario.
Chart 2: The importance of higher yields - Carrying investors through a range of scenarios
Uncertain macro, but attractive yield and value
The macro environment is hard to call confidently. Today, something between a 'soft-landing' and a 'no-landing' narrative (where rates stay higher for longer but the economy remains resilient) is in the ascendency. We must acknowledge though that it wouldn’t take much for the narrative to shift in a more negative hard-landing direction. Indeed, the narrative has oscillated practically every month in 2023 between these scenarios. The point being made in the table above is that the level of carry in leveraged credit portfolios is now extremely protective, while the embedded interest rate exposure in the bond market is a natural hedge for a hard landing scenario.
We don't know exactly what the future holds but at this level of yield, you are rewarded to hold the asset class.
One further thought on value. Aside from yields being attractive, another factor making the asset class look attractive today is price. The average bond price in the high yield market is now well below par as illustrated on the chart bellow (blue line).
When high yield bond prices trade below par, a strong environment for returns presents itself because investors stand to benefit from both current yield (coupon/price) and price appreciation as bonds are repaid at par. We can see a clear relationship between price and subsequent 12-month returns in the chart below. It’s pretty rare not to have strong subsequent returns when average prices are below par and we’ve highlighted these in red. Where a little patience has been needed, the reward has been significant.
Chart 3: Relationship between price and subsequent 12-month returns
To summarise, while the macro-outlook remains difficult to call, it's clear that the pendulum has swung in favour of creditors vs asset owners for the first time in many years. Levered companies are being forced to respond by taking creditor-friendly action. Investors in leveraged credit will earn carry that will likely lead to strong total returns over time and offers significant downside protection in adverse scenarios, if held for the medium term.
While these conditions may not last forever, it could be some time before we see the tide turn back in favour of equity holders. Active managers identifying companies who prioritise balance sheet health are best positioned to reap the rewards. And even equity holders do return back into favour, a significant level of compression in yields will lead to price appreciation that could rival returns of the equity market.
Please note any past performance mentioned is not a guide to future performance and may not be repeated. The sectors, securities, regions and countries shown are for illustrative purposes only and are not to be considered a recommendation to buy or sell.