EDITED BY:

Martin S. Fridson, CFA

Since the advent some 40 years ago of a vibrant primary market for speculative-grade corporate bonds, the high-yield market has evolved from a niche occupied by a small group of specialists into a full-fledged institutional investment category. Asset allocators and portfolio managers now have at their disposal the tools necessary for rigorous investment analysis, including financial statements of the issuers, indexes, trading prices, historical default rates, and time series on such credit factors as liquidity, ratings, and covenant quality. This research brief provides up-to-date techniques for extracting from the extensive data the information that can lead to sound investment decisions.

Conference moderator Martin Fridson, CFA, chief investment officer of Lehmann Livian Fridson Advisors LLC, decomposes long-term returns on high-yield bonds as follows:

• (Treasury yield + Spread vs. Treasuries) – (Default rate + Recovery rate) = Return.

Over shorter periods, Fridson points out, total return can diverge widely from the output of this formula because of changes in the spread-versus-Treasuries and the underlying Treasury yield. As an alternative to gauging the high-yield asset class’s value at a point in time by comparing the spread-versus-Treasuries with its historical average, he offers an econometric model that compares the spread with a comprehensive measure of prevailing risk. Fridson cites research documenting the default rate impact of changes in the composition of the high-yield universe. He also emphasizes the variability of recovery rates over the course of the credit cycle. A striking feature of high-yield returns, Fridson observes, is their extraordinary dispersion in contrast to the investment-grade market.

Bill Hoffman, senior analyst at Investcorp Credit Management US LLC, explains the process by which a high-yield analyst decides whether to recommend investment in a new issue. The analysis compares the new issue with issues of similar credits, taking into account macroeconomic factors, industry fundamentals, business-specific risks, and the issuer’s financial strategy. Financial strategy comprises free cash flow, deleveraging potential, and the risk of additional leveraging transactions. Hoffman emphasizes that this process is an art, not a science. To illustrate, he provides a case study involving Kraton Performance Polymers’ 2015 announcement of the acquisition of Arizona Chemical. His analysis addresses the additional factors of the attractiveness of the business combination and synergies arising from it. Hoffman finds that marketwide technical factors created an exceptional opportunity in the Kraton bond.

Diane Vazza, head of Global Fixed Income Research at Standard & Poor’s Global Ratings, outlines her firm’s forecasting model for the high-yield default rate. The main components are economic variables, financial variables, bank lending practices, the interest burden of high-yield companies, the slope of the Treasury yield curve, and credit-related variables. Vazza elaborates on how the default rate can be suppressed by easy access to credit for refinancing debt and extending maturities or, alternatively, be elevated by a rise in interest rates following heavy borrowing for leveraged buyouts, share repurchases, and increased dividends rather than investment in conventional business activities. She further describes how the default rate can be affected by dynamics within particular industries that do not spill over into the rest of the high-yield universe. Because default probability is highest among the lowest-rated issuers, the universe’s ratings mix also influences the default rate.

Anders Maxwell, Managing Director at PJ Solomon, presents a primer on the legal underpinnings and process of corporate bankruptcy. Emphasizing the centrality of valuing the estate, he explains that to address ambiguities in that task, the court may scrutinize accounting standards, financial projections, and key assumptions underlying competing valuations. Maxwell also describes the conditions under which an out-of-court restructuring is most feasible. He highlights factors that create opportunity in distressed securities, including volatile and uncertain values as a consequence of the opaque and complex dynamics of corporate restructuring, as well as an inefficient market for the securities. Additionally, Maxwell presents two case studies to illustrate the pitfalls of relying on market prices as indications of intrinsic value. One bankrupt company’s securities declined prior to the filing and rose afterwards; the other company’s securities displayed the opposite pattern.

Saish Setty, director of reorg covenants at Reorg Research, provides a theoretical framework for understanding the need for covenants and lays out the main risks to creditors. He describes some common covenants, including those dealing with debt levels, liens, restricted payments and investments, and asset sales. He shows how covenants are necessitated by shareholder–creditor conflicts and inter-creditor conflicts. The risks arising from such conflicts include incurrence of risky investments by the borrower, subordination and dilution, and value leakage. Setty also explains the two general types of covenants, affirmative and negative, and the significance of restricted and unrestricted subsidiaries. In addition, he highlights potential pitfalls. For example, he states that the so-called hookie dook provision historically common in oil and gas issues arguably gutted the liens covenant. Setty argues that close attention to defined terms, differences among an issuer’s outstanding instruments, and interactions among different covenants can help to identify hidden risks in an indenture.

Michael Brown, global head of research at Advantage Data, analyzes high-yield price histories as a function of macroeconomic forces, microeconomic forces, impulse forces (influences that abruptly rise to a peak, then fade gradually), risk, and technical features of the time series themselves. He notes that in the short term, high-yield prices are subject to fluctuations and a high level of noise (random fluctuation). Over longer time intervals, price moves occur at lower frequencies, subject to lower noise and less fluctuation. Brown finds that high-yield prices move in recurring patterns involving trends and cycles. He tells how to filter out the noise and outliers that obscure these patterns. Also, he identifies the most important macro factors in driving fair value. Brown stresses the importance of using as a starting point a price source based on actual trades, such as TRACE (Trade Reporting and Compliance Engine) data for North American bond trades. This information can be supplemented by additional trade-related data—for example, volumes traded and amounts outstanding.

Armed with the analytical methods described in this brief, institutional investors can have confidence in their ability to manage risk in an asset class perhaps better known for its hazards than for its diversifying benefits within a broad portfolio. The contributors also show practitioners how they can potentially exploit inefficiencies in the pricing of individual issues and sectors, as well as the asset class itself. Notwithstanding certain unique features, the high-yield market is analyzable within the same risk–reward framework used for equities, investment-grade bonds, and other institutional categories.