Not Yet Normal: Making sense of the High Yield Market amidst Volatility
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Josh Chisari: Hi everyone. My name is Josh Chisari. I run the North American Consultant Sales Team for JP Morgan Asset Management and I’m pleased to be joined today by Rob Cook, our Global Head of High Yield.
I guess there’s really been a time when our clients have been more in need of guidance when there’ve been more questions about potential outcomes.
So, Rob, thanks for joining us today.
Rob Cook: Thanks for having me.
Josh Chisari: Of course. So, look, I don’t know where to start. There’s a lot we could talk about, right? COVID-19 and the resulting economic slowdown.
(Unintelligible) in the low 20s when I put together these notes. Today we’ve got (Brent) sitting right around 20 blocks with less taxes below zero, 6 million new unemployment claims each week, the alphabet soup facilities have been throwing at the dead market to keep it functional. So maybe that’s where I’ll let you start out.
Can I ask you to give a high level recap of what we’ve seen in the high yield market and what the primary driving forces have been behind the gyrations? Coming into the year, I guess, what were you most cautious of and what are you thinking about today?
Rob Cook: Yes. A lot to unpack there. You know, one of the funny things is we’ve seen really almost a cycle of the six-week timeframe. You know, traditionally, if you think of a high yield marketplace, when it gets to the end of a cycle and then peaks in terms of spreads and defaults, that is something that’s occurring over our 12-month timeframe, right?
The economy starts to - usually it’s growing fairly strongly but, you know, excesses are building, the Fed is kind of pulling liquidity out of the marketplace to the point where it constrains growth too much and that we have that typical cycle. This all was the most compressed cycle certainly than any of us have seen.
So, you know, initially there was this response, this recognition of how impactful setting off the economy was.
And then that proceeds with a grab for liquidity. And so the high yield marketplace, just like equity, saw really a freefall in prices in that early March period. The high yield marketplace declined 20% over about a two-week period. So it widened from a low 400 spread to almost 1100 in the course of really two weeks.
You know, this is so interesting. Most of the companies that we’ve had a chance to talk with over the last six weeks tell us that January, February were one of their best months ever in terms of economic results that they saw. So that’s how abrupt the change in dynamic.
Then there was almost an equal change as it relates to the significant fiscal and monetary response to that and how that changed the dynamics of the marketplace.
So we’ve rallied back in the high yield marketplace about 15% from those loss. So we’ve tightened about 350 basis points.
So certainly not recouping what we’ve sold off. We’ve set in about 750 in spread today or 8% yield. You know, that’s still significantly wider than that low 400s and in the 500 in terms of yield but, you know, still a pretty substantial rally from that bottom.
I guess in getting at your questions in terms of coming into the year, certainly we didn’t perceive this. We were cautiously structured. I think one of the things that I felt very strongly was you weren’t being compensated for taking cyclical risks in the marketplace. We were feeling like we were nearing more end of cycle but you just weren’t being paid for taking cyclical risks. So we were more defensive in structure and that certainly has helped our portfolio positioning.
Again, you know, we didn’t foresee the events that have taken place but when you’re not compensated for risk, there’s no reason to take risk on in portfolios. That’s not how we’re structured.
You know, I guess in terms of things that I’m worried about today, the thing I spend most of the time thinking about is not the near-term impact is significant and each company we’re going through and working through the liquidity burn, understanding, you know, you could be a company like an auto supplier, you have zero revenues, or a food distribution company and you might be down 50% in revenues because a lot of that is going away from home, so you can figure those things out in the short term.
The real question is, what are the aftershocks of this? How do we go to a mall going forward? What are our shopping patterns? How do we go to movie theaters, amusement parks and gaming operations? How will the hotel operations be different?
So those are the things we’re thinking about in terms of portfolios, kind of that second level of impact. And those are the things I worry about for our company, you know, certainly worry about getting through - bridging the next period of time as it relates to ensuring our investments have the liquidity wherewithal to get through whether this is another few months of shutdown and then in some sectors, you know, that there’ll be really almost a lost season for their business because we might be back to working a manufacturing plant in the summer, but we certainly don’t feel like we’re going to be traveling to the degree that we traveled. Certainly things that are more luxury or leisure oriented will be certainly impacted to a larger extent.
So those are the things that we’re really spending a lot of time in terms of portfolio construction process now.
Josh Chisari: So you touched on this a little bit in your response but obviously there’s been a ton of volatility both in the ten-year, with the ten-year making new laws and then quickly backing up before settling back in around 60 basis points where it is today. You alluded to what’s happened with spreads.
I guess the question is, has there been a big enough fundamental change to warrant that kind of volatility or is it all sentiment and stimulus driven? And specifically a week or so ago I was talking (Bob Michael) and he mentioned that we’ve had a lot of stimulus in the market but we’re effectively operating from a playbook drafted in 2008 and 2009.
And so while we’re very quick to market with the stimulus, we don’t necessarily know what we’re solving for yet. We may be using an old playbook. How does that kind of factor into what we’ve seen from volatility perspective?
Rob Cook: Yes, good question again. Listen, I think the reality is it is a big fundamental change. It’s a big fundamental change in the abruptness of the economic shock and, you know, virtually every company is impacted, even things that you would think would be less impacted to this or being impacted in material ways. And so I think it is a real fundamental change.
Now I think that you bring up an excellent point which is, okay, we’ve had a very strong snapback as it relates to really the fiscal and monetary response to that is that going to bridge us to better times. And I think that the question is, there is some real powerful bridge that is being provided by this and I think it’s opening up capital market liquidity.
If I think of March - as I just think sequentially of how we got in terms of the high yield marketplace, you know, March - that middle March period, the markets were in a freefall. There’s no capital market access. Zero market access for companies.
And so what the Fed did in providing these facilities is really floored the market and allowed more normal function.
So what’s happening today, and it started in investment grade market, is companies are able to cap the capital markets to bridge. Because a lot of these programs, if you look at these programs, very few flow directly to the large companies that we’re lending to. You know, there’s a lot of Main Street kind of small business related funding. There’s some direct aid to companies that are larger but it’s really much more the indirect.
So the capital market need to be the source of capital. And just in the last two weeks in terms of the high yield marketplace we’ve seen - and this is even the low investment grade high yield, you know, Six Flags, Saver, Ford, Energizer, Marriott, Neiman Marcus, Cedar Fair, AMC Entertainment, all coming to the marketplace and looking for additional liquidity. So they’re tapping $500 million to, in Ford’s case, $9 billion of really putting liquidity on the balance sheet to bridge themselves to a period of more normalized economic activity. And I think there’s a benefit to the stimulus.
I think maybe (Bob)’s probably point to that would be, well, it doesn’t solve the real economic and demand problem that we have and that’s where I think it gets back to why there’s a big push now about getting back to work. And I know this is a very controversial concept out there right now but if you don’t get people working, feeling better about their situation, if you don’t solve the demand problem at some point, this liquidity that we’re providing is only a temporary solution.
And so we need to be bridging ourselves to somewhere and I think that bridge - but, you know, they threw a lot at the economy and you’re right, I think it’s probably not the exact playbook in hindsight when we look back and some of it will probably have been wasted, but it was, I think, a correct response to - given how significant the real fundamental change in the economic landscape was.
Josh Chisari: Rob, you just touched on a new issuance. Anything that’s coming today that you find particularly interesting? And from a spread perspective, is new issue spread north of 700 still? And obviously how is that compared to pre-COVID? Are we still 300…
Rob Cook: Yes.
Josh Chisari: wide to pre-COVID even in new issue market?
Rob Cook: Yes. I think what you’re seeing is most of the companies that are coming in the marketplace need financing or need some additional liquidity to kind of bolster. So the marketplace is extracting a premium for that.
So - and rightfully so, I think, because those are companies, some of the ones that I mentioned, you know, they’re all impacted by what’s happening today. There’s a significant impact to their business into the marketplace.
I think there are some very unique, for investors, opportunities. So even a very controversial kind of sector, I would say, is a Nordstrom, which is investment grade issuer. So it wasn’t in the high yield marketplace, they had, you know, investment grade bonds. Clearly, you know, all their stores are shut. People aren’t shopping. It’s one of those kind of eye-in-the-storm companies.
So they came and actually went to the high yield marketplace because they needed to just bypass traditional investment grade investors and to talk to people that are more focused on looking at collateral value and that more stressed situation. They tapped the marketplace. We secured their headquarter building, some other distribution centers and some other stores to raise some liquidity financing for that company. That came in about a 9% yield, bond trace at about 105 today. I think that’s a really interesting situation in a very tough sector. Six Flags did the same.
What we’re finding in the new issue market, what they’re doing, Josh, is they’re also - in many cases they’re priming existing. So getting in front of actually secured financing that has more senior in a cap set than the lower part of the cap structure. So many of those companies are using whatever baskets they have. It’s a little bit more attractive than buying securities in the marketplace that exist and, you know, provide some incentive or an enticement to participate.
So I think we are using the new issue market now because the market has gone from, you know, it’s little bit winter today and yesterday was starting to weaken but had been, you know, kind of all for sale for really all bid for the last few weeks. So the calendar was a good way to put money to work in the marketplace at a new issues concession and we were actively doing that.
In the story you have to be selective. I think you have to pick a, you know, right approach to this and understand how companies are going to migrate through the next six months and we’re assuming, you know, again it depends on the business, a pretty severe impact to most companies over the next six months and then prompting that a return to normal revenue dynamics in, say, 2021. And we need to know that this makes sense under that more conservative standard.
Josh Chisari: So we just talked about a couple of names which everybody loves of course. But if we back things up and talk about specific sectors, clearly energy and the consumer are going to be negatively impacted. But do we actually have a case of maybe being thrown out with the bath water here? I mean, are there opportunities being created by indiscriminate selling? A lot has been made of ETF and all the money that’s flowed into them. As money flows out obviously ETFs aren’t choosing what they sell, they’re selling the market. So is that creating opportunities?
Rob Cook: Yes. (Unintelligible), let me kind of walk through the sequence of things and I think it’s going to - again, you know, one of my beliefs is we’re not out of the woods and we’re going to see market volatility continue.
If you think of what happened in the first couple weeks of the sell-off, the market sold everything off almost at the same ratio. Put energy aside because that had the double whammy of the OPEC collapse on top of the COVID. You know, just put that sector aside for a minute. I can address that. And everything kind of just gap lowered by 20 points.
So names like (unintelligible), which is one of the largest cable companies out there, and HCA, and Sprint, really good quality, very defensive sectors, best-in-class operators in what they did, went down about the same as the whole marketplace.
So, you know, in that early March period into that mid-March, the baby was thrown out with the bath. When you could buy defensive companies down 20 points with great franchise value, 100% (unintelligible), you know, the level of asset value beneath you.
Now that part of the market’s rallied substantially back. So the market quickly - and that was very ETF driven, Josh. So exactly what you’re saying they were just sellers in the marketplace. As I mentioned earlier, people just wanted cash. And so that pushed.
So that was the easy trade at first. So the first thing that we did is we bought all those more defensive names. We added those to portfolios. But that’s kind of played out. That’s already bounced back. And I think in the short term, you know, you have to be more discerning.
Now again if we see that technical flow, so right now you do the opposite, the ETFs have been - we had one of the largest weeks of inflows to the ETF ever last week and the market has been nothing but big. We’ve been selling into that. We think that that makes sense on some situations. You know, a name like Hilton Hotels, I’ll give you some specific examples. This is good example of kind of what happened.
So Hilton Hotel has a five-year bond, high yield, very good company, significant equity value beneath the debt, BB company, was trading at 102 at the start of all this, went down 20 points, went down at 82 over the course of two weeks. That’s a name that we thought, “Okay, that’s a survivor, good asset value.” We bought some of that paper as it went down. It’s rallied to 98 today.
Now we’re in that seller of that name into some of the strength because as much as I like that company and its franchise, it’s going to be a year, two and three years from now, it’s going to have some substantial obviously impact in the short term and I think a little bit, you know, more in the intermediate term in terms of just how travel demand is.
So should it be marginally lower than where it was at the start of this, it just feels to me that that’s too much technical buying back up. And so you’re supposed to sell into that. And we’ve done that with some names within the gaming and lodging and leisure space where we’ve just felt that the technicals have overwhelmed the fundamental. That worked on the way down and it’s worked on this initial way back on some names.
So I think you have to shift through that. So I do think active management through this process in general is going to hopefully prove its mettle and that we’ll see that. And I think we’re going to seep out the volatility where you’re going to continue to take advantage of the technicals. You know, we were running elevated cash positions going into this just because we could see a lot of value in the marketplace so we are in a typical institutional account closer to - between 5% and 70% cash which is pretty high for an institutional account in front of max cash we spend into that. We got down to probably 2% cash in most accounts. We’re trying to get to about 5%, thinking that we’ll see a little bit more volatility.
And one of the things that’s happening in this market as things dissipate, it’s very challenging that you buy and sell this trade. You have to kind of do things in advance and do one side of trade first and then the other side because bid offers have widened out.
So, you know, we want to raise some cash. And as volatility picks up, we’ll be able to kind of pick up opportunities that we think are keeping up for technical reasons versus fundamental reasons.
Josh Chisari: So of course keeping up implies a wider spread, spread is supposed to protect you against the risk of default. Where do you see defaults headed? I guess is there two stages? Is there kind of a near-term default if some of these companies don’t have operating cash to continue but then at the depth of things how big do you think we see the defaults get?
Rob Cook: Yes. We’re already seeing a pickup in defaults here in April, there’s a number of names. Obviously the one sector we haven’t talked too much about that’s just - you made the joke that, you know, they were giving away oil yesterday in terms of that is - the energy space is under a tremendous amount of fundamental pressure and we don’t see that abating any time soon. And so that’s going to create a level of defaults.
You know, $20 don’t work. Certainly negative oil prices don’t work. But in all reality even if you luck out the curve it’s a very challenging underlying environment for the energy space. And so defaults are going to rise throughout the course of the year in that space.
And then I think if you think about it, the companies that are going to default are really the companies that were very fully levered and have somewhat cyclical or impacted by what’s happening as sectors.
And so we’re going to see a general rise in defaults. I think they’re going to get - you know, obviously it’s path dependent. So we don’t know, you know, the length of the stay-at-home orders. We don’t know how quick they’ll rebound. So I think it’s - I’d like to give you a (band). I think it’s going to be a 7% to 10% (band) to cycle being that the low end that would be, you know, we’d get a little bit more confidence, we’re able to get back to work sooner. There’s a quicker rebound in economic activity.
The higher end will probably be one where, you know, maybe we’re slower. There’s just more lasting economic impact. People have been out of work, wealth spend, you know, impacted and, you know, the general population depleted savings through this and that dock-on effect hurts more companies as we go forward.
So it’s somewhere in that range, which is, you know, what you typically would see in the cycle giving up to about 10%.
Now previous I would have told you I felt very strongly that the marketplace was going to have a lower default rate than historically. And the reason I said that is the quality of the high yield issuer today is substantially better than any time in history. If you look at the size of the company, the average rating, about 70% of our public companies right now.
So there’s been a real upgrading of the quality of company. The offset has been how swift and severe this turndown has been and that the energy component the real depression that’s occurring in the energy space right now.
Josh Chisari: Oh that’s where it gets interesting. I mean, because you’re theoretically going to have a huge values remain come in to your index as BBB which it swelled in the investment grade market are downgraded.
So are you finding opportunities in fallen angels? Are you being able to take risk in a lower (unintelligible) higher yield?
Rob Cook: Yes. Well, there’s a couple of questions there. You know, yes I think there’s two reasons why something comes down, right? You know, one is, are they good businesses? Put on some leverage and then they have some sort of cyclical impacts to them. And you can take advantage of that.
Then there’s the secular pressure of the businesses think like maybe a Macy’s, you know, okay? So Macy’s just got downgraded. And Macy’s I would argue is in a secular decline. It’s got a real challenge to it. It might be some value at some point the securities of Macy’s but, you know, you have to weigh not just the short-term impacts but longer-term dynamics with this company.
So I think there’s always the opportunity. One of the things I will tell you is very interesting people really worrying about the downgrades into high yield and how that would impact the marketplace. So we saw about 140 billion already downgraded and most of those names all have negative price performance occurred in investment grade marketplace.
So if you look at Occi and Ford Motor Credit and Kraft Heinz, many of these names that have just recently come down all the value destruction occurred while they were investment grade and most are up substantially since they’ve actually entered the mix which is interesting.
It’s also somewhat coincided with a better environment over the last month. So we see opportunities. We see opportunities in some of these stressed exemplary grade names in the marketplace, as an example Hyatt Hotels. Isn’t that a great name? They’re issuing bonds in the marketplace today in the 5% to 6% range. That’s about a 500 spread. It’s not an investment grade typical credit risk in terms of that spread. You know, the investment grade market is trading at about 200 spread today.
So those are situations that, you know, in the high yield marketplace we’re maybe more comfortable coming in, participating with the Marriott view. I mentioned the muni market investment grade.
So I think there’s going to be select opportunities all around that low BBB to high BB and there’s going to be some good assets collection of businesses that you’re going to want to lend to and then there’s going to be some that we would say - that I’ll say energy related that are really likely to do further pressured over the course of the next 6 to 12 to 18 months. It might find themselves, you know, in the B category 12 months from now from just investment grade not too long ago.
Josh Chisari: All right. Well with that then we hope today’s call is helpful as you think through what you’re doing in your portfolios.
Thanks to the audience. Thanks to you, Rob. And a special thank you to (Jeff), (Rosie) and (Kelly) for making (unintelligible) behind the scenes.
Everybody stay safe. We’ll talk again soon.
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