The Coming High Yield Downturn will be Big, Long and Ugly, by Jonathan Rochford

Financial crises kill high yield debt. From Jonathan Rochford at narrowroadcapital.com:

The US high yield market has grown larger and riskier since the financial crisis. Issuers of debt have the whip hand as buyers compete to gain an allocation in the face of surging demand from CLOs and retail funds. Companies are emboldened to seek ever weaker covenants and are taking advantage of the current conditions to borrow more at lower margins. It’s as if the financial crisis never happened and the lessons from it are ancient history.

Whilst the timing of a downturn in high yield debt isn’t predictable, the outcomes when it does happen are. More debt, of lower quality, with weaker covenants means the coming downturn will be bigger, longer and uglier. A quick review of some key data makes this clear.

Firstly, the size of the US high yield bond market and leveraged loan market are both close to double what they were in 2007.

Chart of loan market catching up to bonds

Not only is the debt outstanding larger, but the credit ratings have shifted downwards on leveraged loans. Lower credit ratings mean a higher percentage of the outstanding debt will default when liquidity dries up.

Chart of growth in leveraged load debt outstanding by rating

The other key indicator to watch is the share of the loan market that has weak covenants. In 2007, 17% of outstanding loans were covenant-lite. Today it’s over 75% with over 80% of new issuance lacking decent covenant protections. Weak covenants delay the occurrence of an event of default, which allows zombie companies to continue operating until they either exhaust their cash reserves or cannot refinance maturing debt.

Chart of corporate bond investors

High yield bulls are likely to cite the substantial equity contributions from sponsors and healthy interest coverage ratios as reasons not to be overly concerned. These are definitely much better than 2007, but these indicators do have some inbuilt weaknesses. Equity contributions are only as good as the market valuations they are based on. As US equities are arguably overpriced, sponsors are having to pay more than they historically would have to purchase a company. If price/earnings ratios revert to lower levels, company valuations will fall wiping out some of the equity cushion and making the debt a higher proportion of the enterprise value.

To continue reading: The Coming High Yield Downturn will be Big, Long and Ugly,

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