Tue, 27 Sep 2011
The dichotomy between corporate risk and sovereign risk is striking in terms of what debt investors are getting paid, says BlackRock's Leland Hart.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.
Investors are desperately searching for yields in this incredibly low-yield world.
I'm here today with Leland Hart. He is the managing director and head of loan group at BlackRock, to see where investors should be looking today.
Leland, thanks for joining me today.
Leland Hart: Thank you for having me.
Glaser: I guess my first question really has to do with where you can find yield today. You're getting basically 0% in money market, even Treasuries are yielding almost nothing. If you're looking for lot of more yield, what are some of the areas in the fixed-income space that investors should have their eye on?
Hart: Sure. That's a great question, obviously. Historically, if you looked at fixed income, you would access higher yields one of two ways. You would either go out the yield curve and use duration to provide an increased return, or you would add credit exposure or credit risk, and therefore get it through credit spreads. So these days, given that for the last year or two, the government has done a pretty good job keeping the front end of that curve plus or minus to zero, and then recently with Twist in effect, were pushing down in the middle or long end the curve. So, durations are a harder way to get additional yield. That being said, the government has made it very clear that rates are going to be low for a while. So, duration shouldn't be working against you, but nonetheless duration is a tough way to get paid more.
So, what we are seeing obviously more and more is people using credit spreads to access risk, and therefore the high-yield market or the leveraged loan market are attracting a lot of attention because as we go through this period of people re-racking their economic expectations both here and abroad, the fundamentals of lending whether it's in loans or bonds are actually pretty decent, and the spreads you're getting paid remain at historic highs and more than compensate you for that risk.
So, the dichotomy between corporate risk and sovereign risk, which I'm sure we'll talk about more, is rather striking in what you're getting paid; it's not just relatively higher than everything else; on an absolute level, it's quite a bit. The average loan today pays in the 7s and the average high-yield bond is in the high 8s, and nothing as you know in the fixed-income universe is close to that these days, simply because the yield curve has been pushed so low.
Glaser: Now, you mentioned operation Twist and trying to lower that middle and long run of the yield curve--do you think that this is going to be successful? Do you think the fed's actions are going to be able to bring those yields down even more? What's your outlook on rates over the next, say, five years?
Hart: Well, the government has made it relatively clear that at least until 2013, we're going to keep rates low. So, it's not even really an opinion. It's a stated fact.
I guess what I would tell you is that until U.S. GDP really picks up, until the economy starts ripping, and, as importantly, unemployment falls, we're going to remain in the low interest rate environment. And I guess the third thing you need to think about is housing prices; rising rates will make obviously mortgages even harder, so with a tenuous spot we're in with real estate, I don't foresee rates going up anytime soon because the government has made that clear.
I don't see them going much lower, though, either. This is a low for a lot of us these days and still trying to get used to rates this low, but the near term and medium term outlook certainly is for rates to stay where they are.
Glaser: Now, you mentioned that you're seeing better yields on the loan front when you go out into corporate and into high yield and go into other risks. How are those loans in terms of a risk/reward trade-off, though? Are those really riskier assets? Do you think there could be lots of corporate defaults if we go into another economic slowdown or that there could be some hidden risks there for that extra yield?
Hart: So, your question is pretty timely, because the average investor is saying, "Why am I getting paid so much? What am I missing?" Generally speaking, people are in fixed income due to the certainty of income. I have the following interest payments and principal due to me, and regardless of where equities go, I'm going to get paid that.
The risks you're talking about are, "What could impact my ability to get paid back?" And that's in fact a higher default rate. What I'd say is, when you look at the implied default rates based on the rates today, they are sky-high. But in fact the default rate today is running about or little below 1% for both loans and bonds, when the historic average is 4%, and its projected to remain between 1% and 3% for the next couple of years for the following reasons:
First, interest rates are low. With low interest rates it means companies have naturally more free cash flow. In addition, as you know, earnings have been fantastic. We're about to go through yet another earnings season, and companies are indeed making more money today than they ever have before. Why is that? Because in 2007, '08, '09, they tightened their belts--hence there is a reason unemployment is high--and companies are making more money doing less, and in fact can survive in a sideways economy.
And when you also look at cash on hand and actual leverage of companies today, it's materially different, especially in the high-yield and loan universe versus 2007. So to say it differently, companies are in better fiscal shape than they've been in years. There are no near-term maturities because everyone's refinanced their debt, and interest rates remain low. The combination of those things not just implies, but means it's very hard to default.
So, default rates are actually projected to be low for the next couple of years. Certainly, as you get into 2014 and 2015, there are some of those larger LBOs which may have problems accessing the market just due to size alone, and you could see default pick up then. But we're going to go through a period here for a couple of years where the actual default rate is going to be a fraction of what the average is.
Glaser: So given that defaults look like they are going to be low, then why are those yields so high? Why is the market rewarding you so much for holding this debt right now?
Hart: Globally, there is a lot of risk. There are couple of reasons. First, people feel tangible risk. The economy is slowing not just in the U.S. but globally, and when that happens, things tend to sell. But you do have some other issues this period that are very different than '07. In '07, it was everyone had leverage, and therefore there were margin calls and funds were liquidated and that pressed security prices down.
Today, the issues that we faced in the loan markets that have pushed prices down are two-fold. First, dealers don't have access to the capital they once had, so their ability to put money to work is less, so there's less liquidity in the system.
Then, as you know, outflows in retail funds in the last, call it, six weeks have been relatively strong simply because a lot of hot money went in there to hide from interest rates and when the government made it clear rates weren't going to rise, some of it went out.
So the combination of retail outflows with very low liquidity in the market has added a bit of volatility, but no one has changed their default rate in the last six weeks either, so it's one of those technicals versus fundamentals, and unfortunately some of us can see sometimes, technicals can win for a while.
But nonetheless ... the other reason is that the yield curve is low, and oftentimes when you think about leverage loans or high yields, it's an absolute yield investor, it's not a spread investor. So, when you look at yields today, they're very decent and they are where they have been relatively historically even though it's a massive spread pickup.
Glaser: You did mention that there is lot of fear globally and one of the big drivers has been sovereign debt and credit risk on the government side. You were sanguine on the sovereign debt, some of the higher-yield sovereign debt loans? Or do you think those have more risks?
Hart: I'll let the market speak for itself. It's been quite volatile. As an investor I can say this, I get a lot more certainty looking at companies we cover on a bottom-up basis and their ability to pay me back than I do what's going to happen between countries and rules of law, and how things change quickly. I'm able to look at these companies specifically and get that certainty of the income I'm supposed to receive a lot more than "will Greece default and what will the haircut be?" That's a page in a playbook that very few people have, and a lot of this stuff will be new, in fact it hasn't happened. So, I'm going to stick to my corporate credit roles for now and hope our friends in Europe can really get their act together in the near term.
Glaser: Do you see any direct impact from the sovereign debt crisis in Europe impacting the corporate credit market?
Hart: Yes. To be really simple about it, to the extent Europe slows down, that will probably or definitely have a negative impact on its currency and have a negative impact on its ability to buy goods produced here in the U.S. So, if the euro gets weaker, that makes it harder for us to export and if, in fact, the people to whom we sell have less money, they will buy less as well. So, it's a global economy and it always speeds through.
Glaser: So, it certainly sounds like for investors looking for yield today, you're going to have to take some credit risks versus taking that duration risk but that corporate seem like a safer bet?
Hart: You're getting paid for the risk and on a day-to-day basis given some of these 1%, 2%, 3%, 4%, 5% daily swings in equities, that will filter through. You do have a very high correlation between asset classes in times of dislocation, but as an investor, someone who holds an asset, I feel really good about what we're getting paid today to own this risk.
Glaser: Well, Leland, thank you so much for sharing your thoughts today.
Hart: No problem.
Glaser: For Morningstar, I am Jeremy Glaser.