Marty Whitman, with his age of 85 and 60 years of experience, said he's never even seen it in his lifetime. Therefore, you've got today compared to March 9 where the prices are a lot higher, spreads are a lot tighter.
However, there are reasons to be both negative and cautious, which are macro-oriented and the same things that people investing in the equity markets worry about. But at the same time, there are a number of reasons to be positive and constructive on high yield.
Default rates matter the most for high yield. We're investing in riskier companies. We're getting a premium, a higher spread than investment-grade companies to compensate us for that default risk.
With spreads at 750 basis points, meaning a 10% yield to maturity, it's implying an 8% to 10% default rate. People are saying that it's going to be 4% to 5%. The reason why, if you do the simple math, 10% default rate and if I lose 75 cents on the dollar for every default, that's 750 basis points. So with default rates being mid-single digits, it can be pretty attractive.
The other point is we've had two other peaks in defaults, in 1991, 2002. The first year, the best time to invest in high yield, is right before default rates peak, and investing all the way until they start to tick back up.
If you look at those time periods, there were several years after each of the peaks in default. The first year was tremendous returns, just like we're enjoying now, but then you had several years of positive returns in the high-yield market. So we think that that's attractive.
The other piece, remember, is bank loans. Bank loans are senior secured, rank ahead of the unsecured high-yield bonds. Bank loans have had the same return year-to-date versus high yield and are at a wider-than-normal spread.
We see very attractive opportunities in first-lien, senior-secured bank debt with minimal risk of permanent impairment of capital if the economy does not do as well as thought, but also provides some very attractive upside.
In addition, in the new issue market we're seeing first-lien, senior-secured bonds at 10% to 12% yields that we think are very, very attractive.
Stipp: You had mentioned earlier that the credit markets have come back some, but they haven't come back all the way. We have a lot of people out there saying that there is a new normal environment where lending is going to be tighter, covenants are going to be more conservative.
What is your take on new issuance in the high-yield space, especially for the companies that really need to refinance? Is it going to be a more sober high-yield market, and what are the implications of that?
Gary: Sure. One point you touch on: the tight lending standards. We think that that's going to continue for an extended period of time.
You have massive amounts of maturities. You have about $1.5 trillion of commercial real estate loans on bank balance sheets, plus the high-yield bonds and bank loans that mature over the next five years. $1.5 trillion matures.
So we think that while default rates are coming down to maybe mid-single digits, in essence, we've just extended the runway where we're going to have higher-than-normal default rates for a period of time.
The implications for that are great opportunity for distressed and capital infusion deals, great opportunity for credit-pickers like Third Avenue to be able to sift through the rubble, whether it's new issues or secondary, and find some real diamonds in the rough.
Related to the new issue market--it's been on fire recently. It's a combination of the biggest inflows ever in the high-yield market, the biggest new issuance year-to-date, and the credit markets are opening up.
But, as I mentioned earlier, we're seeing some very attractive opportunities [in] companies that have first-lien bank loan maturities coming up over the next couple years and are doing new high-yield first-lien, senior-secured bond deals with a couple years longer in maturity.
They're pushing out their maturity dates. In exchange, they're giving 10% to 12% rates at first-lien loan opportunities. With all the financial institutions pulling back and not lending as much, that's creating this opportunity where you can get high risk-adjusted returns.
The other piece is the covenants. You remember the term "covenant-lite" before. That is not happening anymore. In many cases, and part of the reason why we find capital infusion deals attractive, the exit financing for these companies and even in new issuance ... have good covenants.
In exit financing deals, actually, the covenants ratchet down, meaning they need to reduce their debt every year, which then provides a catalyst to drive value higher in our investment.
Stipp: Jeff Gary, some really interesting ideas and interesting strategies in your new fund. Thanks so much for joining me today.
Gary: Thank you, Jason. I appreciate it.
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