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High-Yield Bonds Attractive Today

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

High-yield debt has gotten crushed recently. I am here with Rick Tauber, he is a senior credit analyst, to take a look at why high yield is selling off so much and what the opportunities are for investors.

Rick, thanks for joining me.

Rick Tauber: You bet.

Glaser: So, let's take a look at the market. Why has high yield been killed so much recently?

Tauber: Well, high yield is a risky asset class. In fact, it's kind of like a quasi-equity asset class, and in fact, the closest correlation to high-yield performance is small-cap equities. So, if you look at everything that's also been impacting equities negatively--European debt issues and contagion potential as well as potential recession in the U.S.--these are the same things that are causing stress amongst high-yield investors as well. And high yield has actually performed relatively as it should, I think, relative to where equities have performed in the recent downturn.

Glaser: So, if we look at this in a broader historical context, where is high yield trading today versus where it was maybe at the height of 2008 crisis or during other times?

Tauber: Right now, the high-yield market--we use the Merrill Lynch High Yield II as our benchmark--it's trading at about a yield of 9.75%. For reference, it was about 6.75% back in May. So we've backed up quite a bit since then, but also at the bottom of the market in December of '08, yields were up around 22%.

So, long-term average has actually been closer to the 9% to 10% area. So you are sort of in line with the long-term yield averages, although spreads are quite a bit wider now given where Treasuries are.

Glaser: So what does that mean for what's going to happen next? What's your predictions for the high-yield market?

Tauber: Well, it's hard to say. We think high yield is attractive here for a number of reasons. I think the market is pricing in pretty severe [scenarios], either a good chance out of a recession in the U.S. and probably mid- to high-single-digit default rates for high yield, versus trailing rates of about 2% or so for defaults. Defaults peaked in '09, for reference, at about 12% or 13%.

So, clearly, things can get worse, obviously, if we go into a recession and, obviously, if there are additional problems out of Europe that spread, then certainly high yield can go wider. But we think our longer-term economic view is for slow, kind of bumpy growth in the U.S., which is actually good for the high-yield market. In addition, a lot of the companies in the high-yield market have built up their balance sheets, extended debt maturities, and so there are not as many short-term risks in terms of refinancing.

Glaser: So if investors who maybe are looking at individual bonds, what are some high-yield issuers that you think look attractive today?

Tauber: We would have a bias towards higher-quality names. In our [institutional] High Yield Monthly, we try to identify themes in the marketplace and places to invest. In the September monthly, we took a look at the BB versus BBB spread gap, and as the spreads widened out, that gap widened as well. So we think BBs look attractive here, but also layering on our view of credits, we have a number of names that we rate investment grade that trade typically in the 400- to 500-basis-point spread area, names such as Ford, Bombardier, TRW--these are names that we think are investment-grade risk, but you are getting paid BB type levels for them. So those are some of the higher-quality names that we might advise people to get into.

Glaser: What about M&A? There has been a lot of talk about an uptake in merger and acquisition activity with companies sitting on so much cash on their balance sheets. Do you think that's going to have an impact on the high-yield market?

Tauber: It's definitely a good point. We've seen certainly in the bigger, higher-quality, high-grade names, a lot of cash built up and a lot of potential deployment. That's usually good news for high-yield credits that are positioned well because they'll become investment-grade credits or simply get their bonds tendered for and taken out, which provides good upside.

So, in our last monthly, we actually identified some of the names that are potential takeout candidates, and so we looked and picked out some names that we thought are trading somewhere around fair value or maybe slightly cheap, but also give you quite a bit of upside on a takeout. So, a few of those names, one would be Cloud Peak Energy rated BB+. Their 2019 bonds are yielding about 8.25%, which we actually think is cheap here. But on a takeout, they have a nice asset in the Powder River Basin, which we think would be attractive for a buyer. Those bonds could move up 20%.

Another name, ATK, BB+ rated, a solid core holding yielding about 7%. They are a smallish defense contractor; we see them as a possible takeout, again, with possible 20% upside if an investment-grade defense company buys them.

Range Resources is another name, similarly. They've got a strong asset position in the Marcellus Shale. We've got a BBB- rating on them, and again their 2021 bonds we think give about potentially a 20% upside as well on a takeout.

Then, finally, in the more speculative area, Leap Wireless, which we have a B- rating on, and those bonds yield about 10%, which we think is right around fair value here. But their longer-dated bonds also give you the possible of 40%-plus type of upside on a takeout. They have very good assets that might be attractive to a big investment-grade telecom company.

Glaser: All right, Rick. Thanks so much for your thoughts today.

Tauber: You bet.

Glaser: For Morningstar, I'm Jeremy Glaser.