Default Risks for Most High-Yield Issuers Low

Miriam Sjoblom: Hi, I'm Miriam Sjoblom, associate director of fund analysis at Morningstar. I am here today with Jamie Farnham, who is director of credit research at TCW, and also a portfolio manager on MetWest High Yield Bond.

Thanks for joining us today, Jamie.

Jamie Farnham: Thanks, Miriam. Happy to be here.

Sjoblom: One question that's been coming up more and more in the market this year, is whether risk is building in high yield. We're kind of at a point where people should consider reducing their allocation to high yield, and one aspect of your approach that's somewhat unique is you try to locate where we are in the credit cycle. So maybe you could talk a bit about your view on the topic?

Farnham: Yeah, we generally segment the credit cycle into three phases. Phase 1 being when spreads are widening, phase 2 being the retracement of much of that, and phase 3 being a rather prolonged period of gradual tightening-spread environments. The pendulum swings in phase 3 such that it begins with deleveraging, and then it begins to percolate up with increasing shareholder focus and increasing leverage.

To us--in looking at the degree of refinancing in the market, primary issuance, focus on the shareholder, use of proceeds and structures--we're still very comfortable that while the characteristics of the market are not say like those in 2009, which were very creditor friendly, we still think we're in the early to mid-stage of phase 3, such that we would not characterize the risks as being comparable to 2006 and 2007, which were very credit unfriendly.

And so we're still viewing high yield exposures from a long-term standpoint and valuations as being attractive. The median spread is about 75 basis points wide of the historic median. And it appeals to us from a long-term mean-reverting standpoint that high-yield still has value.

Sjoblom: What about some of the arguments against high-yield: "Spreads might be attractive, but absolute yields look low," "The index is priced at a premium," and "Maybe there is more interest-rate sensitivity creeping into the high-yield market"?

Farnham: The interest-rate sensitivity is an absolute important factor to build in when you compare this cycle with previous cycles. The average dollar price of a high-yield bond right now as we sit here today is about a 2% premium to par value. It brings in the risk of negative convexity within high-yield bond structures, which tend to be callable either in 10 noncall 5 or 8 noncall 4, such that as the price of a bond increases, you won't achieve as much of a principal appreciation because of that negative convexity. So the potential for principal appreciation is lower now than say if the bond were at a significant discount to par. To us, from a manager perspective, it augurs for trying to find idiosyncratic or credit selection of lower-dollar-price bonds that don't have as much or any negative-convexity risk.

Sjoblom: Earlier in the year you were hearing concerns about the types of securities that were being issued in that you're seeing fewer bondholder-friendly terms and a rush of new issuance coming out. Are issuance trends something to be concerned about?

Farnham: Issuance trends are one of the factors that we look at; it's important to distinguish between aggregate new issuance and net new issuance. In year to date 2011 about two thirds of all proceeds have been refinancing-related, and so what that means is that there's not net new issuance coming into the leveraged finance markets. I think that's a very important fact to point out. If you compare that figure to 2006-07, the refinancing was give or take about 30% of the market, and so in those periods there was net new issuance, a lot of new leveraged buyouts, primary issuance.

As we sit here today, the new-issuance market is robust and has set records in 2009 and 2010, and potentially will again in 2011, but to us what they are doing is taking advantage of the low interest rates to extend maturities and kick the can down the proverbial road. What it does is even in the prospect of a meager economic recovery, it allows management teams of high yield to weather the storm very well, and it augurs for a low probability of default for most high-yield companies.

Sjoblom: So, as we advance through this phase 3, you're going to want to know when we're getting near the end? What would be some signs that would be red flags?

Farnham: Well, I think, there is no holy grail of looking at things. But certainly we look at the size of the new-issuance market and most importantly the degree of what proceeds are used for, the degree of refinancing acquisition, such as with mergers and acquisitions and LBOs, and also novel structures such as paid in-kind notes, PIK toggles, covenant light transactions in the leverage loan or the senior parts of the capital structure. All-in-all, it's more of a focus on the shareholder versus deleveraging.

There is no panacea of any one being more predictive than the other. Ultimately it's characterizing the market in general and assessing to what degree of risks are inherent in the market on the primary side. And then look at the idiosyncratic risk on a balance sheet, focusing on how much leverage is there and how volatile the business is. We're also stressing different scenarios, such as if the business were to encounter a recessionary environment, to what degree would operating leverage curtail cash flows and stretch liquidity? And so its both market-based in general, and then we're tailing that down and focusing on the individual credits within the market and trying to ascertain which are at risk of higher potential to default.