High-Yield Defaults Should Remain Very Low

Mike Taggart: Hi. I'm Mike Taggart, director of closed-end fund research with Morningstar. With me today is Russ Covode, portfolio manager of Neuberger Berman High Yield Strategies, which has a Morningstar Rating for Funds of 5 stars.

Russ, thanks for joining me.

Russ Covode: Thanks for having me, Mike. I appreciate it.

Taggart: Russ you've been looking at high-yield bonds for about 20 years. It seems like it's a very interesting time right now in the markets in general, especially with speculation of another round of quantitative easing. How would that affect the high-yield bond market?

Covode: Not much directly. We would think that the real impact of that would be to spur economic growth in the future, and that would certainly have an impact on our market. High-yield tends to be driven more by fundamental credit, and obviously, our market would do well with improving gross domestic product growth rates and improving fundamental credit.

Taggart: So, there is not much in the way of duration risk when it comes to the high-yield market, but there is a lot in the way of credit risk?

Covode: Absolutely. Our market really is driven by credit risk, fundamental credit conditions, and the follow-on impact on default rates. The duration of high-yield is actually quite short; it's about four years. But actually it's not interest-rate-sensitive much anyway because our correlation of Treasures is actually negative.

Taggart: So, let's talk a little bit then about fundamental credit risk and about default risk. I think in the big downturn in 2008, the default risk went out to about 10%, and then it's come significantly down. Do you see that going up at all?

Covode: No, we don't. The actual default rate now is running about 1%. We expect it to be in that range for the next couple of years for two real reasons. The first is; fundamental credit conditions are very good in our market. We're through the second-quarter earnings cycle right now. And from a fixed-income standpoint, from our perspective, earnings have been quite good, and expectations for the near-term are OK from a fixed income standpoint.

Taggart: Would that be the case, even if there were a very large slowdown in growth in the U.S.?

Covode: Obviously, much slower economic growth would have some impact on our market, but we think it would be muted to some extent because our companies don't need to grow into their capital structure for them to work. Leverage right now is quite reasonable, and liquidity is very good on our companies' balance sheets.

Taggart: Can you talk a little bit about the term structure in a lot of high-yield firms?

Covode: One of the reasons why we're constructive on the market is our expectation for default rates is quite benign for the next couple of years, and one of the key reasons for that is because most of our issuers have pushed off their maturities during the last couple of years. It's a very active new-issue market. Most of the activity has been refinancing, which has really extended out maturities from the 2012, 2013, and 2014 time frames and pushed them well into the future. So, that balance sheet flexibility we think is a big reason why default rates will remain low during the next couple of years.

Taggart: So coming out of the downturn in 2008, and 2009, these companies may have kept their leverage, but they cleaned up the capital structure in their maturity terms to be able to handle them better in the future?

Covode: Absolutely, and the maturity wall, so to speak, was much different; the one we are facing in December 2008 which was much different than the one we're facing now. You had many more significant near-term maturities over the next couple of years when our perspective was December 2008. Again, CFOs in our world have really spent the last two years pushing out those maturities and refinancing their bank facilities, which has loosened covenants and is also good from a default-rate standpoint. And liquidity is very good on their balance sheets, so we don't expect our issuers to have much problem meeting their cash coupons.

Taggart: So even if the growth rate in the U.S. does slow, you think that they'll still be able to generate the cash--they have the liquidity on their sheets right now--to meet their coupon payments which would be another reason the company might default?

Covode: Absolutely. So our expectations are for default rates to be in the low single-digit range for the next couple of years. Even if we moved into a period of economic slowdown, our expectations would be for default rates to be in the midsingle digits. We would not expect default rates to get to where they were in 2008 and 2009.

Taggart: So even with this benign environment where default rates are under control, you're still finding the market to be constructive and you're still finding good value out there?

Covode: Absolutely. We are constructive on the market. I would say two themes in our portfolio right now. The first would be overweight BB credits, and most of our weight there is in names we call rising stars, companies that we believe will return to investment grade. That will offer us a very nice risk-adjusted return because the credit risk is relatively low in these names, and it will offer very nice spread tightening as they return to investment-grade ratings.

The second theme on our portfolio would be market weight CCC risk right now. We are constructive on a number of CCC rated credits that we think will offer, again, very attractive risk-adjusted returns. These tend to be more defensive CCCs where end markets are more stable.

Taggart: Only somebody who's been looking at high-yield bonds for 20 years would be able to say more defensive CCCs. Yes, I think it speaks to your experience.

Covode: We have a very well-diversified portfolio of CCCs, and I'm very comfortable with the upside-downside relationships in those names.

Taggart: Well, Russ, thanks so much for coming over and joining us today and talking about the high-yield market.

Covode: Thanks, Mike. I appreciate your time.

Taggart: For Morningstar, I'm Mike Taggart. Thanks for watching.