How Healthy Is High Yield?

Eric Jacobson: Hi. I'm Eric Jacobson with Morningstar. We're here today at the Morningstar conference with Jim Keenan of BlackRock. Jim manages BlackRock's high-yield and leveraged loan business, and I just want to say thanks a lot, Jim, for joining us. Appreciate it.

James Keenan: Thanks. Good to see you.

Jacobson: So, with things that have been going on in the bond market, one of the big questions right now is valuation in high yield. Can you talk a little bit about where you think things stand and what the risks are and aren't as far as what people are worried about?

Keenan: Obviously, there has been a lot of volatility in the overall bond markets, and I think the cause of that volatility is different than what we were fearful of in 2010 and 2011. The reality is that the Fed is talking about reducing its asset-purchase program, or the tapering language that everyone is talking about. But the reasons for that is because the economy is actually doing better. When you think about high-yield bonds, it’s about lending to companies. So the risk to a high-yield bond, that spread that you charge above a five-year U.S. Treasury to lend to that company, really is the probability of default of that company and what your potential recovery might be.

So, those spreads are still wide right now. In an improving environment, the companies are doing better. So, the volatility and sell-off of the markets have been because the curve is steepening because the markets are doing better. The velocity of the move, I think, is starting to unnerve some of the markets. But with regard to it as it stabilizes where the health of the high-yield market is, it’s still good, and you look at valuations--and sometimes people look at the overall yield--but you have look at necessarily the spread risk to it because that spread is the premium you're getting from going to Treasuries into high yield. It’s still got a duration [a measure of interest-rate sensitivity] component to it, and that’s the risk. But high yield is still trading at 5.5% over Treasuries. You have a high-yield bond at 6.5% where the market trades, and relative to a five-year Treasury that's up 1%. I mean, the high-yield market doesn't set Treasury rates. Treasury rates are set by growth expectations and inflation expectations, and they are very low right now, because we're still growing through a deleveraging.

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Jacobson: So the scenario that you're kind of talking about is a little bit like what we went through back in 1994 in terms of rising rates but relative health in the high-yield market. We've heard a couple of managers make comparisons to that and talk about whether or not they think we're at greater or worse risk. Obviously, you've kind of stated your case in terms of it sounds like that you're not as worried about it. But how do you respond to those sorts of concerns that perhaps we’re in a worse situation than we were in 1994?

Keenan: I think we’re in a different situation. I mean, we are in a situation where rates are going to increase. We've been talking about at BlackRock of trying to understand in your fixed-income portfolios duration is a risk. We've been in the 30-year bull market in bonds, and now we’re in an environment where, with central-bank policy and an improving market, you are going to see rates increase. We’ve thought the curve is going to steepen first, and we're probably several years away before the federal-funds rate moves because that's still tied toward inflation and unemployment, where there is a still big gap in there at this point.

So, we think the curve is going to steepen because the economy is improving. We don't think that rates are going to really jump up here. The velocity of the move has been fast, but you saw the same move kind of in January. And then you had a little bit of a growth scare, and now it's moved again. That being said, it's starts to stabilize here because growth is still modest because we are still dealing with fiscal drags, we're still dealing with a slowdown in emerging markets, and we're dealing with the European situation. It’s just not as fearful as the liquidity shocks that we were worried about in 2010-2011 because of what the central banks have done.

So, with high-yield, a three-year duration still has a duration to it; it's still is impacted by the fact of the backing up of rates. But it is in a much better situation than many other fixed-income products. And if that rate backup is due to an improving economy, then those spreads should come in because those companies are healthier.

Here's just one quick comparison. If you looked at the market at 6.5% today relative to a 1% Treasury, that additional 550 basis points--compare that versus 2007, when 7.5% high-yield bonds, but the five-year Treasury was at around 5%, or LIBOR was at 5.5%. So, for a very marginal increase, 0.5 times the yield of the Treasury market, you were taking on that risk of the high yield. Now, you’re still in an accommodative stance with regard to central banks, but the household sector, the private sector, and corporate sectors all have been improved over the last several years. So, the corporate risk is not that high anymore. So, typically you want to really sell high-yield bonds at the same time you want to sell equities, if you are going into recession, because that's when default risk will pick up because the company profits will start to decline rapidly.

Jacobson: So, you've given a little sense of the answer to the question I’m about to ask. But as you know, a lot of the discussion that we've had in past years about the credit cycle has revolved around issuance, and not only issuance, but the types of issuance and what bond structures look like. Can you talk about where you think we are in that cycle and whether or not it's as important as it used to be? Conventional wisdom being that you always had to watch like three years out from a big issuance gap and so forth, so what would you have to say about that?

Keenan: Several years ago we talked about the wall of maturities. I think that got a lot of fanfare, and that was because you had a substantial amount of high-yield debt maturing in 2013 and 2014. The capital markets, CFOs and CEOs of companies are very active in the high-yield market to try to extend that out and not have a near-term maturity because they know they are a larger credit risk than say an investment-grade corporate bond. So, they’re very, very active about pushing out maturities before they get inside of a year.

So there are not a lot of maturities over the next several years. There’s been a lot of new issuance, and a lot of that has been refinancing. And certainly refinancing what was historically done by the banks and now is coming to the private markets to get financed. But there are not a lot of near-term maturities, and so it's hard to see a company [default] unless you had a real decline in earnings or a recession where many of these companies are actually going to have a default issue.

We look at a lot of the high-yield companies; lending in general is cyclical. If you lend in an environment like 2008, the lender group charges more restrictive terms. They charge a higher rate of interest associated to that because the companies are scared. Simplistically, if you tried to get a mortgage as a household in 2009 right after the Lehman Brothers collapse, it was more expensive. It was harder to get. The same way is, if you try to get a mortgage today, your mortgage rate is going to be lower and it's going to be easier to get because you as a consumer are less risky based on a more stable economic profile, and that what’s going on in the high-yield market.

So, you're seeing some things getting done that are in better terms and more favorable towards the corporate as opposed to the investor. But in general, it's not in excess. It's very different than '06 and 2007, and companies are starting to look at what's the optimal capital structure they should have based on a low-growth profile.

Jacobson: Let me switch gears on you a little bit and ask about a topic that we've talked about before, which is liquidity. We've had conversations about the size of balance sheets at the Wall Street dealers and how that affects things. I'm wondering how you feel about the size of assets under management at some of the bigger firms. You yourself have a very large book of high-yield business. There are others in the industry that have gotten a lot larger than they used to be. I'm wondering, does that give you pause? Do you worry about that? Should investors worry about their own managers getting too big at some point?

Keenan: Yeah, I think you have to put it in terms. One, if you went back to the ‘90s and the high-yield market, the high-yield market was probably $600 billion. It’s about $1.6 trillion today, so the size of the market has gotten bigger, looking at your percentage relative to those terms. I think a lot of the high-yield managers have grown with the growth of that market, and I think that will continue to grow because the private sector is more important to finance these companies as opposed to the banks now. So, that’s one thing, and it’s still a fraction of the percentage of the overall market. And investors like us, I mean, you have to include other things that we do in bank loans and derivatives and the global aspect in what’s over a $3 trillion market. So, as we grow, we look for opportunities in order to invest.

I think there are lot of positives to this. I think about BlackRock and the leveraged finance and the credit business that we have at BlackRock, because of our scale, the amount of resources that we have in order to really understand credit, the due diligence that we’ll do on companies, sending my team out to go visit these management teams and see their operations. We have legal analysts that are spending time looking at the documents and understanding them. We have traders across the globe. So with the breadth, I view the longer term with how we invest--as opposed to trying to necessarily be tactical within an hour--how we invest, we continue to prove that we have good returns. And if you look at the BlackRock High-Yield Bond fund, it continues to improve with regard to its performance but on a risk-adjusted basis of that performance. So, our three-, five-, seven-, 10-year numbers are still on the top decile.

Jacobson: Just drilling down for a second from the bigger liquidity question down to portfolio-level, bond-level questions, do you have a methodology in place for managing liquidity at the bond and issuer level. And what does that look like?

Keenan: Yeah, we do every time. I would say we try to develop an investment thesis around our portfolio, and then we try to develop an investment thesis around what we’re doing different sectors and down to the security level. And we constantly challenge that. Liquidity is a factor in that. What is the expense?  Because you have to understand, if you’re investing in a specific company and something changed, the company lost a contract, or one of its competitors cut pricing by 50%, it may change your investment thesis. So you have to understand what’s your ability to exit that, and this is why you think about private equity versus public equity.

So, liquidity is a factor and you have to price that on your input as you're going into risk. So, we’ll look at all those factors and try to understand on a security level what happens if we want to change. So, we monitor what our weightings are on a specific issue, within actual issue at the whole company level, and also understand what our investment thesis is. Then we also try to really understand the legal language of the documents. If we have a company that has very restrictive covenants, maybe if they lose that contract, we may be able to renegotiate the terms with that company. So, we have a downside protection associated to that. So, you have to look at each individual one, but we monitor it from a portfolio level as well as a single-name selection.

Jacobson: Well, great. Thank you so much for spending the time with us today. We appreciate it.

Keenan: Thanks, Eric. Good seeing you.