Slim Premiums a Signal for Caution in High Yield

Over the past few weeks there has been a noticeable increase in high yield new issuance, bringing a welcome flurry of activity to what has so far been a relatively benign year.

This pick-up is not overly surprising given current spreads, which are enticing issuers to take advantage of attractive borrowing levels and an investor base with excess cash to put to work ahead of the traditional slowdown over the summer holiday season. The supportive technical environment that arrives in periods where yield is a scarce commodity allows opportunistic issuers to tap the market when they may otherwise have struggled, hence the importance of remaining disciplined with an adherence to thorough due diligence. This is a topic we have blogged about in the past and one we are perennially mindful of, having seen it in previous cycles; the skeletons of tomorrow are being issued today and prudent credit analysis is ever more critical as the cycle matures.

This doesn’t just mean avoiding the skeletons, though. When valuations are tight the premiums investors seek for various credit risks narrow. This is fine while the market is performing, but when the market turns, as it eventually will, the premiums being demanded for factors such as illiquidity, poor covenants and subordination will rapidly come into focus.

The spread differential between the senior secured bonds and senior unsecured bonds of high yield borrowers, for example, has tightened considerably as investors stretch down the capital structure in the hunt for yield, often giving up two to three notches in rating for a minimal amount of extra spread. The lack of security at unsecured level, coupled with the fact these deals are usually smaller and more illiquid, means the moment the market turns and investors start to more rationally price subordination risk, there is a real risk of investors being stuck holding bonds with limited exit options. The liquidity the market is currently offering is not reflective of the liquidity one can expect in a more cautious or stressed environment.

We do see the current benign environment and relatively supportive central bank backdrop as allowing credit to continue to perform in the coming months. However, we also believe adopting a conservative approach in today’s market is prudent, and will not hurt returns as much as investors may think, given the lower risk premiums on offer.