Not Your Father’s High Yield Bond Market

In a zero-interest-rate world, high-yield bonds are one of the last refuges for investors looking to earn a decent return on their capital. Today, the average yield on the Barclays High Yield Bond Index is about 7.3%. This is about 6.3% (630 basis points) higher than 5-year Treasuries.

Within the high-yield universe there are several different ratings classes: BB, B, and CCC. For the most part, BB-rated bonds yield about 5.5% today (457 basis points over 5-year Treasuries), B-rated bonds yield 6-7% (613 basis points over 5-year Treasuries), and CCC+ rated bonds yield significantly higher, depending on the issuer (1100 basis points over 5-year Treasuries, or about 12%). While this is a helpful guide, it must be remembered that each bond must be analyzed individually from a credit perspective.

Current yields and spreads are discounting a 5% default rate, but the actual default rate in 2012 is unlikely to be that high. Most likely, no more than 3.5% of high-yield issuers will default. Therefore, investors are being overcompensated for the risks they are taking by investing in this asset class.

The most attractive opportunities are bonds that are trading at wider spreads than the average spread of their ratings category. Here are some examples of bonds purchased in the last month:

A quick word about the Harrah’s/Caesar’s Entertainment bonds. While they obviously have a very low rating, it should be noted that the company has repurchased $650 million of this $1 billion bond issue financed by the two private equity firms that own the company. Further, this is a short-maturity bond (3 years) and most of the company’s debt matures after these bonds. The combination of the private equity firms’ multibillion-dollar investment in the company and the short maturity of these bonds, coupled with a steadily improving gaming market, strongly suggest that these bonds will be paid off at maturity, providing a 16.64% total return. This bond is illustrative of a number of bonds that were issued by large LBOs that have low ratings, high yields, and a low likelihood of default.

The US economy remains sluggish and is likely to struggle in the months and years ahead, until wiser heads prevail in Washington DC and adopt pro-growth policies and bring some discipline to the federal budget. Such an environment will make credit analysis particularly important in the high-yield sector. But a combination of wide spreads, low defaults, and a significant number of bonds trading at wider spreads than their ratings category offer investors the opportunity to earn attractive risk-adjusted yields on their money in a zero-interest-rate world.

 Moody’s/ S&P  Dollar Price  Yield-to-Worst  CurrentYield Spread to Rating Median
NRG Energy, Inc.  8.25% due 9/1/20  B1/BB-  $96.75  8.80%  8.53%  +204
 Sprint Capital Corp.  6.9% due 5/1/19  B3/B+  $87.50  9.35%  7.89%  +259
Harrah’s Opco/Caesar’s Ent.  5.625% due 6/1/15 Caa3/CCC $74 16.64% 7.60% +651

A quick word about the Harrah’s/Caesar’s Entertainment bonds. While they obviously have a very low rating, it should be noted that the company has repurchased $650 million of this $1 billion bond issue financed by the two private equity firms that own the company. Further, this is a short-maturity bond (3 years) and most of the company’s debt matures after these bonds. The combination of the private equity firms’ multibillion-dollar investment in the company and the short maturity of these bonds, coupled with a steadily improving gaming market, strongly suggest that these bonds will be paid off at maturity, providing a 16.64% total return. This bond is illustrative of a number of bonds that were issued by large LBOs that have low ratings, high yields, and a low likelihood of default.

The US economy remains sluggish and is likely to struggle in the months and years ahead, until wiser heads prevail in Washington DC and adopt pro-growth policies and bring some discipline to the federal budget. Such an environment will make credit analysis particularly important in the high-yield sector. But a combination of wide spreads, low defaults, and a significant number of bonds trading at wider spreads than their ratings category offer investors the opportunity to earn attractive risk-adjusted yields on their money in a zero-interest-rate world.

About Michael Lewitt 2 Articles

Affiliation: Cumberland Advisors

Michael E. Lewitt joined Cumberland Advisors in January 2012 as a Vice President and the Portfolio Manager for the Opportunistic Debt Strategy. Mr. Lewitt has spent the last 25 years in the securities industry and the last 20 years in the investment business. Mr. Lewitt co-founded Harch Capital Management, LLC in 1991 where he was involved in the management of separate accounts, hedge funds, collateralized debt obligations and mutual funds focused on the less-than-investment grade debt markets for U.S. and non-U.S. clients that included LACERA (Los Angeles County Retirement Association), Texas Teachers Retirement System, Investec Bank (UK), Goldman Sachs Asset Management, JPMorgan Chase Asset Management, Highbridge Capital Management, Investcorp, Onex Corporation and Omega Advisers, Inc. Among the funds that Mr. Lewitt has managed was the HCM High Yield Opportunity Fund, L.P., which was among the highest ranked fixed income funds during the 1994-2000 period; HCM Hegemony Fund, a dedicated short-selling fixed income fund that significantly outperformed its benchmark during the 2004-07 period; and Harch CLO I Limited, which produced an annualized return of 15.46% from March 2000-March 2005. Since 2001, Mr. Lewitt has edited and authored The Credit Strategist (formerly known as The HCM Market Letter), a newsletter that covers economics, politics and the financial markets and that is widely read around the world. Mr. Lewitt is recognized as having been one of the few investors and strategists to forecast the financial crisis of 2008 as well as the credit crisis of 2001-2002. Mr. Lewitt also serves as a regular financial columnist for the Spanish newspaper El Mundo and has written for The New York Times, The New Republic, Trusts & Estates and other publications.

In May 2010, Mr. Lewitt published The Death of Capital: How Creative Policy Can Restore Stability (John Wiley & Sons), which was included in the curriculum in economics and history courses at the University of Michigan and Brandeis University during the 2010-2011 academic year. The Spanish edition of the book, La muerta del capital, was published in June 2011 by the Spanish publishing house La esfera de los libros. Mr. Lewitt is also a frequent media commentator on the financial markets. Mr. Lewitt is a graduate of Brown University (Magna Cum Laude; Honors in Comparative Literature and History); and New York University Law School (J.D.; LLM in Taxation).

Visit: Cumberland Advisors

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