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GMO Commentary: Shelter in Credit

Executive Summary

Along with risk assets across the board, the high yield market is currently undergoing a dislocation the magnitude of which occurs only once every decade. Uniquely for high yield credit, returns can be scenario-tested based on discrete cash flows because either coupons and principal are paid or bonds default and creditors recover on the claims. GMO has developed a stress test for the high yield market that demonstrates that while the bottom may not yet be in sight, the sell-off is being overdone given the high yield market can deliver positive real returns through a cycle even under draconian default and loss assumptions. Accordingly, there is shelter in credit. Meanwhile, if heightened volatility subsides, we believe high yield bonds are priced to deliver substantial total returns. Security selection can add incremental alpha as the good is abandoned indiscriminately with the bad and the ugly as people distance themselves from risk. If history once again rhymes, then we believe the return profile for high yield to prove superior to equities post this historic drawdown.

High Yield Market's Wild Ride

The rapid seizing up of global markets has brought into play a new Minsky moment. No longer taking cues from Chuck Prince,1 the markets' music has halted2 abruptly once again, perhaps this time fueled by Lil Nas X's absurdist chart topping 2019 single "Old Town Road" which defiantly proclaimed: "Yeah, I'm gonna take my horse to the old town road. / I'm gonna ride 'til I can't no more." What seemed like an easy ride just months ago has become a bucking bronco, forcing investors, companies, consumers, and policymakers to make challenging decisions in a time of extreme uncertainty. Investors, who spent the past few decades loading up on illiquid assets (private credit, private equity), are now in a mad dash for liquidity all at once.

A scan of valuations in credit markets following the extreme price action of the past month and a half offers some chart-topping data points:

  • The high yield spread has topped 1,000 bps, its widest level since 2009.3
  • High yield through March 20 has registered a -17.5% return, which thus far is the worst month ever recorded (September 2008 registered a -16.3% return).4
  • The trading week ending March 20 registered record outflows of $108.9 billion out of bonds (Monday, March 16 was the largest daily outflow ever at $30.2 billion) while inflows to cash surged to $95.7 billion (fourth largest week ever).5

While this would suggest an attractive entry point, we must also consider the potential downsides and that asset prices might sell off further:

  • The current high yield spread of 1,000 bps compares to ultimate wides of over 1,100 bps in 2002 and 2,000 in 2008.6
  • High yield drawdown was 33% from June through November of 2008.7

In situations of great uncertainty, it is helpful to run scenario analysis. The extent of the unknowns that the Covid-19 pandemic and corresponding policy actions present makes this more challenging than ever. The amplitude and duration of this crisis and all knock-on effects are unknown. On the downside, it is plausible that the tail risk may match or exceed the market stress experienced in the Global Financial Crisis of 2008-2009. On the upside, it is plausible that aggressive actions on virus containment, human resilience, innovation, and fiscal and monetary policy support can level off the spread of the virus and social and economic life can begin to recover within a reasonable timeframe. For financial markets, the scenarios are vague with so much noise and so little signal, so much data but so little predictive capacity, that perhaps the dash for cash is instructed by the chorus from "Old Town Road": "Can't nobody tell me nothing."

Hope for the Best, but Prepare for the Worst - High Yield Loss Absorption Model

In this type of environment, it is typical for risk aversion and decision paralysis to set in. (Is this the bottom? Can we ever recover?) There is something to be said for "hoping for the best but preparing for the worst." In credit investing (and most value investing), we follow the old axiom of focusing on the downside and letting the upside take care of itself. We can use the knowns of the high yield market and create downside scenarios on the unknowns in order to determine how much downside protection the current market level provides.

A flaw of existing high yield modeling exercises is that they start with spread and assume default losses, but do not properly account for starting dollar prices and coupon in place - they are more mark-to-market models than loss absorption models. More fundamentally, currently the high prevalence of distressed energy credits may distort outcomes as, rather than discuss in this paper, we can at least note the sector is experiencing unique supply and demand distortions and business model challenges that should lead to elevated defaults and losses. Perhaps it is best to create a new high yield default loss adjusted returns model.

In order to create a superior model, we can begin by finding an index excluding Energy, and for this purpose use the Bank of America Merrill Lynch U.S. High Index Excluding Energy, Metals and Mining. With the current price (85.7), coupon (6.1%), and maturity (6 years), a simple calculation would provide that if all cash flows were paid until maturity at par, the internal rate of return (IRR) would be roughly 9.3%.8 This naive return is just that: defaults experienced will lead to missed coupons and principal and thus impair cash flows. Accordingly, we need to make assumptions to model defaults and recoveries. To run downside cases, we can make assumptions and create two scenarios:

  • Global Financial Crisis (GFC) Case: uses historical default rates from 2008-2013.
  • Draconian Case: 2 years of peak 2009 level defaults (10.8%), declining 3% per year until reaching a 2.5% floor in year 5.9

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This article first appeared on GuruFocus.