PENN’s 2011 High Yield Outlook
Philadelphia, PA - (January 21, 2011) - Despite two years of strong high yield bond returns following the 2008 credit crisis, PENN Capital Management Company, Inc. founder, Richard A. Hocker, remains constructive on the asset class on an absolute basis and relative to equities and high grade fixed income.
“The US corporate credit markets have returned to health,” says Mr. Hocker, “we remain in a positive cycle for the asset class.”
Richard Hocker, who has managed high yield bond portfolios for institutions since the late 1970’s, references moderate economic growth and minimal low quality (split B-rated and below) net new issuance entering the markets as key factors to continued price stability. “The majority of new issuance in the past 24 months has gone toward refinancing and restructuring current debt. That is a positive factor for the market.”
With respect to security selection, Mr. Hocker and his team focus on EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) stability and growth, citing, “You don’t need earnings growth for high yield bonds to perform well, you just need stability in EBITDA so that the company can support its debt requirements. EBITDA consistency provides a level of certainty that the bond will return its current yield.” The current yield to worst of the Merrill/BofA High Yield Master II constrained Index is 7.21%.
With respect to leading indicators, Mr. Hocker cites the level of “net new” (non-refinancing) low quality issuance as something to watch. “Once you see this number move to peak levels reached in past cycles, expect default rates to begin to increase.”
Although high yield bonds are just that, bonds, Mr. Hocker sees interest rate risks as much less of a factor. “High Yield corporate bond prices are much more sensitive to company fundamentals. If rates are moving up, chances are the economy is doing quite well, which translates to improving credit quality and upgrades by Moody’s and S&P.”
Mr. Hocker believes that market reaction to global macro events remain a more prevalent risk than current US corporate credit fundamentals saying, “If you see a sovereign nation default, it could lead to a flight away from all risk related assets. Domestically, our greatest credit concern is state and local municipal bond markets where credit quality is generally deteriorating.”
Looking to 2011, high unemployment and slack in the domestic economy should keep the Fed on hold as economic growth accelerates, albeit modestly. Despite PENN’s view that short-term interest rates will remain low in 2011, PENN is favoring short maturity, low duration bonds to protect against potential volatility on the longer end of the curve. As stated by Mr. Hocker, “Fundamentals will always be our top focus, but where we can, we will favor shorter maturity paper.”
PENN is also favoring the B rated credit tier. “We believe this is currently the sweet-spot for the high yield market” says Hocker. “Picking good bonds in the B-rated space will allow us to maintain an attractive overall yield while owning stable companies with improving credit quality and avoiding price declines”. PENN currently owns over 120 companies in its Defensive High Yield portfolio. “Diversification is key,” says Hocker “we spread the risk while maintaining an overall yield above what an investor would receive by owing one bond.”
Richard expects borrowers to utilize loosening credit standards to undertake equity enhancing transactions, and the mix of lower quality issuance could rise as a result. “It is impossible to guarantee that we will never again see too much leverage in the market,” says Hocker, “but we have a pretty long runway right now since companies are being much more prudent with their balance sheets and LBOs, for the most part, have been responsibly levered with bigger equity checks. We think this behavior change is not a short-term phenomenon, and we are nowhere close to the levels reached at past cycle peaks, particularly that seen in 2006-2007.”