The simple average Enterprise Value (EV) to EBITDA multiple of 7.4x for Q1 2020 was marginally higher than the previous four quarters. This was the net result of a shift in sentiment considering size and industry factors.
Size Premium
Size became an even greater pricing consideration for the middle market as transaction multiple variances widened for acquisition targets above and below $50 million.
Continued Use of Leverage
Total debt to EBITDA remained at 3.9x from 2019. Senior debt to EBITDA rose steadily to 3.5x, up from 3.2x and 3.0x in 4Q and 3Q 2019, respectively.
Distribution Takes the Top
Transaction multiples for the distribution industry sharply rose above the health care services and technology industries for the first time over the past five years.
Based on our review of GF Data’s latest M&A Report, the reported results for Q1 2020 display a slight increase in transaction multiples, contrary to previous, first-quarter declines. Although enterprise value (EV) to EBITDA multiples rose to 7.4x, an increase of 0.3x from Q4 2019, material shifts occurred between company size and industries as a result of the COVID-19 pandemic. The total number of reported Q1 2020 transactions remained normal at 62. Most of these transactions took place in the first two months of the quarter before business conditions weakened in early March.
Average EV/EBITDA transaction multiples increased for the larger companies in the $50 – 250 million enterprise value range and decreased for the smaller companies in the $10 – 50 million range. The increased market uncertainty likely caused a premium to be paid for the larger and perceived safer, companies.
Industry Analysis
We analyzed industry average EV/EBITDA multiples of acquisition targets to gain a more in-depth understanding of how the market perceived industry risk and growth prospects as COVID-19 began to disrupt the marketplace during the first quarter. Approximately 80% of the reported deal volume comprises four industries: manufacturing, business services, health services, and distribution.
The average EV/EBITDA transaction multiple for health care services experienced a steep decline to 7.4x in Q1 2020, down from 8.4x in 2019. The health care services industry has been negatively impacted in the short-run by the COVID-19 pandemic, as both practices and patients avoided preventative check-ups and elective treatments. On the contrary, the distribution industry average EV/EBITDA multiple increased markedly to surpass all other recorded industries. The distribution industry was valued extremely high in the first quarter as consumer e-commerce presence and demand for deliver-to-door goods grew considerably. Manufacturing and business services transaction multiples remained approximately the same over the last few years. The technology industry experienced a dip in its average EV/EBITDA valuation multiple to its lowest level since 2016. There was no recorded Q1 2020 transaction data for the retail and media telecom industries.
The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.
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Companies are facing cash shortfalls as they struggle to reopen from the COVID-19 lockdown. Companies facing short-term liquidity challenges can seek new cash sources, such as the government’s Payroll Protection Program “PPP” or a bank line-of-credit. However, certain companies may never achieve the revenue and profitability necessary to remain viable as a going-concern and may ultimately be forced into bankruptcy. Understanding whether your company faces a liquidity or solvency issue will allow you to most efficiently utilize your available resources.
Illiquid vs. Insolvent
Operating models of illiquid companies may be viable in the long-term, but cash issues could arise in the near-term due to poor cash management or an exogenous shock to the company’s operating performance. Insolvent companies, on the other hand, have an unsustainable operating model to support operating and debt obligations over the long-term.
What Needs to be Done?
A complete understanding of the company’s financial obligations and operating outlook is necessary to understand whether the company is experiencing a liquidity or solvency issue. Companies which are publicly traded or have bank debt may require solvency opinions to be performed. ValueScope’s team of experienced financial analysts and consultants can help you understand what your options are to get through this difficult time.
Our team of professionals provides:
Experience- we’ve conducted solvency and liquidity analyses for clients across the country
Credibility- Ph.D.’s, CFA’s, CPA’s, ASA’s, CVA’s, and MBA’s
Independence- we have the personnel, expertise and research resources to provide the assurance you require for a solvency opinion
The Issue at Hand
As businesses have been unable to fully function because of the COVID-19 pandemic, governments have stepped in to provide stimulus packages to equip them with the resources to survive the short-term. In the United States, the Payroll Protection Program (“PPP”) was set up to provide small businesses with a direct financial incentive to keep their workers on the payroll [1]. Yet the PPP, or any realistic government program, can only solve a business’s short-term liquidity issues. When a business’s operating performance struggles for a prolonged period of time, and their short and long-term cash inflows are no longer able to meet their financial obligations, the company could become insolvent.
Understanding a Liquidity Issue
A company’s liquidity is a measure of its ability to meet its near-term financial obligations. Companies can be profitable with positive cash flow and experience liquidity issues.
As an example, assume ABC Company has the following cash flow statement:
As the cash flow statement indicates, ABC Company has positive monthly net income of $100, and sufficient cash flow to cover their necessary capital expenditures and debt repayment obligations. As a result, the net monthly cash flow is positive $50. However, a profitable company can still experience a short-term liquidity issue.
As mentioned above, liquidity issues arise when a company cannot meet their near-term financial obligations. Imagine that ABC Company has the following balance sheet:
Companies experiencing a liquidity problem often face a disconnect between their current assets and current liabilities. As the ABC Company balance sheet indicates, the company’s current ratio is below 1.0, meaning current liabilities exceed current assets [2, 3].
Additionally, assume $50 of the salaries payable are due today and $25 of the short-term debt is due tomorrow. Currently ABC Company’s cash on hand is insufficient to meet these needs. ABC Company is now unable to meet their debt obligations and could be forced into bankruptcy if they cannot meet their obligations.
Dealing with Liquidity Issues
Fortunately, liquidity issues can be resolved in the short-term through obtaining additional financing, such as a line of credit, and in the long-term through better cash flow management. Improved cash flow management could include negotiating better terms on a company’s AR and AP, and better managing inventory levels.
The PPP is designed to keep companies from experiencing liquidity issues by providing them with the cash necessary to pay their day-to-day expenses and keep them from experiencing a liquidity issue. However, the PPP is not indefinite, in which case businesses which struggle to regain their customers could ultimately experience a solvency issue.
Understanding When Illiquid Becomes Insolvent
While there are numerous operational and financial options for companies experiencing illiquidity issues, companies experiencing insolvency have far fewer options. Insolvency includes illiquidity, but without realistic financing options and immediate operational opportunities for improvement.
As an example, assume that XYZ Company has the following cash flow statement:
Unlike our illiquid company, XYZ Company’s monthly cash flow is not sufficient to cover their debt repayment obligations. Even if they were to cut their capital expenditures to $0, XYZ Company would not generate sufficient cash flow to service their debt. In this scenario, any short-term financing or accounts receivable improvement would only provide a temporary solution.
Additionally, imagine the XYZ Company has the following balance sheet:
In addition to having cash flow issues, XYZ Company also has total liabilities which exceed total assets. Between their short-term and long-term debt, XYZ Company has total debt of $850. Even if XYZ Company sold all of their assets at book value, they would not be able to cover their debt obligations.
Dealing with Insolvency
Companies facing insolvency do not generate the income and cash flow necessary to support their operational and debt obligations. These companies must identify opportunities to increase net income and cash flow from operations, either through increasing revenue or decreasing expenses. If the company is unable to improve their operations, their debt burden will be too great, and the company will eventually be forced into bankruptcy.
ValueScope Can Assist You
Companies facing liquidity and solvency issues face tremendous challenges. Whether it is dealing with creditors, requiring solvency opinions, or working to improve cash flow management, ValueScope’s team of financial and valuation consultants can assist you and help get you through this difficult time.
[2] Current Ratio = Current Assets / Current Liabilities. The current ratio is the most basic liquidity test. It signifies a company’s ability to meet its short-term liabilities with its short-term assets. A current ratio greater than or equal to one indicates that current assets should be able to satisfy near-term obligations. A current ratio of less than one may mean the firm has liquidity issues. (Source: Morningstar).
[3] Evaluating a “good” current ratio requires a review of the business model, industry averages, and historical performance.
[4] Currently the PPP funds must be spent in the first eight weeks for the loan to be forgiven.
The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.
If you liked this blog you may enjoy reading some of our other blogs here.
Following are excerpts of some of the key energy “themes” for the US in 2020, taken from a recent CreditSuisse energy research report [1]:
E&P companies are evolving from growth-oriented to more capital disciplined and free cash flow generating entities; [2]
Utilities will continue to transform into a lower-carbon and higher tech industry as renewable power without fuel costs and grid modernization drive earnings growth with less customer burden;
Alternative Energy and Renewables to see new business models emerging around batteries as costs decline and customer adoption rates tick up;
Oil prices for WTI/Brent are forecast with average prices per barrel of $55 and $63, respectively;
Natural Gas prices are forecast to average $2.50/MMBtu;
Royalty Minerals expect further consolidations in 2020. Large-scale transactions could pick up from private equity-backed mineral entities, looking to exit either by coming to the public market, or being consolidated by one of the existing publics.
Oilfield Services are expected to face continued headwinds from E&P capital discipline and efficiency gains.
WTI Crude Oil Outlook
The price distribution below shows the crude oil spot price on January 16, 2020, as well as the predicted crude oil prices based on option and futures markets. The blue lines are within one standard deviation (σ) of the mean, and the red lines are within two standard deviations.
Based on January 16, 2020 prices, the markets indicate that in mid-February 2020 there is a 68% chance that oil prices will be between $53.50 and $62.00 per barrel. Likewise, there is about a 95% chance that prices will be between $47.50 and $69.00. By mid-September 2020, the one standard deviation (1σ) price range is $45.00 to $68.00 per barrel, and the two-standard deviation (2σ) range is $33.00 to $80.00 per barrel. In other words, there is a 95% probability that the expected price of oil will be between approximately $33 and $80 per barrel, and a 97.5% probability it will not be above $80 per barrel.
Natural Gas Outlook
We can do the same thing for natural gas, which is currently trading at $2.14 per MMBTU on the Henry Hub. Although more affected by seasonal factors than crude oil, in mid-February 2020, the one standard deviation (1σ) price range is $1.85 to $2.40 per barrel (68% probability) and the two standard deviation (2σ) range is $1.60 to $2.85 per MMBTU (95% probability).
Key Takeaways
Remember, these option analyses deal in expected probabilities, not certain outcomes—but that doesn’t make it any less useful. If someone asks you longingly if oil will be at $100 again soon, you now can respond with “there is about a 97.5% probability that oil prices aren’t expected to get above $80 by mid-September 2020, so I wouldn’t count on it.”
[1] Energy in 2020: Evolving,” December 19, 2019, CreditSuisse Equity Research report. Equity Research Global
[2] Image downloaded and modified from CreativeCommons.org, credit to Fabius Maximus website.
The oil price crash of 2015 and 2016 naturally led to numerous financial difficulties for many oil companies. Following a partial rebounding of prices, oil companies rushed to produce by borrowing significantly. This has led to a “debt wall” with scheduled maturities rising sharply over the next few years.[1]
Many companies will have difficulty paying off these large debt burdens, barring a dramatic increase in oil prices. Bankruptcy filings have increased substantially this year, with 33 filings as of September 30, 2019, relative to 28 all of last year.[2] As the debt burden increases, this number is likely to grow.
Chesapeake Energy Corporation (CHK) announced in early November that there was “substantial doubt” regarding its ability to remain a going concern.[3] Recently CHK received a written notice from the New York Stock Exchange regarding its noncompliance with the requirement to maintain an average closing share price of $1.00 over a consecutive 30 trading-day period.[4]
WTI Crude Oil Outlook
The price distribution below shows the crude oil spot price on December 16, 2019, as well as the predicted crude oil prices based on option and futures markets. The blue lines are within one standard deviation (σ) of the mean, and the red lines are within two standard deviations.
Based on December 16, 2019 prices, the markets indicate that in mid-January 2020 there is a 68% chance that oil prices will be between $55.00 and $64.00 per barrel. Likewise, there is about a 95% chance that prices will be between $48.50 and $70.50. By mid-May 2020, the one standard deviation (1σ) price range is $49.00 to $68.00 per barrel, and the two standard deviation (2σ) range is $38.00 to $83.00 per barrel. In other words, there is a 95% probability that the expected price of oil will be between approximately $38 and $83 per barrel, and a 97.5% probability it will not be above $83 per barrel.
Natural Gas Outlook
We can do the same thing for natural gas, which is currently trading at $2.36 per MMBTU on the Henry Hub. Although more affected by seasonal factors than crude oil, in mid-January 2019, the one standard deviation (1σ) price range is $2.00 to $3.00 per barrel (68% probability) and the two standard deviation (2σ) range is $1.65 to $4.80 per MMBTU (95% probability).
Key Takeaways
Remember, these option analyses deal in expected probabilities, not certain outcomes—but that doesn’t make it any less useful. If someone asks you longingly if oil will be at $100 again soon, you now can respond with “there is about a 97.5% probability that oil prices aren’t expected to get above $83 by mid-May 2020, so I wouldn’t count on it.”
[1] Gladstone, Alexander, “U.S. Oil Patch Stares Down $120 Billion Debt Wall,” The Wall Street Journal, December 3, 2019; https://www.wsj.com/articles/u-s-oil-patch-stares-down-120-billion-debt-wall-11575412192.
[2] Oil Patch Bankruptcy Monitor, Haynes and Boone, LLP, September 30, 2019.
[3] Scurria, Andrew, Alexander Gladstone and Carlo Martuscelli, “Chesapeake Warns On Risk To Business From Sagging Oil Prices,” The Wall Street Journal, November 5, 2019, https://www.wsj.com/articles/chesapeake-warns-on-risk-to-business-from-sagging-oil-prices-11572972005.
[4] Sylvester, Brad, “Chesapeake Energy Corporation Receives Continued Listing Notice From NYSE,” ENP Newswire, December 16, 2019.
Can high yield bond credit risk premiums continue to narrow from present levels?
It’s a significant question. Bonds provide returns to investors in two forms: 1) payment of the contractual rate of interest and 2) capital gains or losses. Credit risk premiums seldom remain constant for any length of time; they continually trend up or down. The chart below illustrate that cycles of decreasing credit risk premiums generally continue for a period of years and that cycles of increasing risk premiums can play out over a period of just a few months.
Thus, the question of whether credit risk premiums can continue to decrease from present levels is very important. If they can continue to decrease, high yield bonds are likely to provide attractive returns for several more quarters, perhaps even a year or two.
The chart above showed that credit risk premiums are nearing their all time lows. The answer to the question of whether or not high yield credit risk premiums can return to their all time lows lies in part in the leveraged loan market.
In Article #2 of this series, we explained that leveraged bank loans and high yield bonds are the two primary leveraged debt investment instruments. Many leveraged debt investors will allocate money to the loan or bond markets depending on which asset class offers more attractive risk/reward relationship. The chart below illustrates that the leveraged bank loan market is not presently retesting its all time lows from 2007.
Explaining the difference
The previous chart raises another important question – how can high yield bond credit risk premiums be approximately 1.0% from their all time lows when the credit risk premium on leveraged loans is almost 2.0% higher than its historic lows? The table below illustrates the significance of this difference.
As we discussed in Article #2, bonds are riskier than senior secured loans. As a result, the credit risk premium on “B” rated high yield bonds prior to and including the historic low was 171 basis points (1.71%) higher than the average on comparably rated loans (5.06% – 3.35%). Today, the credit risk premium on “B” rated loans (4.03%) is higher than it is on “B” rated bonds (3.39%). Credit risk premiums on bonds since 2009 have been very similar to what they were prior to the great recession but credit risk premiums on loans have been very different.
The reason the high yield market has essentially returned to pre-2008 norms while loans have not reflects the fact that the market for leveraged bank loans is far more dependent on the securitization as a source of capital to fund loan investments than the bond market. Roughly half of all new leveraged bank loans are purchased into the investment portfolio’s held by Collateralized Loan Obligations (“CLOs”).
Recall that mortgage loan securitizations (“CDOs”) were the epicenter of the financial crisis and recession that took place in 2008 and 2009. In response to the mortgage loan crisis, new rules were put in place to reduce the risks created in the securitization markets. This affected not only the mortgage loan CDOs but also commercial loan CLOs.
The new rules increased the equity risk exposure CLO managers were required to retain and restricted many of the freedoms the CLO markets previously enjoyed despite the fact that CLO’s performed well during the this period.
The chart above shows that the blended credit risk premium on the average new CLO in 2017 was almost three times larger than the blended credit risk premium on new CLO’s in 2007. The chart below shows that credit risk premiums on the AAA rated tranches of new CLOs have begun to decrease only recently, indicating that the CLOs which funded prior to 2017 had even higher funding costs.
The chart above shows that the average credit risk premium for AAA rated CLO obligations decreased 30 basis points (0.30%) in 2017. This indicates that the credit risk premiums of CLO’s created prior to 2017 are generally 170 basis points (1.70%) or more. This increase in CLO funding costs is a primary factor which has caused credit risk premiums on leveraged bank loans to remain stubbornly high relative to similarly rated high yield bonds.
This brings us back to our original question. Can the high yield bond market retest the all-time low credit risk premiums it experienced in 2007?
In our view, the answer to this question is probably not. Leveraged bank loans are a good substitute asset for high yield bonds. Thus, if bond yields get too low, investors are well advised to move their investments to loans so that they can get higher yields for similar risk.
Conclusion
In January, credit risk premiums on high yield bonds were significantly lower than their long term averages and they were nearing the all time lows experienced in 2007.
If the funding cost of CLOs continues to tighten as it did in 2017, bank loan credit risk premiums could decrease further – this would enable additional decreases in bond credit risk premiums. The magnitude of the decrease in CLO funding costs in recent months suggests that bonds could appreciate further before reaching their next cyclical peak.
The structural changes in the market for leveraged bank loans which occurred after the financial crisis of 2008 and 2009 make it unlikely that credit risk premiums on high yield bonds will return to their 2007 lows in the foreseeable future. The significance of this is that we anticipate high yield credit risk premiums are unlikely to decrease more than an additional 100 basis points from January 2018 levels.
Article #3: Can Leveraged Debt Retest Low Premiums?
Article #4: Signs That It’s Time to Sell Leveraged Debt
Article #5: Signs That It’s Time to Buy Leveraged Debt
Article #6: The Appeal of Investing in Distressed Debt
Article #7: Investment in Leveraged Debt through the Business Cycle
Thereafter: Updates regarding important market statistics with current commentary
Data Sources for the Article
The data presented in this article was obtained from the Federal Reserve Bank of St. Louis (ICE Benchmark Administration Limited (IBA), ICE BofAML US High Yield B Option-Adjusted Spread [BAMLH0A2HYB], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A2HYB, January 8, 2018) and from the Leveraged Commentary and Data news service provided by Standard and Poors Corporation.
This article continues the discussion started in Article #1, “Is It Time to Invest in Leveraged Debt?” and describes the primary debt types that trade in the leveraged debt markets
What is leveraged debt?
Leveraged debt is the financial obligations of large businesses and certain governments whose credit ratings do not qualify as “investment grade.” These obligations take the form of both leveraged bank loans and high yield bonds. Because they are large obligations of large issuers, they are syndicated to investors and may be purchased or sold in secondary markets, much like those for stocks and investment grade bonds. Common characteristics of leveraged bank loans and high yield bonds are described below.
Characteristics of leveraged bank loans
Floating rate coupon (contractual interest rate)
Commonly senior secured
Some benefit from financial covenants
Retail investors can gain exposure through mutual funds and ETFs
Experience significant price volatility over the course of the business cycle
Meaningful risk of bankruptcy and principal loss but less principal risk than for high yield bonds
Characteristics of high yield bonds
Fixed rate coupons
Commonly unsecured
Limited benefits from financial covenants
Retail investors can gain exposure through mutual funds and ETFs and through direct ownership (not recommended due to high trading costs)
Significant cyclical price volatility
Meaningful risk of bankruptcy and principal loss
Leveraged debt background
Leveraged bank loans and high yield bonds are most commonly created to finance acquisitions of large businesses or other transactions by private equity firms. These acquisitions are frequently financed with a combination of bank loans and bonds; as a result there is a large overlap of corporate issuers in the leveraged loan and high yield bond markets. Loans and bonds offer different advantages to borrowers. By investing in the secured claims of the issuer, loan investors take less principal risk than high yield bond investors. As a result, nominal high yield bond coupons tend to be larger than nominal bank loan coupons. Because they take more principal risk, high yield bond prices in the secondary market tend to be more volatile than loans’.
Advantages of investing in leveraged bank loans
They offer large, current, floating-rate coupons (more than LIBOR + 1.75%)
The floating rate coupon shields investors from losses in the event inflation and interest rates begin to rise and thereby simplifies portfolio management
Senior secured status means that bank loan investors will get the best recovery of all investors in the event of the obligor’s bankruptcy. It is common for bank loan investors to recover 100% of their investment despite significant impairment losses at junior levels of the issuer’s capital structure (secured obligations obtain a recovery prior to unsecured obligations)
Second-lien loans provide investment opportunities with more risk and larger coupons
Leveraged bank loans trade in a secondary market which is normally reasonably liquid
Some leveraged bank loans benefit from financial covenants which enable lenders to reprice loans if the borrower fails to meet agreed minimum financial performance targets
Broad downturns in the market can be reasonably anticipated enabling alert investors to take steps to hedge or reduce their risk
Loan market corrections and recoveries tend to precede the equity market’s
Moments of market illiquidity are moments of market inefficiency – finance theory teaches us that inefficient markets create economic opportunity for the astute
Disadvantages of investing in leveraged bank loans
Institutional investors use extensive leverage to finance their investments in leveraged bank loans – this has a twofold impact:
Significant selling pressure can arise when investors who have borrowed money to purchase leveraged bank loans receive margin calls
The secondary market can become very illiquid during broad market corrections
Aggressive lending, especially in the latter stages of a long period of strong demand, can lead to principal losses, even on first-lien secured bank loans
Limited cost to call loans results in frequent demand for interest rate reductions from corporate issuers when economic conditions are favorable
Significant price volatility over the course of a business cycle relative to other classes of fixed income investments can give investors a sense of motion sickness
Cannot be directly acquired by retail investors but there are many ways for retail investors to gain exposure to the asset class – specifically through mutual funds and ETF’s
Advantages of investing in high yield bonds
They offer large, current, fixed-rate coupons
High yield bonds are much more expensive to refinance than loans; as a result investors experience much lower demand for interest rate reductions from corporate issuers than loan investors
High yield bonds trade in a secondary market which is normally reasonably liquid
Broad downturns in the market can be reasonably anticipated enabling alert investors to take steps to hedge or reduce their risk
Investors focused on high yield bonds tend to use less leverage than loan investors; this helped to mute bond volatility somewhat relative to loans in the bear market of 2008 and 2009
Bond market corrections and recoveries tend to precede the equity market’s
Moments of market illiquidity are moments of market inefficiency – finance theory teaches us that inefficient markets create economic opportunity for the astute
High yield bonds may be purchased by retail investors but transaction costs associated with purchasing odd-lots (less than $100,000 of a specific issue) of bonds make this option unattractive for many; there are other ways for retail investors to gain exposure to the asset class – specifically through mutual funds and ETF’s
High yield bond exposure can be hedged by shorting bonds but the cost of carry on short positions is not insignificant
Disadvantages of investing in high yield bonds
High yield bonds absorb a disproportionate share of principal losses relative to leveraged bank loans in the event of the issuer’s default.
Aggressive lending, especially in the latter stages of a long period of strong demand, can lead to principal losses when the business cycle turns
Significant price volatility over the course of a business cycle relative to other classes of fixed income investments can give investors a sense of motion sickness
Absence of collateral increases risk of principal loss on default
Absence of financial covenants creates no opportunity to reprice the bonds during periods of poor business performance
Conclusion
Both leveraged bank loans and high yield bonds offer meaningful compensation to investors but they also offer significant amounts of investment risk. Investors who understand the risks inherent in these investments can take steps to manage the risk they underwrite. Investors who cautiously underwrite their investments in leveraged debt preserve their ability to take advantage of the market in its moments of illiquidity. This creates the opportunity to earn significant economic profits through the credit cycle.
In the week ended January 11, 2018, retail investors poured $2.65 billion into the high yield bond market. Was this a good idea?
The chart below describes the historical yield experience investors have enjoyed (sometimes endured) through their investments in leveraged debt.
Leveraged debt includes all below investment grade (“junk”) debt obligations of large issuers including corporations and certain governments. They are called below investment grade because the issuers have issued large quantities of debt, face significant operational problems or both. Rating agencies assess the likelihood these issuers will default and assign credit ratings ranging from “BB” (good junk) to “B” (questionable junk) to “CCC” (risky junk).
The chart above shows that credit risk premiums were close to historic lows in early January.
The chart above presents credit risk premiums by rating category over a period of more than 20 years. The credit risk premium is the compensation in excess of treasury yields received by investors for investing in corporate debt. To create a simple example, an investor in a the Merrill Lynch BB rated bond index on January 5, 2018 would expect to earn:
Credit Risk Premium + Treasury Bond Yield = Expected Return
1.99% + 2.40% = 4.39%
The yield on 7 year US Treasury bonds on January 5 was 2.40% (we assumed the average term to maturity on bonds in the index approximates 7 years). When we add the credit risk premium on “BB” rated bonds of 1.99%, we obtain an expected return of 4.39%. In the case of an individual bond, the expected return might also be described as the yield to maturity.
The chart above shows that credit risk premiums on below investment grade debt vary widely during the course of the business cycle. During good times, investors are calm and do not require large credit risk premiums. During tough times, investors are fearful and expect much larger returns for putting cash to work in risky investments. Since the contractual rate of interest on a bond is fixed, an increase in the required return is reflected in the price at which the bond trades in the secondary market.
In an extreme case, if the required return (treasury yield + credit risk premium) on a bond with a 5.0% contractual interest rate increases to 20.0%, the bond’s price changes as follows:
5.0% coupon / 20.0% required return = 25
In this example, the bond’s price would fall by 75% to 25 cents on the dollar.
The low points of the graph above represent moments when bonds are expensive (unattractive) relative to their long term average prices and the high points on the graph represent moments when bonds are inexpensive (attractive).
The chart below converts the credit risk premiums described in the first chart into approximate historical prices. For simplicity, we calculated prices assuming the average high yield bond in each index had a remaining term to maturity of seven years and paid an annual cash coupon of 7.0%.
This chart reflects the fact that leveraged debt investment prices are subject to significant changes in value over time. Because these investments are subject to high degree of risk, investors should exercise caution when investing in them.
The next six articles in this series provide important background information regarding the leveraged debt markets (Article #2) and guidance regarding when to invest and how to structure investments in leveraged debt (Articles #3 through #7).
Outlook and Conclusions
The last broad correction in leveraged debt began in the third quarter of 2007, more than 40 quarters ago. Credit risk premiums are nearing their all time lows and structural market changes could make it difficult to every reach previous lows (see Article #3).
We do not anticipate a significant correction in the leveraged debt markets in 2018 but we believe that, as of early January 2018, leveraged debt investments presented modest return potential with significant risk of future loss. Timing is important to successful investment in leveraged debt.
Active investors who vigilantly monitor economic and market conditions will likely be able to wring further gains from this increasingly dry market. Passive investors may find that the risks presently outweigh the rewards.
Article #3: Can Leveraged Debt Retest Low Premiums?
Article #4: Signs That It’s Time to Sell Leveraged Debt
Article #5: Signs That It’s Time to Buy Leveraged Debt
Article #6: The Appeal of Investing in Distressed Debt
Article #7: Investment in Leveraged Debt through the Business Cycle
Thereafter: Updates regarding important market statistics with current commentary
Data Sources for the Article
The data presented in this article was obtained from the Federal Reserve Bank of St. Louis (ICE Benchmark Administration Limited (IBA), ICE BofAML US High Yield B Option-Adjusted Spread [BAMLH0A2HYB], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A2HYB, January 8, 2018) and from the Leveraged Commentary and Data news service provided by Standard and Poors Corporation.
Several quarters remain before bankruptcy attorneys return to high employment. However, weakness in specific sectors should provide an increased flow of near term bankruptcy activity.
Summary of 2015 Shared National Credit Review[1],[2]
In 2013, bank regulatory agencies (the “Regulators”) released the Interagency Guidance on Leveraged Lending (the “Guidance”) intended to curtail perceived excesses in bank lending practices. One of the most impactful elements of the Guidance was the rule that banks should not make “non-pass” loans. The Guidance defined “pass” loans as loans in which the borrower demonstrated the ability to repay all of its senior debt and one-half of its total debt in a five to seven year period.
The Guidance initially proved confusing and banks did not immediately adopt its recommendations to the Regulators’ satisfaction. After the Regulators criticized banks for non-compliance in the 2014 Shared National Credit Review (the 2014 “SNC Review”), banks appear to have gotten the message. After the 2015 SNC Review, Comptroller of the Currency Thomas Curry stated, “[T]he 2015 SNC Review found lower levels of leverage and improved repayment capacity in bank leveraged loan portfolios.”
Statistics compiled by the Loan Syndications and Trading Association shown in the charts below support the findings of the 2015 SNC Review.
Footnotes
[1] Coffey, Meredith, “SNC: Banks Complying With LLG Rules… But SNC Suggests Rules Might Change”, November 2015; Loan Syndication and Trading Website at http://www.lsta.org/news-and-resources/news/1/snc-banks-complying-with-llg-rules-but-snc-suggests-rules-might-change
Several quarters remain before bankruptcy attorneys return to high employment. However, weakness in specific sectors should provide an increased flow of near term bankruptcy activity.
Economic Outlook – Bankruptcy Attorneys
The current economic expansion is aging, but is likely to continue for several more quarters. The charts below provide insight into the economic outlook for the remaining duration of the current economic expansion.
Majority of Evidence – Signs of Stability
Source: united states department of economic analysis at http://www. Bea. Gov/national/
The chart above illustrates our progress through the current business cycle and the length of the prior two cycles. The expansion in the 1990’s remains the longest in US history. The chart above indicates that real GDP growth for the four quarters ending June 2015 averaged a healthy 2.7%.
Unemployment remains low (see chart above), while inflation remains under control (see chart below).
Source: federal reserve bank of minneapolis at https://www. Minneapolisfed. Org/community/teaching-aids/cpi-calculator-information/consumer-price-index-and-inflation-rates-1913; note that the fed has targeted a 2. 0% inflation rate in recent years
The strong US dollar, weak oil and commodity prices and weak global growth are the primary contributors to today’s low inflation rate. Low inflation has allowed the Federal Reserve (the “Fed”) to leave the fed funds rate close to 0% for seven years.
The chart below shows the Fed raised the fed funds rate to fight inflation before each of the last two recessions. In this chart, corporate earnings are a proxy for economic growth. The Fed has not begun the tightening cycle which precedes business contractions.
Correlation between corporate earnings and fed funds rate
The yield curve remains a reliable predictor of the approach of the end of economic expansions.
Source: m. G. J, “the imf urges the fed to delay a rate rise”, the economist, september 3, 2015
The yield curve represents the yield on US Treasury obligations of various maturities. The Fed raises short-term interest rates to reduce the current inflation rate. This effort consistently results in a circumstance where short-term rates rise to yields considered appropriate for long-term Treasury bonds in the final stages of economic expansions.
Minority of Evidence – Signs of Instability
The weak global economy has resulted in weak commodity prices, particularly weak oil prices.
In the manufacturing sector, growth has almost slowed to contraction.
Source: national association of purchasing managers – manufacturers’ purchasing managers’ index
Energy sector weakness has a negative impact on companies that borrowed heavily when oil prices were expected to remain high.
Increasing distress in the energy sector has caused yields on syndicated loans to increase 100 basis points from May 2015.
Source: yield on leveraged loan 100 index at http://www. Leveragedloan. Com
Similarly, more than $5.2 billion in funds have been removed from the loan market since mid-July.
Source: funds flow from syndicated loan market at http://www. Leveragedloan. Com
Conclusion
Several quarters remain before bankruptcy attorneys return to high employment. However, weakness in specific sectors should provide an increased flow of near term bankruptcy activity.
Footnotes
[1] Source: United States Department of Economic Analysis at http://www.bea.gov/national/
[3] Source: Federal Reserve Bank of Minneapolis at https://www.minneapolisfed.org/community/teaching-aids/cpi-calculator-information/consumer-price-index-and-inflation-rates-1913; note that the Fed has targeted a 2.0% inflation rate in recent years
[11] Source: National Association of Purchasing Managers – Manufacturers’ Purchasing Managers’ Index
[12] Source: Kakouris, Rachelle, “Oil & Gas Cos Could See 40% Decline in Borrowing Base – Survey”, September 23, 2015 at www.leveragedloan.com/category/distressed-debt/
[13] Source: Yield on Leveraged Loan 100 Index at http://www.leveragedloan.com
[14] Source: Funds flow from syndicated loan market at http://www.leveragedloan.com
