Cartoons of the Week:
Cherry Hill New Jersey - Late 1970’s - 5:30 AM
As the Gray Hound bus driver was waiting for his last passengers to come aboard for his daily 2-hour drive up to New York City, he spotted an odd-looking man.
This man was wearing a leather aviation cap similar to the one Snoopy wore in his cartoons.
Strapped to the top of this weird-looking hat was a large miner’s headlamp.
As the man walked closer to the bus entrance, the driver noticed he was carrying a large bag that looked extremely heavy.
The man boarded the bus not making eye contact with the driver. He took the seat right kiddy corner to the driver, put his large bag in the seat beside him, and started to unpack.
Inside the bag was reels and reels of paperwork. We would later learn they were SEC filings of 10-K’s, 10-Q’s, bond indenture documents, and management presentation transcripts.
As the bus driver turned off the lights and started to drive, the guy flipped on his miners’ headlight and started to read. His head did not lift up from reading until they pulled into the New York City terminal.
This started a routine. Each morning at 5:20 AM, a man would walk onto the Gray Hound bus to New York with a funny hat and pounds of paperwork.
He did this daily routine for years, reading each morning on the 2-hour commute in, and then again on the 3-hour commute home. He would go to bed for 4-hours, wake up and do it again.
Within a three-year period, this man went from a new hire at a small boutique wall street firm to someone who reinvented the investment landscape, and in turn, became the richest person on Wall Street in the early 1980s.
His name was Michel Milken.
What is a Bond?
A bond is a return of capital not a return on capital.
If a company wants to raise money to grow, there are only a few ways they can go about doing this.
They can give ownership in that company by selling stock or they can issue bonds that pay a coupon (interest rate) that guarantees they will pay back the total amount at a certain point in the future.
Unlike stocks, where the upside is potentially infinity, bonds have a limited upside.
Bonds provide a steady bi-yearly coupon payment.
If the company gets into financial stress and files bankruptcy, the bond holds have first dibs on the assets of the company, while equity holders pick up the scraps at the end.
This is why when a company gets into financial stress, the bonds still hold some value while the stock usually trades under $1 and ultimately goes to $0.
A Bonds Coupon (The Spread)
Prior to the mid-1970s, most U.S. corporations took pride in being debt free. When they looked to use debt, they had to make sure they were rated high enough by the credit rating agencies to be able to have investors loan them money.
A company’s goal, if they did not want to give investors more ownership through stock, was to get a good rating from the credit rating agencies.
Only the biggest and best companies received bond loans in those days. If you were rated “investment grade” you were able to tap into the billions of dollars available for bond loans through pensions and insurance companies.
But if you were a smaller company or wanted to use the advantage of debt and leverage to increase your stockholder’s returns, you were basically out of luck. No one would touch you.
On one of those early morning bus drives from Cherry Hill to New York, Michael Milken came across a paper written in the mid-1950s by W Braddock Hickman.
In that paper, W. Braddock Hickman looked at all corporate bonds from 1900 to 1943 and focused on those that were called “fallen angles”. Fallen angels are bonds that start off as investment grade but because of a slowdown in the economy or deterioration of the business model, fall below investment grade into speculative grade.
What Hickman found was startling. If you took a small position in each one of these low-grade bonds and stayed diversified and held for the long haul, this portfolio of “junk” companies, that everyone disregarded, actually outperformed any portfolio made up of all high-quality “investment grade” bonds.
This paper gave Milken an idea.
He saw an opportunity to introduce investors with a high-risk profile to companies that were classified as “speculative grade” by the credit agencies but still needed to get capital to grow.
He felt if you can charge a high enough interest rate on these “speculative bonds” along with detailed research, you should be able to generate a fantastic risk-adjusted return.
As we talked about in our post HERE, to judge the risk of bonds, we look at their spread. From my post in April 2022:
“We price bonds in this manner so we can understand and track the underlying investor feeling towards risk in any given market.
So in the example above, we said Apple priced their 2031 bonds at 1.70% and their 2061 bonds at 2.80%.
If we know they priced the “risk” of Apple bonds 92 basis points above Treasuries (spread), we know the 10-year treasury then was 0.78% (1.70% - 0.92%) and the 40-year treasury was priced at 1.88% (2.80% - 0.92%).
The 0.92% is the price of the risk above treasuries also know as the spread. We can now easily track this pricing of risk over time, no matter what the yield on the US treasuries would be at that time.”
In the example above, the 92 basis points (or 0.92%) is call the spread.
For high-quality companies like Apple, the spread is very low. But for speculative-grade companies or what we call high-yield companies, the spread can be much wider.
Below is a chart showing the spread for high-yield companies (orange) versus the spread for investment-grade companies (gray) over time from 1996 to 2018.
The average for high yield over this time was 562 basis points (5.62%) while only 150 basis points (1.50%) for investment grade bonds.
This means if a company wanted to issue a 10-year bond today, with the current US treasury yielding 3.26%, a high yield company on average would need to issue a coupon at 8.88% (5.62% + 3.26%) while an investment grade bond could issue the same bond with a coupon of only 4.76% (1.50% + 3.26%).
As you can see below, the spread earlier this week for the JP Morgan High Yield Index was 519 basis points (or 5.19%).
We can see the YTW which stands for yield to worst at 8.46%. This is the current yield or return you can expect to get on the bond index as of yesterday.
If we take the YTW of 8.46% and subtract the spread of 5.19% you get 3.27% which is very close to the current yield on the US 10-year Treasury of 3.26%.
As mentioned before, the spread is just the risk companies need to pay ABOVE U.S. treasury rates to get a bond loan in the market.
During normal times from 1986 to today, looking at the chart below, the average high yield spread was 519 basis points, exactly where we are today. Clearly the high yield market is not forcasting a recession right now.
During recessionary times, the average spread was 971 basis points, or about 452 basis points higher (or 4.52% higher) on average.
This is in comparison to investment grade bonds (second column below) which averages 172 basis points of spread in normal times and 252 basis points of spread in recessionary times.
Currently, the investment grade spread is 145 basis points or 1.45%. If we had a normal recession, we could expect investment-grade bond spreads to increase by 1.07% on average.
Notice this is much lower than the 452 basis points high yield may move on average in a recession. That is because investment-grade bonds are of higher quality and can usually make it through an economic downturn.
In recessionary times, companies that are smaller or carry more debt usually get into more trouble, and eventually, they default.
A Bonds Default and Recovery Rate
The default rate is the percentage of bonds in an index that cannot or will not pay back what they owe.
Basically, if a company defaults, you will not get back what you were promised.
Similar to you purchasing a house and then not paying the mortgage. Once you stop paying that mortgage, the bank will come in and take over the house and try to sell it.
The value the bank receives from selling your house is called the recovery rate.
With mortgages, banks like to protect themselves by not financing more than what the house is worth. With bonds, this is slightly different.
Companies sometimes issue bonds worth more than what their asset values may be worth, with the idea that companies’ intellectual value and future growth are worth more than their current assets.
Because of this, recovery rates on bonds are lower than they would be for banks selling your house.
You can see below the recovery rate in high-yield bonds from 1988 to 2013 (red line).
Like a bond spread, default and recovery rates go along with the economic ups and downs.
You can see below, within the high yield index, the number of defaults per year. This is not the dollar amount but instead the number of companies that defaulted.
Just by looking at the spikes below, you know when the economy was in a recession or worse.
On average, if a company defaults in the high yield space, the bondholders will get about 40% of their money back.
This is a benefit of investing in high yield bonds. Even the worst case scenario, you get some money back.
As Michel Milken stated in the book the Preditor’s Ball:
So for every dollar you invested in a default bond, you will get back 40 cents back on average. This changes by year, by company, and by calculations used in bankruptcy court, but historically, it has been around 40%.
So if we know an average default rate and the current spread on the market, we can back into what Mr. Market feels the default rate will be.
Implied Default Rate = Credit spread / (100%. - 40%).
If today’s credit spread is 519 basis points, we can say the market is pricing in a default rate on bonds of 8.65%.
As you can see below, during the downturn in 2001-2002 and in 2008-2009, default rates approached, and on some indexes, surpassed 10% (real defaults black line).
If we wanted to know where spreads would be if default rates got to this level again, we would just reverse the formula above.
Credit spreads = implied default rate * ( 1- recovery rate)
So, 10% * (1-40%) = 6.00%....We can expect credit spreads to reach 600 basis points.
Clearly, if the average high yield spread is 971 basis points during a recession, the market is factoring in a higher default rate.
This is where investor psychology comes in. Because of many different factors besides pure defaults, usually during a downturn, investors factor in much higher defaults then what actually happens. Fear is very powerful in down markets.
Luckily for high-yield bonds, you have math on your side.
As Michael Milken stated, buying high-yield bonds is not like buying a stock.
“With a stock, its value is generally dependent upon investors collective perceptions of the future. No matter how much research you have done regarding a particular stock, you don’t have a contract as to what the future price will be. But with a high yield bond there is a date certain in the future when it matures, and if you hold it to maturity and your analysis is correct, you will be correct in your calculation of your yield - and you do have a contract as to future price. One is certain if you are right. The other is not.”
Why do we Like High Yield Bonds?
Historically, high-yield bonds are half the risk of US equities.
The benefit of high-yield bonds over stocks is the protection the coupon or yield provide you along with the return of some capital in the case of a default.
Currently the yield on teh high yield index is 8.46%.
To get a negative return in high yield bonds over the next 12-months, we would need to see spreads move more then the 8.46% or 846 basis points.
If the average recession high yield spread is 971 basis points and today we are at 519 basis points on spread, if we faced a normal recession, we would lose 4.52% on spread (9.71% - 5.19%).
Since our yield today is 8.46%, we would still have a positive return of 3.94%, all else equal, if we have a normal recessionary spreads in high yield.
For us to lose money over the next 12 months, all else equal, we would need spreads to get to 1,365 basis points!!!! (8.46% + 5.19%)
We have only seen spreads at that level once since 1986. That was during the Great Financial Crisis.
If we tie this back to equities, since high-yield bonds on average are half the risk of equities, to lose on high yield over the next 12 months, we would need the equity markets to be down almost 17% from this level today.
The S&P 500 is down 18% year-to-date.
To get a negative return on high-yield bonds over the next 12 months, we would need to see the S&P 500 down 35% or more, all else equal.
Looking at the max drawdowns for the S&P 500 since 2008, we would need to see a market like the COVID 2020 downturn or a market like 2008, when the world financial markets were days away from total collapse.
If you are looking for a good risk-adjusted return today in the marketplace, high-yield bonds are hard to beat.
This is why we have been and continue to be significantly overweight in this asset class.
We have no idea what the future holds or how this current economic downturn will play out, but if we use history as our guide we can clearly see that it would take a significant downturn in both the economy and stocks for us to print a total negative return number in high yield over the next 12-months.
What Ever Happened to the Kid on the Bus?
After Milken read the paper from W. Braddock Hickman, he wanted to put his thesis to work.
He made a deal with his friends and eventually his employer, Drexel Burnham. As stated in the book Preditor’s Ball.
His firm initially gave him $2 million to start.
Milken quickly became one of the most powerful men on Wall Steet.
His secret was understanding the power of being a bond holder. As he stated to a companies CEO.
Preaching his vision to the street, Milken was able to create a new market where investors were able to get higher yields on their investment and smaller companies were able to get access to billions of dollars in capital.
It was a win-win all around. It was also one of the reasons teh 1980’s growth we saw was so spectacular. companies who where starving for capital where finally able to get it. On the back of the new market called high yield bonds, M&A and growth on teh back of debt exploded.
The US Government helped companies make the decision to use more debt because of the tax code.
From a market worth just a few million dollars when Miken started, it grew to over $2 billion by 1992. Today the high yield market is worth $1.4 trillion and has led to other markets for smaller companies like leverage loans, CLO’s, and private capital.
By the time the move Wall Street came out in 1987, Milken was the top dog on the street. Gorden Gekko’s character in that movie was inspired by Michael Milken.
But like all those before him with a relentless drive for money at the expense of all else, Milken eventually fell victim to his own ego and narcissism
In 1990, Milken pleaded guilty to six felony counts, including securities fraud, mail fraud and aiding in the filing of a false tax return. He was fined $600 million and sentenced to 10 years in prison at a minimum-security facility but was released after serving two years and cooperating with government investigators.
I hope you all have outstanding and blessed Labor Day Weekend.