High Yield Bonds as Equity Indicator

The management team of a new high yield debt fund at First Eagle have a commentary/interview out where they talk about how they look at the credit cycle, how they construct their portfolio and what makes them buy or sell new high yield bond positions.

The whole thing is worth a read (PDF in link below) but I liked this passage about how high yield debt both leads common stock price performance and can even be less risky than the stock market in some instances.

Here are fund managers Edward Meigs and Sean Slein talking stocks and high yield…


What is relevant about high yield to equity investors?

The high-yield market is relevant for equity investors from the perspective that it can
give you clues as to how open the credit market is, how much risk investors are willing
to take at any given point in time and, essentially, trends within the economy—which
sectors are doing well and which are not doing as well.

We think the high-yield market specifically and the fixed-income market generally will
lead the equity markets, just on a macro level. For example, in late 2008, the highyield
market began to recover as the primary market opened up and investors began to
dip their toe in the water and add risk to their portfolios.

The equity market did not begin its recovery until early March of 2009, while the
high-yield market was in recovery for probably two and a half months before that.
Conversely, back in June of 2007, the high-yield market had reached its tightest level
as far as its spreads to Treasuries for the cycle and began to incrementally widen out,
beginning in late summer and early fall, which led the equity market by another three
to four months. The equity market peaked in October of 2007.

High yield can be a leading indicator because in high yield your upside is capped to
the coupon that you’re receiving and the par level of investment that you’re going to
receive back, hopefully, at maturity. So high-yield investors are certainly interested
in how their companies do quarter by quarter and year by year. Any deviation from
expectations will lead to immediate reaction amongst investors as to what risks a
company may have.

With equities, on the other hand, since it’s a residual claim and since you can hold
them much, much longer your upside is theoretically uncapped. So equity investors
tend to perhaps be a little bit more patient if a company misses a quarter or two, where
many high-yield investors will seek to transition out of companies fairly quickly when
they see performance begin to erode.

Are you saying that high yield could potentially be less risky than equities?

If we speak historically, we should first point out that the high-yield market is only
approximately 25 or 30 years old.

Although there have been a similar number of down years in the equities markets and
the high yield market, the intensity of the decline is what is noticeably dampened in
high yield. Let’s look at 2008 as the example—the worst-performing year in the past
25. The Barclays Capital U.S. Corporate High Yield Index declined approximately
27%. The MSCI World declined 41%; the S&P 500 declined 37%.

A reason for that is the coupon. The coupon may provide a cushion, whereas a stock
may not pay any dividend at all.






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