“Equities with Coupons” is a cynical description of high yield bonds. The expression, like many of its kind, contains more than an element of truth. Usually it’s invoked when trying to illustrate the risk of owning bonds priced near par. You may collect your coupons and see your bond mature at par if things go well or, if they do not, you could end up with a severely depreciated or worthless piece of paper, suitable only for framing. The flip side of being a par holder of high yield bonds, one who bought their paper at issue price, is being a buyer of junk when it is stressed or distressed. Such buyers often are rewarded with strongly positive returns that rival those of the stock market. Given the fall in the junk bond market over the last several months, it may be time to think about whether it’s safe to go back in the water.
During the 30ish year existence of the high yield market, most negative returns have been moderate and have been followed by extremely strong rebounds. Two exceptions stand out: 1) the global financial crisis, which saw severely negative returns before a strong rebound and 2) the period from late 1998 through 2002 which saw an extended run of low and modestly negative returns before strong returns kicked in. Today has similarities to the turn of the millenium scenario. We are not going through a systemic crisis as we were in 2008-09.
Back in the day of Y2K, there was a lot of fixed investment in equipment related to the build out of the internet. From about 3% of GDP in 1990, investment in information processing equipment and the like rose to 4.75% at the end of 2000. It came down in the subsequent bust. Infotech investment has stayed higher than it was prior to the tech boom, but has not revisited its peak levels.
During the tech boom, cable companies and telecom companies issued immense amounts of debt. Many of these firms went bankrupt, restructured their debt or made adjustments in their underlying businesses to survive. The workout took several years.
The high yield market performance reflected that drawn out process, but in the end it turned in a very strong performance. There were many companies that had built infrastructure using unrealistic assumptions about the returns. Once these companies capital structures were scaled to the actual returns that they were able to generate, the restructured bonds and the bonds of restructured companies performed extremely well. It was a triumph for distressed investing, for those who had the grit to buy bonds cheaply and hold them through the volatility.
Now we have a high yield market that is coming apart because of what has turned out to be overinvestment in oil and gas production and basic materials production. Like infotech investment during the tech boom, commodity oriented invesments have surged. Mining and oilfield machinery investment rose to 0.19% of GDP in 2012, echoing, but not quite reattaining its peak of 0.24% from 1981.*
Now non-agricultural commodity prices have crashed and taken down the junk bond market with them. Many companies in the US and around the world have been hit hard by this disaster.
In the US, the affected companies will restructure themselves to reflect the new realities of commodity markets or they will be restructured by their debtholders. As resource companies’ capital structures and operations are adjusted to reflect the new realities their stressed and distressed bonds will rally.
How long will this take? It is hard to say. Perhaps it’s worth sticking a toe in the water.
* I realize that the oilfield equipment investment numbers are small. I am assuming that they comprise a small part of the investment in oil and gas exploration, production and infrastructure. I did check the BEA data to be sure that their scale was correct. On a related note, US non-financial corporate debt to GDP is at a similar level to where it was when the last few large junk bond selloffs occurred.