The legendary investor and philanthropist Sir John Templeton coined the famous phrase “The four most expensive words in the English language are ‘this time it’s different’". While this is repeated so often that some investors have grown tired of it, we believe the year-to-date sell-off in high-yield markets is indeed different to previous ‘risk-off’ episodes: And for the first time in recent memory, the asset class is now offering true convexity and substantial upside potential from event risk.
A quick recap: In the last few years, with the short exception of spring 2020 (during the outbreak of Covid), high-yield bonds have traded near or above par, meaning that significant upside was difficult to achieve. This is because when an issuer calls its bonds, it will pay investors the face value and a premium plus accrued interest, limiting the upside potential even if fundamentals improve further. Consequently, investors were left with much greater downside risk from adverse events (which fortunately proved a rare occurrence). Even when market conditions were unusually favourable, high-yield investors rarely received much in terms of significant price appreciation. However, with the recent substantial correction, the profile has changed so that, by the end of May, approximately 25% of bonds rated BB traded at a price of 90 or below, which is close to the highest level since the financial crisis of 2008. Also, only roughly 6% of the market is call-constrained compared with an average of over 40% since 2011. This means that only 6% of bonds trade at prices above the one of the next call.
As such, the current environment enables investors to benefit from significant event risk, which typically comes in the form of mergers and acquisitions. For example, when a high-yield issuer is acquired, a so-called ‘change-of-control put’ is usually triggered, so that the investor has the right to sell bonds back to the company at a price of 101. Until recently, that option was often not very attractive as bonds traded above that level. Since the sell-off, we have seen multiple situations where bonds have jumped on acquisition announcements to reflect that optionality (e.g. Twitter, Tenneco, Nielsen). Using Twitter as an example, rating agencies expect downgrades of several notches as its debt would likely rise substantially in case it is taken over by Elon Musk. Without such a change-of-control put, its bond price would drop to reflect the expected worsening of the financial position, hence the value of this provision becomes obvious. Sometimes investors will benefit even more as the issuer chooses to exercise the ‘make-whole provision’, meaning that the issuer will pay off remaining debt early. The investor is hence compensated for the remaining coupon payments on top of receiving back the principal. This will typically result in prices well above 101. We expect further such situations, providing investors with attractive opportunities.
Other recent events that showcase the value of convexity include partial calls (American Axle), the use of a ‘sinking fund’ (Tullow Oil), and bankruptcy (Talen Energy). It may seem a bit strange to speak about the value of convexity in the case of a bankruptcy, but in respect of secured debt, as was partly the case with Talen, a bankruptcy filing can often trigger the start of a process that leads to the repayment of the bonds at par. Consequently, in each of these varied situations, the returns for investors would have been lower or even negative if the bonds did not exhibit convexity from trading at or below par.
In short, the high yield market will likely continue to show high volatility in the coming months as numerous risks remain in focus. Nonetheless, the value of convexity is becoming increasingly apparent. With spreads and yields near or above their long-term averages (and above medians), combined with below-average default rates, the case for high yield is beginning to look compelling.