Let’s Spot A High Yield Bubble!

The Times and the Journal today are pretty excited by the new high yield bubble and I guess? What is the deal with high-yield yields being not as high as high-yield yields have been in the past, yield-wise? The answer may be giddiness:*

“In a yield-starved world, high-yield bonds are right now the only game in town,” said Les Levi, a managing director at the investment bank North Sea Partners. “The market is giddy.”

How giddy? 5.375% giddy, that’s how giddy:

The $700 million bond Nuance Communications sold last week looks like a textbook high yield deal, except it doesn’t have the yield. … Underwriter Barclays managed to squeeze 5.375% yield out of the fund managers who bought the eight-year deal. That’s almost half the 9.55% average of Barclays US Corporate high yield index since 2002 and is right above the 5.1% average yield of the bank’s investment grade bond index over the same time period. The average interest rate – or coupon – on new junk bonds over the past 30 years has been 11%, according to Thomson Reuters. …

But the top determinant of high yield bond performance, the default rate, is headed the other way. The trailing twelve-month default rate rose to 2.7% in July from 2% at the end of 2011, according to Standard & Poor’s. The rating agency expects defaults to hit 3.7% by this time next year, within hailing distance of the 4.5% 30-year average for speculative-grade bonds.

Because I was bored I went and modeled that Nuance deal in a stupid way. Here is my model. The key assumption is the default rate**: if you assume that Nuance’s probability of default is 2.7% a year over the next 8 years, then this bond is worth about 106 cents on the dollar and not bubbly at all; if you assume 3.7% then it’s worth 99 cents on the dollar and so is fair-ish; and if you assume 4.5% then it’s worth about 93 cents on the dollar and you should stay the heck away.

What should you assume? Well, that Journal article gives you those three data points, with 4.5% being the long-term average for junk bonds and 2.7% being the current run rate, but remember that Nuance’s bond is rated Ba3/BB- so it should do a bit better than that. S&P has a more nuanced (HA!) transition matrix here; over the last 30 years about 1.3% of BB- bonds have defaulted within twelve months (though another 13% or so have moved to lower ratings).*** At a 1.3% annual probability of default, this Nuance bond is a steal, worth almost 117 cents on the dollar.

Obviously I am not going to go around predicting the future of junk bonds. I don’t need that kind of risk; all my money is safely tucked away in Great Idea Corp. And obviously there is much going on in the world besides default risk – FT Alphaville the other day put up this note from Citi arguing that ~100% of the BBB spread to Treasuries is due to macro factors and ~0% is due to default risk which, what?, okay:

DealBook gives the last word to Les Levi of the giddiness worries, saying “This could pave the way for some heartbreak down the road.” Sure, why not. One thing to think about the Great High-Yield Bubble of 2012 is that it doesn’t look like a bubble in high-yield bonds. That Nuance bond is trading at around 101.5 today, per Bloomberg, which implies on my dopey math an expected annual default probability of 3.3% – two percentage points above S&P historical BB- default rates.**** That does not sound like a market that is totally blind to the risks of high-yield issuers, or that has put a lot of faith in this-time-is-different-ness. Rather, it sounds like a market that is just really really used to low (risk-free) interest rates and expects them to continue for quite a while. Which they probably will. But if there is heartbreak to come, that’s where it’ll probably come from.

An idiot builds a bond model [Google Docs]
Risk Builds as Junk Bonds Boom [DealBook]
Taking the High Out of High Yield [MarketBeat]

* Here is another explanation:

The record-low yields in the junk bond market are a function of several factors.

First, they reflect the low-interest rate world that has persisted since the crisis. Treasuries are the benchmark for pricing high-yield bonds. Investors receive a higher interest rate for junk bonds, a so-called spread over Treasuries, because the risk of default is higher. And since interest rates on government bonds are so low — the 10-year Treasury is paying a paltry 1.8 percent — companies do not have to pay as much on their bonds.

Yields on junk bonds have also declined because the price of a bond moves inversely to its yield. So as junk bond prices have appreciated, yields have dropped. The return on a bond is made up of its interest rate and price appreciation.

What would you do if your analyst said this to you?

You: Why are junk bond yields down?

Analyst: Because prices have gone up, and prices move inversely to yields.

I feel like in his first week on the job I’d be nice (“Okay, great, well put. Now: why have prices gone up?”). After that, not so much.

** Another key assumption is the risk-free rate used to discount the default-risked cash flows. You don’t have to trouble your pretty little head about it in the model, since I’m using Libor swap rates pulled from Bloomberg this afternoon. But, of course: why would you discount at Libor? Anyway. Your life will not change dramatically if you discount some other way.

Also big: I sort of assumed zero recovery on default, why not. If you throw in a market-standard 40% recovery these bonds start to look great.

*** Here is the matrix; read across from any rating to see what % of bonds with that rating were at whatever other rating within 12 months. D is default:

You could of course build a much better model than mine using these matrices – my model implicitly assumes BB- or whatever forever with a potential jump to default each year, which is dumb – BUT THEN: if you wanted to do that you probably already have a better model and don’t mess around with Google Docs, so.

**** Or like 5.3% implied default rate if you assume 40% recovery on default.

(hidden for your protection)
Show all comments

137 Responses to “Let’s Spot A High Yield Bubble!”

  1. Dan Bricklin says:

    How do you unhide columns in google docs?

  2. Guest says:

    Someone needs to tell Benny Boy at the FED to stop Blowing!

  3. Guest says:

    What are we going to do with all that Junk and that Junk inside that trunk?

    BarCap MD

  4. guest says:

    Is it just me trying to go through my terminal or does the google doc not work for anyone else?

    -Guy not sure if he can call IT on this one

  5. Guest says:

    Read Only? Come on Matt…

  6. Lets Not says:

    Lets not!

  7. Guest says:

    Matt – loving the TLDR in the tags.
    Let's get those up to the top of the article and we'll be golden

  8. guest says:

    Dopey math? Like an eighth is $30 and a quarter is $50?

  9. Wire says:

    Best part is seeing the dozen or so other people all clicking around in the spreadsheet.

  10. Guest says:

    Matt, have we met?


  11. Guest says:

    i get a YTM adjusted for default risk of 1.877%. (US 10 year 1.84%.) seems like a tiny spread to account for downgrade risk, liquidity risk etc. vs. the 10 year.

  12. Guest says:

    Matt, funny caption on the first picture, keep it up!

    – Guy who pays attention to details

  13. mr. McKnuckles says:

    I appreciate the math, but still not sure it's an awesome idea to lend at 5.4% to an over-leveraged company that runs around spending all their cash flow buying up "high tech" outfits like Dictaphone.

  14. Hyperinflation says:

    Could be a problem

  15. Guest says:

    I would say recovery will be more than 0 on this one.

  16. Festoon says:

    The download is full of midget porn. What gives?

  17. Guest says:

    Hey, Matt? Hi, this is Fitch. Um, are you by chance looking for a job?

  18. Guest says:

    Building models without the NPV function or use of the F2 key would drive me crazy. I don't know how you do it Matt.

  19. Guest says:

    Am I the only one who reads these articles and yells at the (non-responsive) author through the screen: high yield spreads are no where near record lows? I realize that explaining spread takes a bit (but only a little bit!) more time in an article, but why does everyone obsess ONLY over yields in these articles?

    Seriously: the index is at ~600 spread, which isn't that far off the long run average for the universe. It's not like we're back in the crazy, bubbly 2005-2007 period where yields may have been higher but spreads were hilariously low.

    • guest says:

      thank you. with rates at all time lows it doesnt make much sense to look at pure yield.

      • Mordecai says:

        negavitve expected returns? we de-risked by leverage

        negative margins? we made it up in volume

        -LEH Bubble Quant Analyst

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    Too much math, need to call the Whale to explain it to us.

    — Jamie D.

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    We will just blame and tax wall st when the bubble bursts

    – Barack Obama, Ben bernanke, Tim geitner

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