As of today, we have hit the record high-yield bond issuance in a year. Typically, high-yield bond defaults peak three years after a new peak in issuance. With high-yield spreads so tight and Treasury yields so low, I don't blame companies that are lining up for cheap financing. But the market doesn't discriminate between good and bad credits so well when spreads are so tight, and new deals quickly oversubscribe. Managers buy now and figure it out later.
Borrowers almost always look their best immediately after borrowing money. They are liquid, and new, seemingly promising investments can proceed. By the time three years have passed, a sizeable minority of those companies will be out of cash and their ideas will have flopped.
Dividing concepts into good, marginal and bad: After three years, good concepts have made it and bad concepts are dead. Liquidity being cyclical and squeamish once defaults begin, there is no guarantee that future financing will be available at rates favorable enough to keep marginal concepts alive. The beginning of an increase in the default rate makes the ratings agencies and investors skittish, which makes raising fresh capital difficult. This is why defaults tend to come in cycles rather than evenly, over time. Marginal concepts often get pushed over the edge along with bad concepts when refinancing is hard to come by.
But managers need yield today, and will play on until things get nasty. This is just part of what makes the game of being a high-yield bond manager so much fun. You can never quite tell when the music will stop in this high-stakes game of musical chairs.
P.S. Will you be there when Cramer makes his next move?
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David Merkel Snarls in Insurance Investigation, Part 2 12/1/2004 8:59 AM EST Enforcing behavior standards in the industry will have economic, political and investment implications for longs and shorts.
David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to david.merkel@thestreet.com.
Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.
Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.
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