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Potential Crash in the High Yield Space: Anyone Here Getting Ready to Profit?


BargainValueHunter
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Not saying that HY is a coiled spring like CDS on mortgages in 2006 but...

 

http://www.distressed-debt-investing.com/2013/01/the-high-yield-market-is-completely-out.html

 

The yields on fixed incomes securities have declined markedly, and in many cases they're the lowest they've ever been in our nation's history. Yield spreads, or credit risk premiums, are fair to full - meaning the relative returns on riskier securities are attractive - but the absolute returns are minimal. I find it remarkable that the average high yield bond offers only about 6% today.

 

Daily I see my partner Sheldon Stone selling callable bonds at prices of 110 and 115 because their yield to call or yields to worst start with numbers - 'handles' - of 3 or 4 percent. The yields are down to those levels because of strong demands for short paper with perspective returns in that range. I've never seen anything like it.

 

As was the case in the years leading up to the onset of the crisis, the ability to execute aggressive transactions indicated the presence of risk tolerance in the markets. Triple-C bonds can be issued readily. Companies can borrow money for the purpose of paying dividends to their shareholders. And CLOs are again being formed to buy leveraged loans with heavy leverage."

 

http://4.bp.blogspot.com/--YqWjchcjIw/UJ7TGxZYr_I/AAAAAAAATCQ/juHuxkHvp2M/s1600/HY+Index+yield.png

 

http://soberlook.com/2012/11/2012-high-yield-debt-issuance-hits-all.html

 

We are, however, starting to see some signs of speculative primary market activity. According to JPM, six toggle notes have been issued in October ($2.6bn). These are debt securities that give borrowers the option to skip coupon payments, increasing the face value of the debt instead (payment in kind or PIK). It is roughly the corporate equivalent of option ARM mortgages.

 

Also October saw 11 so-called dividend deals in which the proceeds from a bond sale are used to pay a dividend to the shareholders. This is considered a more risky transaction because rather than using cash to refinance existing debt or acquire a business, the company simply pays it out, causing its leverage to increase.

 

In the mortgage world this is the equivalent of using a home equity loan to take a vacation rather than to put an addition to the house or to repay credit card debt. In spite of some of the more risky transactions, on average the deals have been far less speculative in nature than during the 2006-07 period. This trend of potentially loosening lending standards (such as toggle notes or dividend deals) in the leveraged finance markets will be important to watch going forward.

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Given that HY performs similar to equities, perhaps like a low risk equity, if you see a HY bubble crashing, would you make the same prediction for equities then?

 

Essentially, I don't see that they are in a huge bubble as their performance has very much been in line with Large Caps. But I could be wrong I suppose, in which case, there should be a nice buying opportunity...

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Companies can borrow money for the purpose of paying dividends to their shareholders.

 

This has always baffled me. It happens a lot, but how can an efficient market ever tolerate a stock that borrows money just to pay out a dividend? The stockholder has spare cash to invest in the stock market, yet at the same time borrows money from the bank (through the company) to provide a stream of cash. Yield pigs .. ?

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Yeah, but there's a slight difference here: Microsoft has a great ROIC, their business is stable so they can (should) leverage up a little. They should do this regardless of the dividend policy. The article mentions companies who borrow with the purpose of paying dividend. That's something different. If you have to borrow just to pay out a dividend, you shouldn't do it. Unless you have some nice options and you want the yield-hungry investor to drive up your stock price.

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Guest wellmont

Companies can borrow money for the purpose of paying dividends to their shareholders.

 

This has always baffled me. It happens a lot, but how can an efficient market ever tolerate a stock that borrows money just to pay out a dividend? The stockholder has spare cash to invest in the stock market, yet at the same time borrows money from the bank (through the company) to provide a stream of cash. Yield pigs .. ?

 

because they don't Actually borrow to pay the dividend. they are optimizing the capital structure. most companies that do this have balance sheets and business models that can support this. costco just did this I believe. Intel just did this. if you are not over leveraged it makes perfect sense to put some leverage on at 3%-4%. if not now, when?

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the article mentions companies who borrow with the purpose of paying dividend. That's something different. If you have to borrow just to pay out a dividend, you shouldn't do it. Unless you have some nice options and you want the yield-hungry investor to drive up your stock price.

 

market has "dividend fetish".....pretty much the only justification then...

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I have 2 comments. First, although the absolute yield looks low the HY OAS to treasuries is closer to 500 bp which is closer to normal.  The historical OAS lows were closer to 250bp in 2005 to 2007.  Second, a way to take advantage of the market is to issue debt at a low yield to buy equity at a higher FCF yield.  Sort of a do-it-yourself capital structure arbitrage.  I see this in some radio and TV firms via purchasing FCF generating assets with low cost debt and shielding existing FCFs from taxes. 

 

Packer

 

 

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Guest wellmont

I would like to go back to BargainHunter's original comment.  How do we take advantage of high yield corporate bonds being highly priced?  Short sell high yield bonds?  Very hard to borrow for a retail investor.

 

i would short hyg, but not yet. that has all the overvalued bonds in it because of the etf structure.

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