Professor Edward Altman Discusses Fallen Angels
To view Professor Altman's outlook on high-yield bond markets, please click here
FRAN RODILOSSO: Hello, I'm Fran Rodilosso, the Senior Investment Officer for Fixed-Income ETFs at Van Eck Global and its Market Vectors unit. I'm honored to be joined today by Professor Edward Altman. Ed is the Max L. Heine Professor of Finance at the NYU Stern School of Business. He has been considered a leading authority on high yield, distressed debt, and credit risk analysis for more than 30 years. Ed has also been a visiting professor at leading universities around the world and he has been a consultant to both public and private institutions, including central banks and some of the largest hedge funds in the world. He has testified before Congress; after the 2008-2009 crisis, he testified about the events of the crisis and the government’s response. Ed, thank you for joining us today.
EDWARD ALTMAN: My pleasure.
RODILOSSO: Let's talk about the high-yield market in general first, i.e., the broader high-yield market and current valuations, where we are in 2014 after somewhat mild returns. Is the market particularly rich or particularly cheap at this point in time?
ALTMAN: In the near term, I would say the market is fairly priced in terms of still expecting lower default rates, higher recovery rates on the defaults, and interest rates not likely to rise very much in the near term. Spreads of close to 500 basis points, which is near the historic average, likely make the market fairly priced. I would not have said that a couple months ago. As you know, in general, high-yield bonds have not done well in the last couple of months, dropping by around 3% or so from their high of the year. That's not true of all parts of the market. In the short term, I would say that it's fairly priced. What I am concerned about is the middle term and longer term, with respect to the outlook. Perhaps there the market is a little too pricey.
RODILOSSO: When we talk about the high-yield market, I mean one market: the high-yield market and whether it is rich or cheap. There are, however, different credit qualities within the high-yield space. Should investors consider that? Should they think about whether their BB holdings are in better shape from a short-to-medium term perspective versus their CCC or vice versa? Should investors look more deeply at their funds and their holdings?
ALTMAN: Absolutely. The market is not one simple bond or security. It is quite large at close to $1.5 trillion by my estimate. Additionally, it involves not only the different spectrums of ratings, from BB down to CCC, but also the higher quality end, including fallen angels, which are companies that at one time were investment-grade. They're usually in the BB range. You have the more risky segment, the B-, CCC range, which is also something I'd like to get back to with respect to the current new issuance in the market. There's even distressed high yield, which I'd like to differentiate from high-yield distressed. It is still paying coupons on time unlike defaulted distressed, which comprises companies that are not.
RODILOSSO: We discussed the potential turn in the credit cycle, which you define as default rates moving above the historic average.
RODILOSSO: Think about a different part of the credit spectrum: the crossover part of the universe, where lower rated investment-grade bonds get downgraded to high-yield status. They're subsequently called "fallen angels." Given your view for 2015, 2016, and beyond, you would think if and when the cycle does turn, you'd see an increase of supply of fallen angels.
ALTMAN: Definitely. It's not just the high-yield market that's going to suffer in a period of stress. The fallen angel market, which is about 12% now of the total high-yield market, will definitely grow. Historically, it has been between 15% and 25%. Now it's below the historic average, mainly because interest rates are so low and there haven’t been that many downgrades in the last few years. It’s going to grow. Then you have to look at the risk of these relative to the risk in the market. Historically, high-yield bonds have about a 1% per year higher default rate than fallen angels. I mean original issue high yield versus fallen angels. While it’s barely statistically significant, 1%-1.5% is the default rate for fallen angels. In a market such as today's market, where there are negative forces with respect to returns, generally the higher quality segment of the market will do better than the lower quality segment. Usually a fallen angel has dropped from investment-grade, maybe BBB to the BB range, and constitutes the higher quality part of the high-yield market. I think this year this phenomenon is illustrated very clearly. From what I've been able to observe, fallen angels are up 7%-8% this year, whereas the overall high-yield market is up 2%-3%.
ALTMAN: That's not just by chance.
ALTMAN: There's something about the higher quality segment that appeals to investors in an increasingly stressed market.
RODILOSSO: I’d like to share a couple of numbers. The BofA Merrill Lynch US Fallen Angel High Yield Index that Merrill Lynch created more than a decade ago has outperformed the high-yield market in, I believe, seven out of the last ten years.
RODILOSSO: It's currently about 78% BB, BB-, and BB+.
ALTMAN: That’s interesting.
RODILOSSO: The broader high-yield market is about 46% BB. Also, back to your comment about CCC issuance, some fallen angels do keep falling; they become "falling knives," as people like to say.
ALTMAN: I call them "broken angels."
RODILOSSO: The CCC and below component of the angel universe is about 4%, I believe, and it's almost 15% for the high-yield universe.
ALTMAN: It's not surprising in the sense that it takes a while for something that is BBB to go to CCC, although there has been some evidence of that in the mortgage-backed securities market.
ALTMAN: It doesn’t usually occur in the corporate bond market. It's usually a steady drop if it happens at all and therefore I'm not surprised that it's a very low percentage of fallen angels that are CCCs.
RODILOSSO: I think the numbers are 4.6% versus 14.9%.
ALTMAN: That's quite a difference.
RODILOSSO: Fallen angels, I should also mention, because they're a higher credit quality, are typically a tighter spread. They're going to have a little higher sensitivity to interest rates. Since many of them were originally investment-grade bonds, they tend to have a longer term to maturity.
RODILOSSO: It's a longer duration index. Certainly the interest rate component has helped fallen angels versus the broader high-yield market this year.
RODILOSSO: Apparently, the credit quality has also.
ALTMAN: Yes, the double issue. From the investor standpoint, that's wonderful in the distressed period. We would need to analyze what the inverse of that is, in terms of very positive less stressed markets. Will the fallen angels still outperform? If they don't, it's almost like being a value investor in the high-yield space, which is the mantra for value investing in equities. You're going to do better in down periods but perhaps not as good as in really up periods. Overall, however, you do very well and sleep better at night.
RODILOSSO: Ed, is there anything else you would like to add about your outlook over the short-, medium-, and long-term for the high-yield or defaulted distressed markets?
ALTMAN: To summarize, I think short term, i.e., over the next year to 18 months, we're talking about 2.5%-3% default rates, which is lower than the historic average. I think the default rates will then spike, particularly with respect to industries such as energy, retailing, healthcare in some cases, and export related to countries that are having trouble. The default rate in the medium term could then be 4%-6%. Then all bets are off if you have a combination of deteriorating economic performance and these higher risk new issuance. It may be 8%-11% in the 2.5-4-year range.
RODILOSSO: I can't thank you enough for taking the time to join us today and offer your opinions and expertise on all these topics.
ALTMAN: My pleasure.
RODILOSSO: Thank you very much.
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BofA Merrill Lynch U.S. High Yield Master II Index (H0A0) is comprised of below-investment grade corporate bonds (based on an average of Moody’s, S&P and Fitch) denominated in U.S. dollars. The country of risk of qualifying issuers must be an FX-G10 member, a Western European nation, or a territory of the US or a Western European nation.
BofA Merrill Lynch US Fallen Angel High Yield Index (H0FA), a subset of H0A0, is comprised of below- investment grade corporate bonds denominated in U.S. dollars that were rated investment grade at the time of issuance.
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