In Beware of the Walking Dead, we revealed an analysis illustrating those companies in the S&P 1500 that qualify as zombie corporations. As promised in the article, we are providing a full list of those companies here for RIA Pro members.
According to James Grant of Grant’s Interest Rate Observer, zombie companies fail to generate enough operating income to cover the interest on their outstanding debt. The screen we used evaluates companies based on their three-year average for that metric. Those companies highlighted in yellow in Table 1 are the worst offenders with three consecutive years of a negative zombie metric. The remaining zombie companies are in Table 2.
The list of stocks that qualify as zombies under this definition is based on Bloomberg data through Q1 2019, revealing a total of 128 companies or 9% of the S&P 1500. The listing below also includes the three-year annualized total rate of return on those stocks as well as S&P rating and rating outlook when available.
“Markets and economies, like nature itself, are beholden to a cycle, and part of the cycle involves a cleansing that allows for healthy growth in the future. Does it really make sense to prop up dead “trees” in the economy rather than allow them to fall and be used as a resource making way for new growth?”
We come back to that thought in this article inspired by the notion that investors find themselves in a forest increasingly littered with dead trees. In today’s market parlance, the dead trees (corporations) are called zombies. This article details the corporate zombie concept in-depth and provides a few examples to illustrate the topic.
The Walking Dead
It is no small irony that one year after the end of the great recession, a television show about the zombie apocalypse quickly became one of the most successful shows on TV. The Walking Dead features a large cast of “survivor” characters under near-constant threat of attack from mindless zombies, or “walkers” as they are called.
In the investment world, the term zombie has a special connotation generally referring to a company that might otherwise not be around had the Federal Reserve not suppressed interest rates for so long. The zombie label is fitting as these companies do not die as they should and at the same time, they devour capital and resources that could otherwise be used by healthy companies. They are a drain on the economy.
Although not a matter of life and death, investing in zombie companies or failing to understand the implications of their existence poses a unique risk to one’s economic well-being.
The generic description used for zombified companies is too obtuse to use to precisely identify such companies. If the suppression of interest rates served a key role in maintaining these firms, what would be the circumstances fundamental to that condition?
Corporate zombies are generally described as companies that cannot function without bailouts and/or those firms that can only afford to service the interest on their debt while deferring repayment of principal indefinitely. In our view, those definitions do not go far enough.
In a recent interview, James Grant of Grant’s Interest Rate Observer offered what seems to be the most precise definition – zombie companies fail to generate enough operating income to cover the interest on their outstanding debt. Furthermore, that condition would have to persist for more than one year to eliminate any anomalous results.
In other words, a corporation that fails to cover its interest expense can, for a time, keep borrowing to make up the shortfall, especially if money is cheap. On the other hand, true zombie status is revealed, and the “headshot” of demise ultimately comes, when the company runs out of borrowing runway. That circumstance can unfold rather quickly in an economic downturn or a period of rising interest rates when the negative differential between operating income and interest expense widens further.
Operating Income is defined as gross revenue minus wages, cost of goods sold, and selling, general and administrative expenses (SG&A). Operating income does not include items such as investments in other companies, taxes, or interest expense. Isolating the difference between operating income and interest expense is a way of comparing the revenue that a company expects to become profit versus the cost incurred for borrowed funds. It is a variation of a leverage ratio.
We analyzed the broad S&P 1500 to identify companies having zombie characteristics under Grant’s definition. Namely, does their interest expense exceed their operating income and has it done so when averaged over the last three years?
The list of stocks that qualify as zombies under this definition using Bloomberg data through Q1 2019 reveals 204 companies or 13.5% of the S&P 1500. Some of these companies do not show any interest expense but have operating income losses, so we removed those companies. That leaves 128 companies or 9% of the members of the index. Using a stricter methodology of requiring three consecutive years of interest expense exceeding operating income returns 43 companies that meet the criteria or roughly 3% of the index. These 43 companies are the worst in class of the zombie population.
While defining and identifying the zombies is a good start, what we care about is a divergence between fundamentals and valuations. In other words, we want to truly protect ourselves from the zombies who appear alive due solely to a well-performing share price. In doing this, we find that 34% of the 128 companies have positive 3-year annualized total returns. Of these firms, the average 3-year annualized return of that population through June 30, 2019, is 13.6%. There are also another 11 companies that have been relatively stable as defined by annualized total returns of zero to -5%.
Such returns do not reflect the underlying fundamentals of companies that cannot service their debt and are a recession away from going bankrupt. The graph below charts operating income less interest expense with the three-year total returns for the 128 zombie companies.
Data Courtesy Bloomberg
For the 128 companies represented in the graph, they either have weak revenue generation and/or onerous debt levels. That, however, raises another issue for consideration – just how bad is the situation if the company cannot cover the interest expense on their debt due to weak demand for their products and/or services? Equally concerning, what if there is so much debt that even solid demand for their products and accompanying revenues do not cover that expense?
Awareness of this issue and quantifying it is useful and important to help us understand the kinds of imbalances that exist in the economy. At the same time, while most zombie companies would not exist were it not for years of suppressed interest rates, those that do should be priced for the uncertainty of an economic downturn and the higher probability of their demise in that event. As mentioned, many are not. Out of the 128 companies whose operating income cannot cover interest expense, many are priced at valuations that imply they are a normal going concern.
To gain a better perspective of zombies, we selected three individual candidates to explore in-depth. As discussed, the market is crawling with these companies that bear very similar characteristics. A table of the relevant fundamental statistics for each company is shown below each summary.
RIA Pro subscribers are being provided a complete list of zombie companies beyond the three detailed below.
Rent-A-Center, Inc. (RCII)
RCII, a BB-rated company with a stable outlook, operates and franchises rent-to-own merchandise stores offering electronics, appliances, and furniture under “flexible rental purchase agreements” (lucrative financing plans). Based in Plano, Texas, they have 14,000 employees and a market capitalization of $1.3 billion. RCII stock has a three-year annualized return of 30.7% and three-year average EBITDA (earnings before interest taxes depreciation and amortization) through the end of 2018 of $51.2 million. Meanwhile, three-year average net income and free cash flow are negative $30.0 million and negative $106.2 million respectively.
Their zombie metric of operating income less interest expense was positive $18.3 million in 2018, but the three-year average is negative $69.9 million. Additionally, revenue for 2018 was the lowest since 2006 at $2.66 billion and total debt for the company increased by 52% (from $540 million to $825 million) in the first quarter of this year alone. It is hard to imagine the consumer showing enough strength to bail out the circumstances facing RCII. However, apart from us, most analysts are constructive in their outlook.
Scientific Games Corp. (SGMS)
Based in Las Vegas, Nevada, SGMS is a single-B-rated company with a stable outlook that provides gambling products and services under four operating divisions of gaming, lottery, digital, and social. The company has 9,700 employees and a market cap of $1.7 billion. Despite a significant correction since June 2018, SGMS stock has a stellar three-year annualized return of 29.2%. Given their negative earnings per share, the current price-to-earnings (PE) multiple cannot be calculated, but the expected PE for the end of the year based on earnings projections is 1,693. The company generated over $3.3 billion in revenue in 2018 but had net income of negative $352 million. The company sports a net debt obligation (net of cash) of $8.8 billion at the end of 2018.
Their zombie metric is -$332 million and has been negative every year since 2008. Despite their fundamentals, through June 30, 2018, SGMS produced a 47% 3-year annualized return showing the power and irrationality of momentum investing. The enthusiasm for SGMS revolves around the legalization and commercialization of nation-wide sports betting. Over the last ten years, insider selling dominated executive transaction flows. Our guess is they will wish they had sold even more.
The Williams Companies (WMB)
WMB, based in Tulsa, Oklahoma, is an energy infrastructure company focused on connecting North America’s hydrocarbon resources to markets for natural gas. The company owns and operates midstream gathering and processing assets, and interstate natural gas pipelines. It has 5,300 employees and a market cap of $33 billion. WMB is rated BBB by Standard & Poors with a negative outlook. Through the end of June 2019, WMB shares have a 3-year annualized total return of 14.0%. Net income for 2018 was -$155 million on revenue of $8.7 billion. Revenue grew at a three-year average of 5.7%, but net income was negative in three of the past four years. The company has net debt outstanding of over $22 billion, which is up 200% from $7.4 billion in 2011. Interest expense on that debt has exceeded operating income (zombie metric) in each of the past four years. Since 2017, insider selling of company shares was 4.4 times larger than insider purchases.
The following table compares our three zombies:
Data Courtesy Bloomberg
Loose monetary policy contributed to the financial crisis as the Fed held interest rates at 1.0% in 2003-2004 despite an economy that was rebounding and a housing bubble that was inflating well beyond its natural means. The Fed also imprudently used forward guidance to keep rates low for “a considerable period” which further prompted investors to speculate. In a troubling parallel, and proving lessons learned in finance are cyclical, not cumulative, the Fed has maintained and extended emergency policies following the crisis for nearly a decade. New bubbles have since replaced those that popped in 2008.
Upon receiving the Alexander Hamilton award in 2018, Stan Druckenmiller said, “If I were trying to create a deflationary bust, I would do exactly what the world’s central banks have been doing for the past six years.” The important point of his comment is that the deflationary episodes most feared by central bankers are caused by imploding asset bubbles. Those asset bubbles are invariably caused, in large part, by imprudent monetary policies that encourage market participants – households, corporations, and governments – to misallocate resources.
Corporate zombies are but one example. Their existence is evident, but the true extent to which they populate the market landscape cannot be known. Our analysis here reveals only the easiest to identify but rest assured, when economic twilight comes, many more zombies will be fully exposed.
Monthly Fixed Income Review – December 2018
The fourth quarter of 2018 was a bad year for lower rated, riskier fixed income products.
In review of December’s fixed-income performance as well as 2018 in general, there are a few key themes that are prevalent.
Interest rates moved higher throughout the first three quarters of the year and then abruptly reversed course and reclaimed nearly 75% of the selloff from the first nine months (5, 7, 10 and 30-year U.S. Treasury bonds).
After outperforming all other primary fixed-income sectors for the first nine months, high yield bonds collapsed in the final three months finishing the year with negative total returns.
Investment grade corporate bonds and emerging market bonds were the worst performing sectors throughout the year losing roughly 2.50%.
Without regard for the direction of interest rates, the yield curve continued to flatten as Fed policy and more recently economic concerns caused the short end (2-year Treasuries) to underperform and the long end (10-year and 30-year bonds) to outperform.
December proved exceptionally strong for safe haven securities like Treasuries, municipal securities and mortgages helping turn those categories positive for the year.
There were numerous times throughout the year when our recommendation to take a conservative tack by moving up in credit and avoiding the more expensive and riskier fixed income categories seemed foolish. In hindsight, the description foolish should be replaced with smart.
Investors can draw a bright line at September 30, 2018 as a point of demarcation. Prior to that date, high yield and other risky sectors like leveraged loans, could do no wrong while every other fixed income asset class languished as interest rates rose. With the economy humming along, employment and hiring robust and inflation concerns burgeoning, the Fed was methodically hiking interest rates. The adjustable rate of interest on leveraged loans made them attractive in a rising rate environment and the higher coupons and shrinking supply of junk bonds (high yield securities) similarly made them appetizing to investors. The last thing investors were worried about in a strengthening economy was credit related losses.
Complacency peaked at the end of September, with fresh record highs in the stock market and favorable returns from its closest proxy, high yield debt. A variety of issues have since emerged as global growth is slowing rapidly and the benefits of domestic fiscal policy move past their point of peak contribution. Needless to say, optimism is waning. The chart below shows how high-yield debt languished in the final three months while safer sectors performed admirably.
As we have expressed throughout the year, there is a lot to worry about in the world and the United States is not immune to those concerns. Concurrently, U.S. markets have assigned expensive prices to the riskiest of assets. For all of 2018, we have urged readers to adjust their investment posture increasingly toward protecting capital. Although now the second longest in recent history, the current expansion has been the weakest on record as it was mostly promoted by artificial stimulus and incremental increases in all forms of debt. Temporarily supportive of growth, rising debt loads create their own headwind and eventually lead to instability. That is in fact what we appear to be witnessing.
The optimists will say that recent underperformance sets the stage for a terrific buying opportunity and that may well be, but value investors are more discerning. The hiccup in performance in the fourth quarter is likely a harbinger of more difficulties to come as China, Europe, Australia and Japan all demonstrate weakening trends in growth and troubling strains from imprudent debt accumulation. It is important to note that approximately 40% of U.S. corporate earnings come from foreign sales.
The United States may soon face similar issues given the sensitivity of our economy to high and rising debt. To the extent that the Fed has properly chosen to wean our economic decision-making off of crisis-era policies, albeit belatedly, those assets that have been the biggest beneficiaries of such policies should also brace to bear the burden of their removal. What we are beginning to see is the lagged effects of higher interest rates and less artificial liquidity as a result – the tightening of financial conditions.
The “tell” has been the Treasury yield curve. Using the spread between 2-year and 10-year Treasury yields, 2018 provided many insights. The 2s-10s curve spread declined throughout most of the year which encompassed both rising rates and falling rates. The price of money, the basis upon which all other assets derive their projections of value, implied that there was a growing concern for rate hikes and inflation (rates up) through the third quarter and then a growing concern for a recession (rates down) thereafter.
Higher risk investment credit is likely to languish for quite some time or at least until the trajectory of the economy becomes clearer. As revealed by high yield bond performance and the direction of interest rates, the trends of 2018 are clear. Our prior guidance of moving up in to higher quality credit and into safer categories of the fixed income markets still holds.
All data courtesy Barclays
Monthly Fixed Income Review – November 2018
The price depreciation of risky assets in the financial markets continued through most of November but took a breather late in the month. The rebound in the final week provided for month-end to month-end optics that were otherwise better than what one might expect had they been watching markets transpire day-to-day.
Performance across the fixed-income sector was reflective of the recent challenges that extended into November. The list of issues included the sell-off of General Electric stock and bonds, Brexit uncertainty and the devastation and financial uncertainty associated with the California wildfires. The market reaction to these events has been justifiably imposing and leaves investors to consider the anxiety-inducing potential for contagion risk.
Money flowed into the safety of Treasuries, mortgages and municipal securities (Munis) and out of corporate bonds and emerging market bonds. As for year-to-date performance, only munis and high-yield corporate bonds are positive at this point, and in both cases, just barely. All other sectors are negative.
ETFs performed similarly but the Muni bond ETF, unlike the index, is now negative on a year-to-date basis. Somewhat surprisingly and concerning, the emerging market ETF (EMB) is down almost twice the index (-7.24% vs. -3.79%) on a year-to-date basis.
Corporate credit spreads widened meaningfully in November largely offsetting the decline in Treasury yields. Investors appear to be contemplating an imminent slowdown in corporate earnings growth and the associated rating implications. This will be an important story to follow given the large percentage of companies that are BBB, and near junk status. The decline in crude oil prices, down -33% from the early October high, among other languishing commodities raises further concerns about a broader global growth slowdown.
Looking in detail at high yield sector spreads, the best junk rating (BB) widened only modestly (+85 bps) off recent tight levels while the worst rating (CCC) widened substantially (+255 bps).
Considering the drop in the price of crude oil in recent months, an evaluation of the relationship between high yield spreads and oil prices is informative and troubling. As shown in the chart below, crude oil prices below $50 over the past four years are associated with significantly wider high yield spreads.
Finally, there has been a lot of recent discussion about various yield curves beginning to invert. In U.S. Treasuries, the 2y-3y part of the curve is now imperceptibly positive (less than 1 basis point), and the 2y-5y curve is slightly negative. Treasury yields and various curves are highlighted below.
In recent history, an inverted yield curve has implied the eventuality of a recession. Based on the financial media and research from Wall Street, the current yield curve trends are becoming worrisome for investors. While there are good reasons for an economy so dependent on activities associated with borrowing and lending to succumb to an inverted curve, the anxiety being projected is probably more troubling at this stage than the early phase of this event. It is important to watch but should not be a major concern just yet.
Given the volatility in stocks and other risky assets in the early days of December, it remains unclear whether investors should count on the traditional healthy seasonal performance to which they have become accustomed. Uncertainties about the economic and geopolitical outlook loom large, urging a cautious approach and defensive posture in the fixed-income sector. Safer sectors, such as Treasuries, MBS and munis might continue to benefit if recent market turmoil continues.
Data source: Barclays
Monthly Fixed Income Review – October 2018
October 2018 was decidedly a “risk-off” month and posed a challenge for every asset class within the fixed-income market. In terms of total return, U.S. Treasuries performed the best (down -0.48%) while investment grade corporates, high-yield and emerging market bonds all posted losses of over 1%. For emerging markets, it was the worst monthly performance since November 2016 and for high-yield, the worst since January 2016. Year-to-date, however, only the high-yield sector remains positive up +0.96%.
A new addition to the monthly fixed-income review is a composite of spread changes as seen in the table below. The data in this table are option-adjusted spreads (OAS). Positive numbers reflect spread widening or higher yields relative to the benchmark which is what normally occurs in months of poor performance. Negative numbers are spread tightening which is constructive. The OAS is measured in relation to the U.S. Treasury benchmark curve.
As illustrated in the table, most OAS spreads are wider across every time frame but not dramatically so. The fact remains that in a historical context, spreads remain very tight to the benchmark. As a point of comparison, current high-yield spreads are 3.71% (371 basis points) above the benchmark curve. In January 2016, they were 7.33% above the benchmark.
In a rather unusual turn of events, despite the sell-off in equity markets, Treasury yields uncharacteristically rose. Over the course of the past 30 years, when we have seen stress emerge in risky assets like that which occurred in October, U.S. Treasuries experience a flight-to-quality bid and yields fall. One could argue that October was an anomaly, but the same thing happened this past February and March.
This irregular relationship may be due to one of a couple of factors, some of both or another unidentified dynamic. Either (1) the correction in equity markets did not stir investors’ fear of a deeper correction given the strength of the economy or (2) on-going concern about heavy U.S. Treasury supply prevented yields from falling. In any event, it is highly unusual and may represent a troubling change in the contour of the markets. The absolute level of interest rates remains low by historical measures but after nearly 10 years of zero-interest rate policies and little volatility, it is the change in rates that matters most to investors and borrowers. Similar increases in rates in prior periods were destabilizing to the equity markets.
The implications of higher interest rates are beginning to show in housing and auto activity. Neither industry, both vital to economic growth in the recent expansion, is collapsing but both are demonstrating a clear weakening trend. In the modern age of excessive debt, this is how topping markets typically progress.
October unveiled another bout of higher volatility, higher interest rates and falling asset prices. This may be a temporary setback but given the age of the cycle, how tight credit spreads are, and the economy’s dependence on debt, we would not advise throwing caution to the wind.
Election Night Cheat Sheet
Historically, the last two years of a president’s term have been great for stock investors as shown below. We can blindly follow history and hope that this is once again the case, or we can examine the facts in front of us and decide if there is reason to be suspect.
Public policy matters to markets and the economy and as a result a significant determinant of the next two years depends on what happens tonight. While the pollsters from both sides of the aisle are claiming victory, the fact of the matter is no one knows what this election may bring. Trump proved the pollsters wrong two years ago and we have little reason to believe they have it right this time. The results depend heavily on the much anticipated “Blue Wave” and whether Democratic turnout can offset the successes, economic and otherwise, of the Trump administration’s first two years.
The question of whether or not the Republicans can keep control of the House and Senate has vast implications for the economy and markets. The following Cheat Sheet provides our latest thoughts on three election result scenarios and what each might mean for the stock and bond markets as well as Federal Reserve policy, the U.S. dollar and economic activity. Please click on the picture to enlarge it.
A Preferred Way to Generate Yield – Part 2 Trade Idea
The following article expands on, A Preferred Way to Generate Yield, by exploring the preferred shares of Government Guaranteed Agency-Backed Mortgage Real Estate Investment Trusts (REIT) and discussing a compelling trade idea within this sector. Neither the common nor the preferred equity classes of this style of REIT are widely followed, which helps explain why the opportunity of relatively high dividends without excessive risk exists.
What is a Mortgage REIT?
Real estate investment trusts, better known as REITs, are companies that own income-producing real estate and/or the debt backing real estate. REITs are legally required to pay out at least 90% of their profits to shareholders. Therefore, ownership of REIT common equity, preferred equity and debt requires that investors analyze the underlying assets and liabilities as well as the hierarchy of credit risks and investor payments within the capital structure.
The most popular types of REITs are called equity REITs (eREIT). They own apartment and office buildings, shopping centers, hotels and a host of other property types. There is a smaller class of REITs, known as mortgage REITs (mREIT), which own the debt (mortgage) on real-estate properties. Within this sector is a subset known as Agency mREITs that predominately own securitized residential mortgages guaranteed against default by Fannie Mae, Freddie Mac, Ginnie Mae and ultimately the U.S. government.
The main distinguishing characteristic between eREITs and mREITs is in their risk profiles. The shareholders of eREIT securities primarily assume credit risk associated with rising vacancies and declining property values. Most mREITs, on the other hand, take on less credit risk. Instead, their dividends are largely based on interest rate risk or the yield spread between borrowing rates and the return on assets. Agency mREITS that solely own agency guaranteed mortgages take on no credit risk. Mortgage and equity REITs frequently employ leverage which enhances returns but adds another layer of risk.
Mortgage REIT Capital Structures
MREIT’s use debt, common equity, preferred equity and derivatives to fund and hedge their portfolios. Debt is the largest component of their capital structure, often accounting for more than 75% of the financing. Common equity is next in line and preferred equity is typically the smallest. The REITs choice of financing is generally governed by a balance between cost and desired leverage.
When a REIT issues common or preferred equity, leverage declines. Conversely, when debt is employed, leverage rises. The decision to increase or decrease leverage is often a function of balance sheet preferences, hedging strategies, market views and the respective costs of each type of financing. The choice between preferred and common is frequently a function of where the common stock is trading versus its book value as well as the financing costs and liquidity of the two options.
Selecting Agency mREIT Preferred Shares
Agency mREIT (again holding predominately government-guaranteed mortgages) preferred shares currently offer investors a reasonable return with manageable risk. In the current environment there are two primary reasons why we like preferred securities versus their common shares:
Discount to Book Value- Currently, several of the Agency mREITs that offer preferred alternatives are trading at price -to- book values below 1.0. While below fair value, we are worried shareholders might get diluted as they are at or near levels where new equity was issued in the past. We prefer to buy the common shares at even deeper discounts (in the .80’s or even .70’s) for this reason. Discriminating on price in this way offers a sound margin of safety where the upside potential is enhanced and risk of new share issuance diminished.
Interest Rate Risk- The Fed is raising rates and the yield curve is generally flattening. Profitability of mREITs is largely based on the spread between shorter-term borrowing rates and longer-term mortgage rates. As this differential converges, mREIT profitability declines. Also, as mentioned in our Technical Alert – 30 Year Treasury Bonds, longer-term yields might be reversing a multi-decade pattern of declining yields. While the funding spread is a key performance factor, rising yields introduce complexities not evident in a falling rate environment. Namely, hedging is more difficult and asset prices decline as rates rise. While we still think probabilities favor lower yields, a sustainable break in the long-term trend must be given proper consideration as a risk.
Before selecting a particular REIT issuer and specific preferred shares, we provide a list of all Agency mREIT preferred shares that meet our qualifications.
Data Courtesy Bloomberg
As shown in the Yield -to- Worst column (far right), the lowest expected yields are somewhat similar for all of the issues with five or more years remaining to the next call date.
To help further differentiate these issues, the table below highlights key risk factors of the REITs.
Data Courtesy Bloomberg
The bullet points below describe the four factors in the table:
Leverage Multiple– This is the ratio of total assets to common and preferred equity. Higher leverage multiples tend to result in bigger swings in profitability and the potential for a reduction in common and preferred dividends. It is important to note that leverage can change quickly based on the respective portfolio managers view on the markets.
Price -to- Book Value (P/B)– This is the ratio of the market capitalization of the common stock to the value of the assets. As the P/B approaches fair value (1.00) the odds increase that common or preferred equity may be issued, putting shareholders at the risk of dilution. The column to the right of P/B provides context for the range of P/B within the last five years.
1 and 3 Year Price Sensitivity– This measures the change in book value as compared to the change in U.S. Treasury yields over selected time periods. This is an indication of hedging practices at each of the firms. The lower the number, the more aggressively they are hedging to protect against changes in yields. This measure, like leverage, can change quickly based on the actions of the firm’s portfolio managers.
Preferred as a Percent of Total Equity– This metric offers a gauge of the percentage of preferred shares relative to all equity shares. Preferred shareholders would rather this ratio be small. However, if the number is too low versus competitors, it might mean that preferred shares will be issued soon which would temporarily pressure the price of existing preferred shares.
Given the current interest rate volatility and the potential for large binary moves in mortgage rates, we think Two Harbors Investment Corporation (TWO) appears to present the least overall risk based on the measures above. In particular, we are focused on their aggressive hedging strategy which has resulted in the lowest interest rate sensitivity over the one and three year time periods. A closer look at performance since June 2016, the point at which interest rates began to rise, also argues in favor of TWO as they have produced superior risk-adjusted total returns.
Data Courtesy Bloomberg
We are largely indifferent between the preferred issues of TWO (A, B and C) shown in the first table. The investor must choose between a preference for a higher coupon and a price above par ($25), and a lower coupon but price below par. On a total return basis, they yield similar results.
TWO spun off Granite Point in the fourth quarter of 2017 and therefore data related to that transaction was adjusted in the table to compensate for the event.
Disclaimer: This material is subject to change without notice. This document is for information and illustrative purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action, including without limitation as those terms are used in any applicable law or regulation.
A Preferred Way to Generate Yield
In the current environment investors must dig a little deeper and into less traversed areas of the capital markets to find value. In this article we provide a base knowledge of preferred equity shares, discuss the benefits and risks associated with owning them, and provide comparisons versus other asset classes. This article lays the groundwork for a forthcoming article that will analyze a sub-sector of the preferred market and make a specific trade recommendation.
Fixed-income investors in search of stable income and sufficient yield but wary of excessive risks are likely settling for assets that are sub-optimal. For instance, High-yield corporate debt yields have fallen to near record low levels and yield spreads versus safer fixed-income assets are at their tightest levels in at least the last 20 years. As stated in “High Risk in High Yield” – “As such, the risk/reward proposition for HY appears negatively skewed, and chasing additional outperformance at this point in the cycle appears to be a fool’s errand.”
Equity investors can find somewhat dependable, high-single-digit/low- teen dividend yields in the Master Limited Partnership (MLP) and Real Estate Investment Trust (REIT) sectors. The primary risk of these investments is price volatility which can frequently negate the dividend and much more in adverse conditions.
Fortunately for higher income seekers, there is the preferred stock sector that lies between equity and fixed- income assets in corporate capital structures. This sector tends to be largely underfollowed and not well understood. Because of its relative obscurity and inefficiencies, it can present rewarding options versus other highly followed markets.
What is Preferred Stock?
Preferred stock is a class of equity issued primarily by financial companies. In a textbook corporate capital structure, preferred shares are a hybrid of debt and equity. In the event of a corporate default, preferred shareholders have a claim on the company’s assets that is secondary to unsecured creditors, such as debt holders, but superior to common equity holders. This hierarchy applies to the distribution of dividends in the normal course of business as well. Debt coupons are paid in full first, then preferred dividends and lastly common equity dividends.
To help offset the risk of non-payment of a preferred dividend, most issues are cumulative, meaning that any missed dividends must be paid before any common equity dividends are paid.
Preferred stock is most commonly issued at a $25 price (par value) and price changes from that point are based on changes to the dividend yield. For example, if a company’s credit conditions are deteriorating or if interest rates in general rise, the price of preferred shares will decline to produce a higher current dividend yield. Prices of preferred shares tend to be relatively stable compared to underlying equity shares. In this respect they are much more bond-like, with price changes a function of the general creditworthiness of the issuer, supply and demand for the issue and the general level of interest rates.
Unlike bonds, most preferred offerings do not have a fixed maturity date. However, most issues are callable, which allows the company to repurchase the shares at par ($25) after a specified call date. Dividends paid on preferred shares are taxed as long-term capital gains, in contrast with bond coupons which are taxed as income.
The following are key risks to preferred shares:
Callable- The ability of the issuer to call, or repurchase, the securities at par ($25) is a risk if the shares are trading above $25. Obviously, the incentive to call preferred shares increases as the price rises. In assessing this risk, the yield – to -call should be calculated.
Interest Rate Risk- Like bonds, the price of preferred shares will rise as interest rates fall and fall as rates rise.
Credit Risk- Preferred shares fall behind debt in the credit structure. As such, the loss in the event of default could be severe. Further, deterioration of a company’s credit situation will likely push prices lower.
Voting Rights- Preferred shareholders do not have voting rights and therefore the holder’s influence on the company’s management is greatly limited.
Liquidity- Shares are not as frequently traded as those of common stock. Therefore, bid/offer spreads can widen at times. For those looking to trade in large share blocks, patience over a longer period is required, a contrast with the immediacy of execution for most common shares.
Performance and Risk Comparisons
The table below compares total return performance and yields for the ETF’s of preferred shares and other comparable asset classes. We include a modified Sharpe Ratio which calculates the current dividend/coupon yield to price volatility (risk). This ratio provides a gauge of the amount of risk incurred per unit of dividend. The traditional Sharpe Ratio is backward looking, comparing prior total return performance versus volatility over the same period.
Performance over the last five years has favored preferred shares over corporate debt and has been mixed versus higher yielding equity choices. Importantly, if we presume that price volatility stays at current levels, preferred stocks offer the highest dividends/coupon per level of risk (modified Sharpe). It is important to note that volatility has been abnormally low for all asset classes over the last five years, and investors in all of the assets shown should expect and account for higher volatility going forward.
Since preferred shares are not widely followed, they can offer investors a value proposition that is elusive in the more traditional markets at times. However, like all higher-yielding securities, they offer above-average yields for a reason. In the case of preferred shares, this is attributable to lower levels of liquidity, and the real and present danger of credit risk. Given the credit assessment required to invest in preferred shares, experience in the fixed- income markets is beneficial in assessing the risks.
As stated above, financial companies are among the most frequent issuers of preferred shares. As such, a bank/financial system-centric economic crisis as experienced in 2008 could be devastating. The preferred ETF (PGF) declined nearly 70% through 2008 and early 2009. Once the Fed halted the decline in the financial sector with the provision of excess liquidity, bailouts, and favorable accounting changes, the sector roared back. By January 2010, PGF had totally recovered all losses while the ETF representing equities of the financial sector (XLF) was still down over 50% from its 2008 highs. Importantly, PGF made all dividend payments during the crisis, and the dividend amounts were on par to slightly higher than those preceding the crisis.
As mentioned, we will soon follow-up to this article with a recommendation of a unique preferred sector and specific shares.
High Risk in High Yield
Tesla’s corporate debt is rated B2 and B- by Moody’s and Standard & Poors respectively. In market parlance, this means that Tesla debt is rated “junk”. This term is often a substitute way of saying “low-rated” or frequently the term “high-yield” is used interchangeably. Tesla’s bond maturing in October of 2021 pays a 4.00% coupon and has a current yield to maturity of 6.29% based on a market price of $93.625 per $100 of face value. Based on prices in the credit default swap markets, Tesla has a 41% percent chance of defaulting within the next five years.
The upside of owning this Tesla bond is 6.29% annually
The bond’s annual expected return, factoring in the odds of a default and a generous 50% default recovery rate, is 0.17%
Should Tesla default an investor could easily lose half of their initial investment.
Tesla is, in many ways, symbolic of the poor risk/return proposition being offered throughout the high-yield (HY) corporate bond market. Recent strength in the HY sector has resulted in historically low current yields to maturity and tight spreads versus other fixed income classes deemed less risky. Given the current state of yields and spreads and the overall risks in the sector, we must not assume that the outperformance of the HY sector versus other sectors can continue. Instead, we must ask why the HY sector has done so well to ascertain the expected future returns and inherent risks of an investment in this sector.
In this article we’ll examine:
What is driving HY to such returns?
How much lower can yields on HY debt go?
Is further spread tightening possible?
What does scenario analysis portend for the HY sector?
All data in this article is courtesy of Barclays.
The HY sector, again also known as “junk bonds”, is defined as corporate bonds with credit ratings below the investment grade (IG) rating of BBB- and Baa3 using Standard and Poors and Moody’s rating scales respectively.
The table below presents returns over various time frames and the current yields for six popular fixed income sectors as well as Barclay’s aggregate fixed income composite. As shown, the HY sector is clearly outperforming every other sector on a year-to-date basis and over the last 12 months.
We believe the outperformance is primarily due to four factors.
First, many investors tend to treat the HY sector as a hybrid between a fixed-income and an equity security. The combination of surging equity markets, low HY default rates and historically low yields offered by alternative fixed-income asset classes has led to a speculative rush of demand for HY from equity and fixed income investors.
The following graph compares the performance between the HY aggregate index and its subcomponents to the S&P 500 since 2015. Note that highly risky, CCC-rated bonds have offered the most similar returns to the stock market.
The next graph further highlights the correlation between stocks and HY. Implied equity volatility (VIX) tends to be negatively correlated with stocks. As such, the VIX tends to rise when stocks fall and vice versa. Similar, HY returns tend to decline as VIX rises and vice versa.
Second, the supply of high yield debt has been stable while the supply of higher rated investment grade (IG) bonds has been steadily rising. The following graph compares the amount of BBB rated securities to the amount of HY bonds outstanding. As shown, the ratio of the amount of BBB bonds, again the lowest rating that equates to “investment grade, to HY bonds has been cut in half over the last 10 years. This is important to note as increased demand for HY has not been matched with increased supply thus resulting in higher prices and lower yields.
Third, ETF’s representing the HY sector have become very popular. The two largest, HYG and JNK, have grown four times faster than HY issuance since 2008. This has led many new investors to HY, some with little understanding of the intricacies and risk of the HY sector.
Fourth, the recent tax reform package boosted corporate earnings overall and provided corporate bond investors a greater amount of credit cushion. While the credit boost due to tax reform applies to most corporate issuers of debt, HY investors tend to be more appreciative as credit analysis plays a much bigger role in the pricing of HY debt. However, it is important to note that many HY corporations do not have positive earnings and therefore are currently not impacted by the reform.
In summation, decreased supply from issuers relative to investment grade supply and increased demand from ETF holders, coupled with better earnings and investors desperately seeking yield, have been the driving forces behind the recent outperformance of the HY sector.
HY Yields and Spreads
Analyzing the yield and spread levels of the high yield sector will help us understand if the positive factors mentioned above can continue to result in appreciable returns. This will help us quantify risk and reward for the HY sector.
As shown below, HY yields are not at the lows of the last five years, but they are at historically very low levels. The y-axis was truncated to better show the trend of the last 30 years.
Yields can decline slightly to reach the all-time lows seen in 2013 and 2016, which would provide HY investors marginal price gains. However, when we look at HY debt on a spread basis, or versus other fixed-income instruments, there appears to be little room for improvement. Spreads versus other fixed income products are at the tightest levels seen in over 20 years as shown below in the chart of HY to IG option adjusted spread (OAS) differential.
The table below shows spreads between HY, IG, Treasury (UST) securities and components of the high-yield sector versus each other by credit rating.
The following graph depicts option adjusted spreads (OAS) across the HY sector broken down by credit rating. Again, spreads versus U.S. Treasuries are tight versus historical levels and tight within the credit stack that comprises the HY sector.
Down in Credit
As mentioned, the HY sector has done well over the last three years. Extremely low levels of volatility over the period have provided further comfort to investors.
The strong demand for lower rated credits and lack of substantial volatility has led to an interesting dynamic. The Sharpe Ratio is a barometer of return per unit of risk typically measured by standard deviation. The higher the ratio the more return one is rewarded for the risk taken.
When long term Sharpe ratios and return performance of IG and HY are compared, we find that HY investors earned greater returns but withstood significantly greater volatility to do so. Note the Sharpe Ratios for IG compared to HY and its subcomponents for the 2000-2014 period as shown below. Now, do the same visual analysis for the last three years. The differences can also be viewed in the “Difference” section of the table.
The bottom line is that HY investors were provided much better returns than IG investors but with significantly decreased volatility. Dare we declare this recent period an anomaly?
Given the current state of yields and recent highs and lows in yield, we can build a scenario analysis model. To do this we created three conservative scenarios as follows:
HY yields fall to their minimum of the last three years
No change in yields
HY yields rise to the maximum of the last three years
Further, we introduce default rates. As shown below, the set of expected returns on the left is based on the relatively benign default experience of the last three years, while the data on the right is based on nearly 100 years of actual default experience.
Regardless of default assumptions and given the recent levels of volatility, the biggest takeaway from the table is that Sharpe Ratios are likely to revert back to more normal levels.
The volatility levels, potential yield changes and credit default rates used above are conservative as they do not accurately portray what could happen in a recession. Given that the current economic cycle is now over ten years old, consider the following default rates that occurred during the last three recessions as compared to historical mean.
Needless to say, a recession with a sharp increase in HY defaults accompanied with a surge in volatility would likely produce negative returns and gut wrenching changes in price. This scenario may seem like an outlier to those looking in the rear view mirror, but those investors looking ahead should consider the high likelihood of a recession in the coming year or two and what that might mean for HY investors.
An interest rate is the cost for borrowing money and the return for lending money. Most importantly for investors, interest rates or yields help ascertain the amount of risk investors believe is inherent in a security. When one’s risk expectation and those of the market are vastly different, an opportunity exists.
Given the limited ability for yields, spreads, volatility and default rates to decline further, we think the reward for holding HY over IG or other fixed income sectors is minimal. Not surprisingly, we believe the risk of a recession, higher yields, wider spreads, higher default rates and increased volatility carries a higher probability weighting. As such, the risk/reward proposition for HY appears negatively skewed, and chasing additional outperformance at this point in the cycle appears to be a fool’s errand.
For those investors using ETF’s to replicate the performance of the HY sector, you should also be especially cautious. As a point of reference, Barclays HY ETF (JNK) fell 33% in the last few months of 2008. A repeat of that performance or even a fraction thereof would be a high price to pay for the desire to pick up an additional 2.03% in dividend yield over an IG ETF such as LQD.
The bottom line: Markets are not adequately paying you to take credit risk, move up in credit!
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