In the latter stages of the credit cycle when fundamentals are strong but valuations are compressed, lower-rated high yield credit can offer some of the best rewards for taking risk. The more the bond’s spread and the greater its duration, the higher is its potential return. For sellers of risk (i.e. the issuers) looking to lower borrowing costs, leverage their equity, loosen their covenants, and lock in these favourable terms for as long as possible, few settings are more favourable.
But something is amiss in the current European high yield credit cycle. While bond investors should be looking to extract maximum upside from riskier assets and riskier issuers should be borrowing longer while it’s cheap to do so, it is increasingly rare for a European high yield bond to have a maturity greater than 6 years. A quick analysis of our benchmark (ICE HECM as of 31 Jan 2008, 2013, and 2018) shows that the tenor of debt from the riskiest borrowers (those with Bloomberg composite ratings of CCC1 and B3) has steadily declined. For example, the average maturity of a B3-rated bond was 8.9 years in January 2008, 7.1 years in January 2013 and 6.7 years at the end of last month.
If an issuer as a seller of risk is simultaneously a buyer of options, (e.g. fixed coupon, callability, portability, and maturity) then why wouldn’t it buy each of these options when it is so cheap to do so? Granted, an upward sloping yield curve makes it more expensive to issue a longer maturity and shorter maturities with shorter call protection allows issuers to pay a smaller premium to redeem the bond early. But, if Eurozone growth is improving, the ECB is tapering, and deflation fears have abated, a rational borrower should think that locking in today’s borrowing costs for longer is a highly appealing option. While there have been credits in the cable sector that have issued bonds out to 2029, these have been the exceptions rather than the rule. In recent years leveraged borrowers for the most part have preferred to print 5- and 6-year paper. This suggests that issuers and their owners have valued the option of retiring debt earlier or the chance to refinance at cheaper levels sooner more than they have valued the bargain basement option of locking up cheap liquidity for longer.
The blame does not lie wholly with the issuers. After all, the vast majority of European HY fund flows have gone into short duration strategies in the past two years. Frenetic European CLO activity also points to the strength of demand for leveraged credit with minimal duration. Such flows are understandable when one considers that credit fundamentals are strong and the ECB is tapering. However, by catering to this demand it seems that both issuers and investors are creating unnecessary risks. While shorter dated bonds might mitigate the investor’s exposure to rising interest rates, both bond portfolios and borrowers will suffer to the extent that shorter maturities result in increased refinancing risk.
Longer-dated bonds might come with a higher cost to the issuer, but in return, it is buying the option of more time to see it through the next credit cycle, operational downturn, or sector slump. It is difficult to see that option becoming any cheaper for high yield bond issuers than it is now. As for the investor, the increased duration in longer maturities can provide more potential upside for good credit selection. Given that strong European high yield fundamentals currently afford lower-rated credits a good chance to deliver performance, high yield investors should not fear longer duration.
But alas, supply and demand for lower quality high yield credits do not currently intersect at longer maturities. Inevitably we will move into a less benevolent phase of the credit cycle in which liquidity becomes scarcer as risk aversion moves higher. Many a high yield issuer might find themselves wishing they had paid up to borrow long while the sun was shining.