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It’s Different This Time, Right?

Amid all the research coverage on the state of the high yield market that came out last week, one report from Deutsche Bank, in particular, stood out. The research report has attracted some attention, mainly because it’s predicting that there’s yet more pain ahead for the high yield market:

Late stages of every credit cycle, by definition, are built on a theory as to why this time is different.

This type of attitude was prevalent going into 2015, when credit markets largely dismissed the oil sector distress, choosing to believe that this was an isolated issue and will stay that way. Historical evidence pointed to the contrary, where no earlier precedents existed of the largest sector being in distress and the rest of the market remaining firm. Today, two out of three sectors in US HY have more than 10% of debt trading at distressed levels.

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From its starting point in energy a year ago, it has now reached other commodity-sensitive areas such as transportation, materials, capital goods, and commercial services. But it did not stop here and is also visible in places like retail, gaming, media, consumer staples, and technology – all areas that were widely expected to be insulated from low oil prices, if not even benefitting form them.

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“…what percent of names are in deep distress today, defined here somewhat arbitrarily as 2,000bps (dollar prices around 50pts), the answer we get is 7.1%. This level is materially higher that 2% in US HY back in Oct 2011 or 6% in EU HY back in Jan 2012.”

But it’s not all bad news. In fact, for value investors, there could be some opportunities out there:

“Think about the significance of this number. While some names flirt with modest levels of distress from time to time throughout the normal course of events during the expansionary phase of a cycle, many of them stage comebacks and remain current on their debt obligations. In other words, not all distressed names today will default tomorrow. To witness, the total value of unique cusips in our DM HY index that ever touched on 1,000bps since 2009 through 2014 is $600bn. The actual grand total of defaults during this time is $135bn.”

Although, junk-hunters need to be cautious as few names ever come back from the deeply distressed levels:

“For that same timeframe, $130bn of unique bonds touched on a 2,000bp level. It’s also interesting to note that peak in deep-distress ratio in Figure 2 reflects peaks in actual default rates closely (18% deep distress par vs 20% par default rate in 2002 cycle, for example)3 . It appears that few names ever come back from the deeply distressed levels, and their prevalence in today’s environment has to be taken seriously by credit investors. Ex-energy this metric currently stands at 3.1% of index face value.”

For the first time in many years, some sections of the bond market might be beginning to look attractive for value investors.

Lastly, some thoughts on the Third Avenue Focused Credit Fund closure from Driehaus Capital Management.

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