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Is the Gilded Age of High Yield Over?

Takeaway: On an absolute basis, high yield bonds are priced to perfection, especially with corporate earnings slowing.

Unless you have just been ignoring your Bloomberg terminal for the last few years, the fact that interest rates are literally at all-time lows should be no surprise.  In the chart below we look at the yield on 10-year Treasuries going back 30 years.  The yield on the 10-year Treasury hit an all-time low of 1.47% in July of this year.   


Is the Gilded Age of High Yield Over? - aa. 10yr



For the last few years, many investors have articulated a bear thesis on U.S. government bonds based on the extremely low yields.  For those that have actually implemented the thesis and shorted U.S. government debt, the trade was likely painful. In reality, shorting U.S. government bonds has been the proverbial “widow maker” trade over the past few years as bond prices have gone straight up and yields down.


Despite potential credit events, like the debt ceiling crisis in the summer of 2011 and a subsequent downgrade of U.S. government debt, yields on treasuries have continued to trend lower.  The monetary policy implemented by the Federal Reserve has had the intended impact of keeping rates low and has, seemingly, made investors think that the Fed is the ultimate lender of last resort, albeit by printing money.


By keeping interest rates at abnormally low levels, not only has the Fed induced lower rates on U.S. government bonds, but it has also induced lower rates on many types of loans – from mortgages to corporate debt.  In the two charts below, we highlight this by looking at the rates on 30-year mortgages going back 10 years versus a high yield US corporate bond index.


Is the Gilded Age of High Yield Over? - aa. mortgage



In some markets, like the residential mortgage rate, low rates have not increased money supply because of tightening lending standards.  Conversely, the high yield market is, as they say, flush with liquidity. Related to that last point, in October the U.S. high yield primary market hit $41.9 billion in issuance.  This trailed only September’s all-time high of $46.8 billion.  Yes, you read that correctly . . . September 2012 was the highest month of high yield issuance in the history of capital markets.  As of October, this year is 34% ahead of 2011’s full-year total and up 52% year-over-year through ten months.


Is the Gilded Age of High Yield Over? - a3



Clearly, low rates are inducing corporate issuers to refinance at record rates.  In fact, in the year-to-date 59% of total issuance of high yield debt has been utilized for refinancing.  This is a little less than the 64% of proceeds used for refinancing in 2010, although in 2010 55% of proceeds were used to address maturities versus only 43% this year.  So, corporations are taking advantage of the low interest rates to reduce their all in cost of borrowing.  In addition, these issuers are taking advantage of the search for yield by many investors to sell record amounts of bonds.


Morningstar published their most recent fund flows data for flows through October.  In the year-to-date, high yield fund inflows are +$27.9 billion and + $30.1 billion in the last twelve months.   High yield is the second largest inflow category in the last twelve months after intermediate term bonds.  On a percentage basis, though, high yield has seen the largest inflow of any of Morningstar’s top 95 asset categories growing 15.2% year-over-year.


The other interesting point relating to the high yield market -in addition to record low interest rates, record high issuance and record high yield fund inflows- is that terms for the issuers are almost as flexible as they have ever been.   This is best characterized by the re-emergence of covenant-lite loans, or loans with much more lenient terms for borrowers.   In the year-to-date, covenant-lite loan issuance is $49 billion.  According to Fitch, the recovery rate for covenant-lite loans is 55 – 60% versus an overall recovery rate of 62% for loans from 2008 – 2009.


Is the Gilded Age of High Yield Over? - a4



In aggregate, it seems like a frothy market for high yield, but high yield bulls would counter that the long term spread versus treasuries is not even close to its lows.  The chart below from the St. Louis Fed highlights this point as it looks at the spread of high yield versus comparable duration treasuries going back to 1997.  Currently, this spread is at 5.7% versus its low of 2.5% in 2007.


Is the Gilded Age of High Yield Over? - a5



While the spread versus Treasuries is an important metric, the underlying creditworthiness is probably even more critical, especially with high yields bonds trading at their lowest absolute level ever. The caveat is that defaults rates are currently very low on high yield bonds.   In fact, as of September the par weighted default rate, according to J.P. Morgan, fell to 1.83% and the issuer weighted default rate fell to 2.98%.  This is well below the peak on par basis of 16.3% in November 2009 and the peak on an issuer basis of 12.2% in March 2002.


Is the Gilded Age of High Yield Over? - a6



The reality is, though, that high yield bonds in aggregate are pricing in these low default rates.  On absolute basis, high yield bonds are almost perfectly priced given their all-time lows in yield.  So, investors are getting paid the lowest interest rate they have ever been paid to take the risk of owning high yield debt.


Our primary concern going forward relates to the corporate earnings and cash flow outlook.  One of our three Q4 themes is that corporate earnings growth is slowing, which we highlight in the chart below and played out in Q3 with SP500 earnings only up 0.9% year-over-year. To the extent that corporate earnings and cash flow begin to decline year-over-year, this will have a direct impact on the ability of corporations to pay their interest rates on borrowing and adversely impact their overall credit worthiness.  


Is the Gilded Age of High Yield Over? - a7



In addition to the outlook for corporate earnings and cash flow, the other key red flag we see for high yield is that volatility for the asset class is starting to accelerate.  By a recent estimate from ConvergEx Group, implied volatility for high yield bonds is up 64% in the last month.  This comes even as yields for these bonds have continued to decline.  Even if the high yield asset class is cheap on a relative basis, chasing high yield is far from a contrarian call at this point in the cycle, especially as corporate earnings look to be peaking.


Daryl G. Jones

Director of Research



  • With the implementation of the new slot machine rules in Macau today, five slot parlours will have to be relocated within one year— Yat Yuen Canidrome Slot Lounge and the Treasure Hunt Slot Lounge, both operated by SJM, and The Mocha Lan Kwai Fong, Mocha Marina Plaza and Mocha Hotel Taipa Best Western clubs, all operated by Mocha Clubs (MPEL).
  • As the cascading pie charts show below, we estimate the slot revenue that may be affected by this relocation is very minimal — only 0.5% of total GGR of SJM and MPEL combined.
  • The upcoming smoking restrictions and plateauing Mass table hold % are bigger issues facing Macau operators than the slot parlour relocations.



FL: Solid Update for Top Long

Takeaway: One of our top longs, FL’s sales are tracking ahead of plan and the setup is increasingly favorable into year-end

As a follow up to FL’s recent 3Q results, we think a reacceleration in athletic footwear industry sales after a slow start to November and a favorable near-term setup suggest a strong finish into year-end. We are also positive on FINL and NKE, which is another top long idea.

Consider the following on a TRADE basis (3-weeks or Less):

  • Athletic footwear sales have come in up +5.3% over the last two weeks after coming in down -6% in the first two weeks of November accelerating sequentially each of the last 3-weeks.
  • As seen in the chart below, continued underperformance in the other channels cause weekly sales to significantly understate performance in the Athletic Specialty channel (i.e. FL, FINL, DKS, etc.).
  • Basketball continues to be a significant driver with trailing 3-week domestic sales accelerating sharply higher +27% from +15% over each of the prior four weeks.
  • With FL reporting comps up +MSD through the first half of November despite the industry down -6% and sales over the last two weeks running +5%, we believe FL comps are tracking well ahead of the “upper end of mid-single digit” comp plan.
  • With a favorable setup through year-end and shift towards basketball in Europe, we expect more opportunity for further upside in performance.
  • Retailer sales gains over the holiday weekend were heavily reliant on deep promotional activity. We think athletic footwear retailers (FL/FINL) were substantially less impacted and benefitted from more full-priced sell through with several new launches hitting over the holiday week. Moreover, while several apparel and home furnishing retailers offered free shipping on certain items for the first time, there was no incremental hit to footwear retailer margins as free shipping has become standard.


The longer-term TREND (3-Months or More) & TAIL (3-Year or Less) call:

  • Still in the early stages of its turnaround, FL is not solely reliant on the ‘footwear cycle’ for growth.
  • A return to new store growth for the first time in over 6-years will augment comps benefitting from higher growth and higher margin businesses (i.e. Women’s, Apparel, and Kids).
  • After a decade of inventories outpacing sales growth and contracting margins under Matt Serra, FL has posted positive sales/inventory growth and margins expansion over the last three years under Ken Hicks.
  • We’re see more opportunity for upside performance over the intermediate-term and are looking at $3 in earnings power next year approaching $3.50 in F14.

FL: Solid Update for Top Long - FW App Table

Source: NPD Weekly POS Data


FL: Solid Update for Top Long - FW 1YR


FL: Solid Update for Top Long - FW Cat


FL: Solid Update for Top Long - FW Channl



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One theme we will be highlighting on Thursday’s call is Return on Incremental Invested Capital.  Yum! Brands has proven itself reliable when it comes to generating returns.


Setting Expectations


YUM’s management team is set to present at the company’s annual Investor & Analyst Conference in New York on December 6th.  Our conference call with clients, on November 29th, will outline our thoughts on the outlook for 2013 and what we expect management to focus on the following week. Please contact for access to our call on Thursday, November 29th, at 1:30pm.



Diversifying Growth


We expect the company to emphasize YUM’s increasing geographic diversification during the Investor & Analyst Conference.  The case will be made that increasing the deployment of capital to emerging markets within the YRI division will generate higher incremental returns on capital than the overall enterprise currently produces. 


We believe that ROIIC (chart below) is an important metric for restaurant companies focused on growth and expect YUM’s strong share price performance to continue throughout 2013. 



YUM CALL PREVIEW - yum roiic



Howard Penney

Managing Director


Rory Green


Changes In Housing

For the last five years, the housing market has been a headwind for many banks, including regional player TCF Financial (TCB). The recession’s impact in the midwest affected the company greatly as borrowers lost jobs and dealt with falling home prices. These days, the outlook is improving as the worst is over with in terms of the housing bubble. Housing prices in markets like Denver and Phoenix are rising and will strengthen TCF. The stock remains one of our favorite long positions for all three durations: TRADE, TREND and TAIL.


Changes In Housing - image003

Energy Capex Growth

Compared to other industries that are part of the S&P 500, energy takes the lead for the amount of dollars spent in terms of capital expenditures. In 2012, energy companies in the S&P500 will spend 38% of all S&P500 capex; this compares to just 12% in 1999 and 2000.  Oilfield service and equipment companies are the least capital intensive and include names like Dril-Quip (DRQ), National Oilwell Varco (NOV) and Core Laboratories (CLB). 


While we expect a slight tick down in capex for the energy sector in 2013, between 1996 and 2012, nominal capex for the S&P500 increased 108%; nominal capex for the energy sector increased 472% over the same time period.  Energy accounted for 61% of total S&P500 capex growth from ’96 – ‘12, while utilities was second at 20% of the growth.


Energy Capex Growth - 1

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