The Overvalued Junk-Bond Market Still Has Pockets of Opportunity

Marty, welcome back to the show. It's always good to see you. Yeah, great to be here. Nice to see you. It's been a while. It's been four years since 2020, August of 2020, since you were here. A lot's happened since then. The world's kind of turned upside down since then. To say the least, yeah. All right, Marty, I got a tweet for you. I just put this out less than an hour ago, and I put a link to the ICEB of A high yield index option adjusted spread from the Federal Reserve educational website there. And it indicates that at 2.73, 273 basis points, that's the second lowest going back to September of 1997. And it was lower one month, May 2007, in all that time. Is that top down view of the high yield world worth anything to you? Well, it is a very small risk premium by historical standards. More important is that if risk is below average, then it makes sense for the risk premium to be below average. So what I do is to create a model of the fair value based on the factors that historically have driven it. And those are specifically credit availability, which is measured by the number reported by the Fed senior loan officer survey, the percentage of banks that are currently tightening credit minus the percentage that are using credit. There are two economic indicators, which are capacity utilization and industrial production. And that might say, why not unemployment and GDP, the obvious ones that say, well, this is not Marty Fridson's idea of how the world ought to work. It's just empirically based on the evidence, what has the strongest correlation, then the default rate, which is a backward looking number. So it's limited value, but it has some correlation. And then the five-year treasury yield because the spread is inversely correlated with the underlying treasury yield. And then finally, I have a dummy variable for quantitative easing because everything else, if the Fed is intervening in the long-term bond market, which is not currently doing, but if it is, then that also has an effect on the market. But right now, as of month end, the spread was 183 basis points tighter than the fair value calculated by that model. And that compares to a one standard deviation of 133 basis points. The point of all this being that it is, the high yield market is extremely overvalued by these measures. And that's been true since almost continuously since the middle of 2023. Okay, so we are at a historically extreme moment. Is there, what does a guy like you do? I mean, are you just on vacation the whole time? What does a guy like you do at a time like this? Does that mean there's nothing to buy in high yield? No, because the clients use my high-yield research by and large have mandates that require them to be in the high-yield market. In other words, their end investors, pension plans, endowments, what have you, have said to them, we want to have X percent of our portfolio in high yield. We'll make the asset allocation decision. Your job is to outperform the benchmark that's been assigned to you within that index. So it's very important to say, all right, if the high-yield market has a negative 5% return over the next 12 months, that's not a forecast, but just as an example, if it has a negative 5% return and we return zero, we're heroes. So what we want from Marty Pritzen is give us some advice on which industry sectors, which quality sectors, if we invest cross-regionally, tell us whether emerging markets, whether European high-yield debt is relatively attractive right now and so forth. So there's always work to be done. Okay, it actually reminds me of somebody else who has dealt in this space named Howard Marks. And he made the case in a similar way a couple of years ago. I forget when it was exactly. And he said, carefully we proceed and then it is what it is. That was what he said, it is what it is. So you gotta do what you gotta do. Is there right now, so I would guess, when spreads are tight, that tells me maybe, you tell me, that the investors perceive the conditions as we said, very sanguine, very safe. Is there a danger in your mind that, for example, take a really important variable like default rates? What is the likelihood in your mind that people are really kind of underestimating where default rates could be, however far out means something to you, a year, six, 12 months, farther? Yeah, another analysis I do suggest that the market is actually forecasting a slightly higher default rate than Moody's, which is one of several models is, but I think the Moody's forecast based on a consensus forecast of the economy, let me say that, their base case tends to be in line with sort of the consensus economic forecast, whether by design or elsewhere. The market, as tight as it is, is actually forecasting a slightly higher default rate because that forecast is a function of the percentage of issues in the high yield index that are trading at distressed levels, which is at a very low level by historical standards currently about half the median level. But nonetheless, when you're at a low percentage of issues trading at distressed levels, a fairly high percentage of them are expected to default. In other words, the ones that are trading at distressed levels very much deserve to be there, whereas there are times when you have recessions, you have typically about 30% of all the issues trading at distressed levels, and a lot of them are there for technical reasons, not because they're really at a high risk of default within 12 months. So I think the question you asked, the likelihood of the default rate being significantly higher than investors currently expect 12 months from now is really a function of economic surprises. If it turns out to be that the economy, if we go into recession, which is very clearly not the consensus forecast right now, despite the fact that we've only recently come out of the long standing inverted yield curve, and all recessions have been predicted by an inverted yield curve, in other words, the short term rates being higher than the long term rates, there have been some false signals that were not followed by recessions, but those were comparatively mild and short live inversions. Here we had an inversion that went on for two years, got to extreme level, and so far, no signs. If you look at some forecasters, they do kind of find in the data indications that yes, we are headed still toward a recession, but that's become a much less common view over the last few months. And now with the Fed on an easing track, that view of things has become even less prominent. Yeah, Marty, that was one of the questions I had for you, the inverted yield curve. I know you've written, you write about it. What do you make of the fact that we haven't had, quote unquote, an official recession after it's been inverted for two years? I mean, you could go back to early 2022 and say, we had a technical recession, two straight quarters, does that matter to you? And just like, where do you see the economy in general going right now? Yeah, I'd say I don't feel I have a special expertise in economic, macroeconomic forecasting. I follow- That's okay, Marty, nobody does. Yeah, well, that's right. So I, of course, follow it with interest, and I'm interested in insights that are provided by others about it. Right now, I would say that it's, I think, I actually once did a report, I didn't name the economists involved, but I called one Dr. Glass half empty and one Dr. Glass half full, and showed how in the exact same release on labor statistics at the time, one was able to create a very negative picture and the other a very positive picture. So I take all that with a bit of a grain of salt. But I would say right now, I've sort of softened the view. During the inversion of the yield curve, I was emphasizing the fact that recessions haven't started until the yield curve ceased to be inverted. So the fact that it had gone on as inversion for a long time wasn't an argument to say, well, this is, for the first time ever, a sign that we won't have a recession in following a sustained inverted yield curve. But there is always a first time, the possibility of a first time, and we may dodge the bullet. Yeah, everywhere I look, among people who do seem to think they have an expertise in macroeconomic forecasting, you just see over and over again, it's pretty good consensus, no landing, not even soft landing, just no landing. There's no sign of a recession anywhere. So I love the confidence, and of course, most people make the opposite mistake. They'll say, well, I predicted nine of the last two recessions or something. And any kind of a consensus always worries me, but hey, nobody wants a recession, right? So I certainly hope they're all right. And the reasons for it seem pretty good. Do you feel, I've heard, again, this is sort of like the economist thing that you described. People are black and white on this, both sides. Do you feel that the Fed has, they hiked too quickly? Or some people are saying, well, they shouldn't be cutting now, et cetera. So do you come down on either side of that, where you say, well, they hiked too quickly, and they, or are you more like saying, well, no, they shouldn't be cutting so much? Yeah, well, I had an opportunity to present to Alan Greenspan on one occasion, and when he was Fed chairman, and I told him that you've got the toughest job in the world, because whatever you do, you're gonna get critics on both sides, and they'll speak very adamantly about that, and say in so many words that the Fed is really stupid or ill-informed. The ill-informed part is hard to believe, because I've gotta think that they've got the best information of anyone out there. And the point, I think, to keep in mind in that, when people talk about policy errors, you have to keep in mind that Fed policy famously works with a lag, Milton Friedman really emphasized this point. So when you say, what is the impact? Another analogy, well, the impact, it's hard to tell what the impact really was, because other things happen. I like to make the analogy of one of the easiest jobs, taking nothing away from these people, but in a sense, in one sense, an easy job is the guy who puts fluorine in the swimming pool, because the only thing you have to worry about is putting in too much or doing it at a time when the air temperature is outside the proper range. If you get those two things right, you will get the desired effect a million times in a row. And I use that to contrast with the Fed's job, where you have many, many variables, many of which aren't even known, and which don't even necessarily act in a consistent way over time. So in that environment, you're gonna take a policy move with massive uncertainty. So I tend not to be critical of the Fed. I genuinely believe they're doing the best job they can. I wrote about this comment after the Fed made its half point cut on September 18th. You had people saying, and it's not at all to make a political statement on my part, but there were people, including one United States Senator that I noticed saying, oh, the Fed was trying to put its thumb on the scale and tilt the election toward the incumbent party. And there's been this idea that always, regardless of which the incumbent party is, that the Fed is somehow always biased toward supporting the incumbent party. And I really don't believe, certainly nothing that happened on September 18th was gonna affect the real economy in time to sway the election. The result was that long-term interest rates went up and with them mortgage rates, which certainly wasn't a way to win votes for the incumbent party to cause mortgage rates to go up. So I tend to be on the side of saying, I have confidence they're doing the best job they can. There may be mistakes in the sense with the benefit of hindsight largely, but no, so I don't really agree with those who say, well, they were too slow to stop raising rates too fast or too aggressive in lowering rates. It's just really hard to tell what the impact is going to be at a point in time. Yeah, one thing the long-term, I mean, one thing that 50 point cut did do is what you said, the longer term yields rising. Jay Powell just yesterday as we're recording this said, he thought that was, it's more an indication of growth expectations and other factors than inflation expectations. I'm curious your thoughts on that. And if how that, it's another macro question, but how that maybe impacts your, how you go about trying to find opportunities, weighing those factors as well, whether it's inflation, whether it's growth. Yeah, well, let me just say, before I answer that directly, let me just say that the Fed funds rate change and the 10-year treasury yield going in opposite directions happens about 40% of the time on a month-over-month basis. There is a statistically significant bias toward them going in the same direction, but 40% of the time going opposite direction suggests this is not wildly anomalous. And I think that hasn't been brought out enough. So that's interesting that he, Powell attributed it to growth expectations. And I hope that's right, that it really is a function of there's gonna be growth, therefore demand for capital and the cost of that capital going up in the market foreseeing that. I think there is, and again, it's very hard to talk about this without sounding political about it, but if the president-elect is serious about the extent of the tariffs he wants to impose, I have a hard time finding how that won't be inflationary. I mean, he's argued that it won't be. I think there is some good commentary coming out now, and I think your viewers can judge for themselves on that, but I think the record has been that those costs have been passed along to consumers. So I think that that is likely a factor in it. But again, Jerome Powell has a huge staff of economists working for him, and I'm sure he has some good support for making that kind of a statement that is certainly gonna be listened to and paid close attention paid to. It's a good point about the 10-year versus the short-term rates moving in different directions. I hadn't heard anyone tell me that it was 40% of the time, which is not insignificant. You, yeah. Almost 50, right? That's right. No, I wanna come back. You also asked about how this would affect my analysis, and rates going up, it certainly isn't helpful. The high-yield market, and we talked about distressed bonds as well as a segment within the speculative grade or usually referred to by the press as junk bonds because that fits into the headlines more easily than high yield. But it's certainly not a help that companies could be faced with having to roll over their existing debt into higher rates. Now, the good news is that it's not the case as you sometimes might infer from reading the media coverage that all of the debt is coming to in the next six months, and their cost of debt is gonna go up immediately by 100 basis points. The reality is that companies do, by and large, manage their debt responsibly. They have their maturity spaced out. So if a chunk of it comes due, and that's at a higher cost, their overall cost of debt doesn't go up by a whole lot because of that one piece of it coming due. Over a long period of time, many years, yeah, their rates will go up significantly, but that also suggests they have time to adjust for that, such as reducing their amount of debt. Some of the leverage ratios went up during this period of very low rates, which, again, some of the media tried to make a big case about being very negative. But the fact is the cost of that debt was lower, so companies could support larger components of debt in their capital structures. Now, whether they will go and do the responsible thing as they see rates going up and lower their debt will matter on a case-by-case basis by the company, and that will certainly be a factor that I'd look at. I think the most important factor will be the availability of credit. One important development over just the last few years is that the private credit lenders, funds that provided credit historically to small and medium-sized companies have now been so successful, they've raised so much money, they've been able to go in and compete directly with the high-yield bond market and the syndicated loan market, and what they do in particular is offer more flexible terms. They may get actually a premium rate for doing that, but they offer a lot of flexibility, they can act swiftly so crises can be averted at companies that suddenly run into a problem for whatever reason, and they're also good at finding loopholes in the existing credit agreements that enable them to come in, get ahead of the existing lenders in their standing in the capital structure, but that all works to the benefit of the issuers, not to the buyers of high-yield bonds necessarily, but will get some companies over bumps that might otherwise result in them going as far as defaulting on their debt. So this is a good place to maybe transition a little bit from top-down thinking to bottom-up. You mentioned that your model was indicating that bonds were, I think you said it was 183 paces points over fair value, more than a standard deviation. Well, tighter than that. Tighter, sorry, tighter. So if that's your main selection criteria, or presumably a very important one, it is what it is, and you got clients to serve. What do you do? How do you proceed? Okay, well, from the very bottom up, we also have a model on security selection that is based on financial ratios. It's a proprietary model, but I myself would be skeptical of a black box, I think. So we got TSG, also known as the Spalding Group, to attest to our back-tested results on this model. And that firm is basically, the main business is validating the performance record presented by asset managers who say, oh, we beat the index by so many basis points over period. And TSG confirms according to standards, promulgated by the Chartered Financial Analyst Institute, that those performance numbers are accurate. So we got them to do a test for this model. So we provide that. Currently, there are 147 issues that are significantly undervalued, again, using a cutoff. And I apologize to anyone not too familiar with some of the statistical jargon, but those that are achieved by one standard deviation or more. And that full list is available to the subscribers for Princeton Vision High Yield Strategy each month, in each report, which comes out bi-weekly. Once a month, we highlight a few issues to show that they're not just the bonds that are trading at abnormally wide spreads. We have bonds that are trading at narrower spreads than even this very narrow spread of the index as a whole right now that still show up as significantly undervalued according to this model. Now, moving up from that bottom, we do analysis based on sectors. So right now, for example, we look at industries and we evaluate them in two ways. The first way is how are they trading relative to their peer group within the 20 largest industries in the high yield universe. And to do that, we do something that I think is unique to my work, because for a long time, I struggled with the fact that, well, how can you say that one industry is cheap relative to the other based on the difference in their spreads when one is mostly double B companies and one is mostly triple C companies? So I came up with a methodology and with the help of some very bright people in an internship program at the Masters of Quantitative Finance program at Fordham University, which is a really excellent program. My toughest thing is picking a candidate from the ones who apply because they're all so good. But with their help, I do that analysis where I equalize for the difference in ratings mix, kind of a laborious process. But the upshot of that is that I can say this industry on a rating for rating basis is cheap or expensive relative to that peer group. And then the other thing I look at is what the rating agencies are saying about their rating outlook, because for every high yield issuer, Moody's and S&P and Fitch have rating outlooks that they're saying the rating is likely to be stable or improving or declining over a period, something like a year and a half. They don't state that explicitly, but people figure that it's about the timeframe they're looking at. Well, currently there are five industries that are in the Northwest quadrant of the graph that emerged from that, meaning that they're trading cheap to their peer group, even though the rating agencies say their credit quality is improving, which is kind of anomalous. Usually there are only a couple of industries in that period because the market by and large agrees that yeah, these are improving or deteriorating industries, but currently diversified financial services, energy, building materials, home builders in real estate and utility are all in that category of being cheap despite improving outlooks. I think there's a thread through there of several of those of being interest rate related and investors may be shying away from those because they feel they'll be hurt by rising interest rates if that turns out to be the case. But those are areas where you should generate some superior returns. Right now with spreads very tight, there are not a lot of things that are out of line. One exception is that we would underweight emerging markets high yield debt if you're again a cross regional investor. Europe is not out of line right now and we don't see a great opportunity in terms of the triple Cs as opposed to the double Bs and single Bs. But it is interesting that although they're not cheap enough to be overweighted right now, you've never had the double B, single B confined spread as narrow as it is with the triple C and lower spread as wide as it is by a good margin. And what that says to me is that investors are saying, okay, we went through a long period where yields on bonds were so low we couldn't justify owning them. Thank goodness we can now get back to running something like a balanced portfolio, which is a prudent thing to do over time to have a mixture of equities which benefit from economic growth, bonds which give you protection on the downside in a recession. We'd like to have some reasonable mix between those two. We can do that again. Well, we'll have to sort of look the other way about the narrowness of the risk premiums because they aren't too good right now, but it's good to have bonds back in the portfolio. But that doesn't mean we're gonna go crazy and buy those bottom tier triple C and lower rated bonds. We're gonna stick to the so-called quality within the junk sector as we, again, as the press likes to refer to it. So I think that is a really telling message about the current market and getting back to something that we were talking about, what do investors think? What are they confident in? They're not so confident that they wanna buy the bonds that are at a serious risk of default. So bonds rated double B don't default, not while they're rated double B. There've been a few exceptions where there was a financial reporting fraud or something like that. But by and large, the rating agencies, despite a lot of criticism of them, do get bonds down to at least the triple C category, often double C, even lower than that, before they go into default. So the fact that investors are shying away from triple C and lower rated bonds at present means that, yeah, they're not as complacent about credit quality as might appear just from the raw spreads. So my knee-jerk reaction to that is, I wanna look at single B and triple C to see if there's a bargain in there somewhere. Is that a danger? Oh, yeah, on a company-by-company basis, yeah, they're certainly going to be. Again, it may turn out that way. The triple Cs and lowers will outperform in a rally and in a period of spread tightening. And they could get back to that all-time low of 241 that you mentioned back in 2007. As today, the overall spread on the high-yield index that you mentioned is 273 basis points. So I would say the odds, I would think against a rally. Now, if spread stay and yield stay roughly where they are, triple Cs will outperform simply because they have a higher yield. So there are several different scenarios you could draw, but within the triple C category, there are individual issues that are substantially undervalued right now. And that often has to do with, well, they performed poorly in a recent period. So we're not going to get back into that one again, even if you can, is that a strong fundamental case? It's just something we got burned on. We just don't want to touch that again for a while. Right, so let me ask you this. If you're looking something in your models and your selection and everything says, well, spread is very tight, but we view it to be undervalued. What are those other variables? Are they like quality variables about the business? What are they that sort of override the spread, if you will? Yeah, well, the model is a strictly quantitative model. I would say, some people wouldn't be comfortable with that, but I would point out that the late Jim Simon's performance record was twice as good as Warren Buffett's. And that was done with purely quantitative methods. I had a big team of PhDs working for him. So I wouldn't dismiss it out of hand as an approach. So that particular work is strictly quantitative and it's based purely on financial ratios. So numbers coming out of the income statements, balance sheets, cashflow statements of the companies. And we have our own formula for that, tested by what has worked. And again, that is proprietary. But that's not the only work that I'm involved in. When it comes to looking at distressed credits in particular, those with spreads of 1000 basis points are more above treasuries. And in some cases, looking at companies in defaults that should come out of it with good recoveries for the bondholders who stand ahead of the shareholders in how the assets get distributed. In that work, the statistics will only carry you so far. I mean, you really do have to get down into the nitty gritty of the company's fundamentals, their operations, and that can be a function of sometimes you have a company that looks pretty sketchy, going out and having some big debt maturities coming out, four or five years down the road and some real questions about whether they can make it. But in the meantime, they have some debt coming due two years from now, where they actually have enough cash on hand right now to cover that. Now, something could go drastically wrong over the next two years, so there's always risk. And if you get involved in these distress issues, you certainly wanna spread your risk around, and have a portfolio of these issues rather than put all your eggs in one basket. Surely, although that's good advice in general in the market. So yes, you do get into other more qualitative factors. I just thought of a question that I'm sure our listeners will be very interested in. They're individual investors, they're buying stocks for their own accounts. Presumably, they're not son of Marty Fridson and they don't know high yield inside, upside down, or backwards. So a typical thing I'm sure many of them do when they want this exposure is they go to one of these two big ETFs. The tickers are HYG and JNK. And I wonder if I could say if you only had two or three things or one thing to tell them about those two ETFs by way of warning or recommendation or anything, what would you tell them about those? Well, I think that you do get benefit of diversification. There are gonna be some expenses associated with it. But I think it's come to think I should do more of a correlation with the indexes. This is great talking to people because my best ideas for studies come from these kinds of conversations. I'm just not smart enough to come up with all the good ideas on my own. When I worked on Wall Street, I used to make road trips to visit our institutional customers. And when I'm playing back, I would often think, you know, I heard that same question in three different places on this trip. There are probably others wondering that same thing. And then I would put out a study and I get feedback saying, wow, this is exactly the topic we were planning to discuss at our Monday morning meeting. And my hope was that my competitors didn't figure out my secret, which was actually listening to what the customer is saying. You know, heaven forbid you would do that. The other point I would make about the ETFs is that unlike an index such, you know, you can buy an index of the S&P 500, which will exactly replicate what is in that index. High yield bonds are not anywhere near as liquid as the stocks that you see in the S&P 500. You know, the large cap stocks where there's at any given instant, there's an active market, there are bids and offers above and below. The market and you can get an immediate execution. So it is possible for the index managers or the ETF managers to precisely replicate what's in those indices. That's just not feasible in high yield. So they're always gonna be a representation of what's in the index. And you know, they can do a pretty good approximation by the distribution by industry and quality and so forth, but it won't exactly replicate it. So you are gonna have some variance, even, you know, prior to expenses between what that index will return and what the high yield index. But you know, that could wind up being in a certain period of positive variance. You know, you do better for that. I saw a fellow do a presentation one time about, he was talking about like how the sausage is made or whatever. And he was talking about bond funds generally. And part of the argument he was making was that he had some concerns. And one of them was, if I understood it right, basically you've got this highly liquid thing. Like I'm looking at these two ETFs while we're talking on the screen. That's what I'm looking at here while you're talking. And you know, they trade like millions of shares, like the JNK just trade like 3.4 million shares average volume, they're hugely liquid. But the underlying contents, you know, like the underlying contents of an S&P 500 fund is pretty liquid, right? It's highly liquid. But this underlying content is less liquid. And I don't remember his whole argument, but I remember that being a concern. And I'm wondering if that ever troubles you about these ETFs. Yeah, no, it's an excellent point. And it also points to another reason for variance between the ETF and the index performance, namely that they have to buy and sell these securities where the index doesn't have to. There's no transaction costs and you can have fairly wide bid ask spreads, particularly on the lesser quality, smaller size issues. And so the transactions that are required to maintain the mix within those portfolios will detract somewhat from the performance. But you're right. The underlying securities are less liquid and particularly for an open-end mutual fund that faces daily redemptions, that could become a significant issue. It would take a very severe market disruption, sell-off, you know, loss of liquidity and so on before it really became material. But it is a possibility that the managers have to be conscious of and protect against and not kind of get too cute about it, let's say, about what they offer and cutting it too close where they don't have that cushion to account for that. With ETFs, there is a redemption and sort of renewal process that is open to selected large investors where they can come in. So it does enter into that process as well. But I would say within a reasonably wide range of performance, it's not gonna become a practical issue. But like a lot of things in the market, you do have to think about what could happen under very extreme circumstances and be conscious of that factor. Okay. We actually, we're at the point where I wanna ask you my final question, which you've answered it before. As always, I feel like we could sit here and pepper you for three hours because you're sort of the expert's experts and this is something we don't normally discuss. But for now, I'll just give you my final question. This is for our listeners. So if you could, and if you've already said the answer to the final question, just feel free to repeat it. That's no problem. But the final question is always the same for every guest, no matter what the topic. And it's simply, if you could leave our listeners with a single thought today, what would that be? What would you like it to be? Take your time. Yeah. Now, my one thought that I'd like to leave your listeners with is that you do have to take a long-term view. I know that's kind of a cliche, perhaps investors get tired of hearing it, but it really is true. The high yield market is subject to fairly significant moves over short run periods in response to events that wind up not having a lot of real consequences over any extended period. And it's very clear that if you try to time the market to that extent, I mean, absent a really major view about something that's gonna be a multi-year trend in the market, which may or may not be right about, but perhaps you could justify on the strength of very strong evidence. But reacting to short-term developments, I've done work on this and I've shown very clearly that you subtract and the active managers wind up underperforming the index because of this very reason that they do try to outguess the market about these short-term moves. So things that look very important today, I think it's a good exercise to go back over some of those news reports and see a year later whether people are still talking about it, whether it really wound up making a difference. So I think that's one of the most important things. It doesn't apply only to high yield, but given the swings because of the illiquidity we were talking about earlier, you can have swings that very definitely exaggerate the underlying significance of the event that triggered that move. Timely advice. Many people said, if so-and-so gets elected, I'm gonna sell it all. And they said it in 2016, in 2020, in 2024. It's the wrong thing every time. Great message. Thank you very much. And thanks for being here, Marty. It is always a great pleasure to speak with you. Yeah, it's always fun to being on the show and hope to be back again sooner than four years from now. Sooner than four years. You have my word. Sooner than four years. Great. Opinions expressed on this program are solely those of the contributor and do not necessarily reflect the opinions of Stansbury Research, its parent company, or affiliates.