May 1, 2025 • 44 mins
More corporate debt will plunge into distress when the US economy tanks, Marty Fridson, chief executive officer of Fridson Vision High Yield Strategy. “I have high confidence that we will get back to 1,000 basis points on the high-yield index as a whole at the worst point of the next recession,” the veteran credit strategist tells Bloomberg News’ James Crombie and Bloomberg Intelligence’s Spencer Cutter in the latest Credit Edge podcast. Corporate bonds trading at 1,000 basis points over Treasuries are usually seen by markets as being in distress, with a high likelihood of default. Fridson and Cutter also discuss energy sector bond opportunities, corporate bond default rates, ratings trends, the Federal Reserve put and liability management.
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Episode Transcript
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Speaker 1 (00:17):
Hello, and welcome to the Credit Edge, a weekly markets podcast.
My name is James Crumbie. I'm a senior editor at Bloomberg.
Speaker 2 (00:23):
Hi, this is Spencer Cutter. I'm a senior credit analyst
with Bloomberg Intelligence. And today we are thrilled to have
with us a legitimate fixed income legend, mister Marty Fritzen.
He's the youngest person ever to be inducted in the
Fixed Income Society Hall of Fame. Marty's Wall Street fixed
income background Drake dates back to the nineteen seventies and
includes stints at such firms as Solomon Brothers, Morgan Stanley,
(00:44):
and Merrill Lynch, where he was instrumental in the development
of Merrill's highield bond Index. He's since gone out on
his own and now runs fritz en Vision, which provides
empirically based, value focused investment recommendations.
Speaker 1 (00:55):
Yes, Spencer, As you mentioned, global markets are being royal
by trade wars and concerns about Federal Reserve independence. US
equity markets and the dollar have both dropped. Bond yields
are also higher this month. There's no safe haven bid
for treasuries as there has been another periods of prior
volatility and global investors are trying to find alternatives to
US assets As the storm rages on, Analysts meanwhile slashing
(01:17):
earnings estimates, fearing that a severe economic slowdown is coming
as a result of tariffs, and the risk of stagflation,
which would be very bad for corporate borrowers, is rising.
Despite all of this, the credit market reaction has been
relatively muted. So given a very troubling macro and geopolitical outlook,
we do expect to see a repricing wider in credit,
(01:37):
especially in high yeld bonds and loans. I do want
to start there, Marty, because one of the data sets
you are known for is a model of high yield
bond fair value. What do all the data tell us
about high yield bond fair value right now?
Speaker 3 (01:50):
Well, there's a lot wrapped up in that question. When
you talk about fair value, you're not really that's sure
making a market forecast. If the economy goes into recession,
particularly in a way that's not anticipated for an advance,
(02:13):
high old will perform poorly. It's and I think there
is a kind of a false confidence about how far
it can fall. Notion is that well, the credit mix,
the ratings mix, of the High Old Index is close
to the best it's ever been. That comparison really is
(02:37):
fairly strong. If you look at the history of the
High Old Index going back to nineteen eighty six, or
where you get a more specific rating breakdown from nineteen
ninety six onward, it hasn't changed all that much in
the last decade. And we had a recession in twenty twenty.
(03:00):
The spread on the High Old Index, and I use
here the option adjusted spread on the ice B of
a US High Old Index that did get to over
one thousand, close to eleven hundred in that very brief
recession of twenty twenty. The percentage of double b's is
(03:23):
a little bit higher than it was there the inconveniently
for those making such arguments, the triple C and lower
component is also slightly higher than it was when you
net it all out. If the spreads on the rating categories,
which weighted by those their representation in the High Held Index,
(03:48):
produce the spread on the index as a whole, you'll
get to about the same actually a few basis points
higher by my calculation than in the two So this
idea that well, we've had this radical improvement in the
quality of the index, and you can throw out all
history as far as how far spreads can go. Now
(04:10):
that is, does assume that a double bee of today
is similar to a double bee of just five years ago.
I mean, if you were to say, oh, well, let's
compare it to double b's of twenty five years ago,
I'm not sure there would be a big difference, but
at least that might be a plausible argument. But certainly
over the last five years there hasn't been some radical
(04:33):
change in rating standards, so I think there is some
false confidence out there. You mentioned the point about the
private credit, which is very important. The supply of highial
debt is no higher than it was ten years ago.
(04:53):
If you look at the face amount of bonds in
the that ic B of a us hilde so I mentioned,
it's essentially flat from a decade ago. And you can
assume that wealth has increased, investible funds allocations to the
demand for high old debt has increased. So we went
(05:14):
through quite a long period up until this recent sell
off started on Liberation Day on April second, where the
spreads were persistently too tight relative to fair value, which
talked about how I get to that fair value estimate.
(05:36):
That problem has been corrected by a substantial widening of
the spread since then, so we're close to fair value now.
But again, if you take the view within your shop
that we're on the verge of recession, yeah, you can
expect spreads to widen quite a bit from the four
(05:58):
to five hundred to where they'll reach in at the
maximum during the recession.
Speaker 2 (06:03):
Following up on your points of fair value and the
credit rating metric, our standards haven't really changed, and a
lot of the analysis is looking you know, as a
very empirically based, so you know, looking at just the
numbers where we are today versus where we've been. It
feels like for many of us, you know, part of
that is saying, well, this time it's not different, and
(06:24):
maybe it's not. Maybe it is, but we're now in
a position where global alliances are being reshuffled. The US
dollars position is a safe haven is you know, still there.
But it's being questioned. We saw the outflows of the
United States altogether. How much does that impact the empirical
analysis that that you're doing. Can you adjust for that
(06:46):
or do you feel like this time is really not
that different? It's different factors driving the volatility and sell
off today versus twenty twenty when oil prices briefly went,
you know, down to zero or negative. That was a
different driver. But the market's still the market, and fair
value is still fair value today versus five years ago.
Speaker 3 (07:06):
Yeah. Well, especially you can bring in all sorts of
predictions of the future. Keep in mind that there's a
ring of hell in Dante's Inferno reserved for fortune tellers.
Predicting the future for pay is illegal in New York City.
When the mayor finally starts to enforce that law, a
lot of people are going to be in serious trouble.
(07:28):
So I don't do that. I have views about all
those things you've mentioned, and investors should certainly take that
into account. But the as far as to say what
has driven spreads over time, they are really four factors
(07:49):
in my model that are not related or the views
on those things are subsumed in them. So one is
the most powerful factor is credit availability, and I use
for that a survey that's done quarterly by the Federal
(08:10):
Reserve of Senior Loan officers at banks and ask are
you currently tightening or easing your standards for companies to
qualify for loans, So it's not the rate that they're setting,
but the standard to qualify. Now, one limitation of that
is that it's done only once a quarter, and unfortunately
we're currently close to getting a new update. It was
(08:35):
mildly in the direction of net tightening a quarter ago
when the last survey was done. You would think that
if it's going to go in any direction from there,
it's going to be more in the direction of tightening
rather than easing in light of some of the factors
you've stated, So that could result in the fair value
(08:57):
spread going somewhat higher than it is and putting the
current spread back not necessarily an extreme relative to the
fair value that would cause you to make a significant
asset reallocation, but toward the tight side relative to fair value.
The other factors in the model, industrial production turns out
(09:18):
to be the most useful economic indicator. People sometimes say
to me, well, why not unemployment or GDP, and I say,
this is not Marty Fritzen's subjective view of how the
world ought to work. You know, basically, we take a
lot of things and throw them against the wall and
see what sticks. And capacity utilization and industrial production have
consistently over the years been the best economic indicators for
(09:41):
the high yield spreads. Specifically, the spread is also inversely
correlated with the underlying yield. The five year yield is
the closest to the average maturity for the high Yield index,
So the lower the treasure yield, the fair value spread.
(10:01):
And then I do bring in ratings mixed because over
a very long term there have been significant changes in
the breakdowns between double B single b's and triple C
and lower. So the triple C percentage specifically is the
best proxy for rating change. So that is taken into
account in my fair value estimate.
Speaker 1 (10:21):
But last time I looked at the model, Marty. And
also we should mention that the Bank of America indices
that you mentioned on high Yield, you were instrumental in
setting those up. You essentially created those.
Speaker 3 (10:33):
Well, no, I don't want to take unfair credit. I
did have some role in setting up the industry breakdowns,
and when payment and kind bonds and zero coupon bonds
came along, I encouraged them to bring that in. Those
bonds had not been included in the previous version of
(10:53):
the index. But Phil Galdy, who ran that operation Preston
Peacock along with him other ones. It's a tremendous, tremendous tool,
and I don't want to take on Dreker, but thank
you for mention. I did have some role.
Speaker 1 (11:10):
In it, a huge innovator. But going back to your model,
the last time I looked at it, the CIR called
fair value was let's say, I'm guessing about four twenty
five basis points over treasuries. We kind of went above
that in the volatility posts Tariff's announcements, but now we're back.
I'm looking at our own Bloomberg indext but we're now
back at three sixty, so, you know, closer to what
(11:32):
I think you were previously calling overvalue, maybe not extremely overvalued.
But it also seems to me things have only gotten
a lot worse since I last looked at the model.
So you know, to me, it would it would it
would imply in my head that fair value must be
a lot higher in terms of the high yield spread.
Speaker 3 (11:47):
Yeah, no, I think it's a valid point. The likelihood
is divergence in both directions. The spread because of the
credit availability measure, likely to go somewhat while and as
you say, the spreads have come in after that initial reaction,
and I think that that is related to the as
(12:09):
I mentioned, the supply has not grown because the issuance
has been diverted in large measure initially to the leverage
loan market, and more recently the private credit market has
been so successful that the lenders there who were previously
(12:31):
focused on small and medium enterprises have graduated to being
able to compete in the market for even the large
issuers that have access to the public hig bond market.
So we have a kind of a crowned shortage of supply.
And you can look at that in two ways to say, well,
that's a technical factor that supports and justifies spreads wherever
(12:54):
they are, or you can say, well that's a vulnerability
because it won't matter when a fault risk starts to
escalate significantly and investors will really be concerned and looking
to safety and not as an alternative to go into
private credit, but to go into treasury bonds or even
treasury bills if they're concerned enough about the outlook.
Speaker 1 (13:17):
But if you run the model today, what would it
give you as a fair value spread behind yield? Where
should we be based on all of the inputs you have.
Speaker 3 (13:24):
Well, it's a little hard to say. We're a little
ways away from getting an update on the credit availability measure,
so probably we're looking at moving somewhere upwards from four
hundred and fifty or so.
Speaker 2 (13:38):
Quick follow up question on the supply point that you
brought up, as mentioned earlier, I follow the energy sector,
and I've clearly noticed that same trend within energy if
you go back to twenty fifteen when we probably peaked
in terms of high old energy supply, and then where
we are today. I haven't done the analysis recently, but
(13:59):
I looked at like high yield independent energy debt outstanding
in the Bloomberg Index, and it's we're back down to
kind of where we were, as you mentioned ten, if
not fifteen years ago, from an energy standpoint. A lot
of that was bankruptcies that you know, companies went bankrupt
in twenty sixteen again twenty twenty, so those bonds disappeared
and they wrote off, you know, billions and billions of
dollars worth of debt, and then some of it was
(14:20):
also credit rating upgrades. Since twenty twenty, a lot of
the oil and gas companies, not just the producers, but
even the midstream companies which were relatively safe havens within
energy have been very focused on paying down debt, generating,
focusing on free cash flow, and you've seen leverage metrics
come down, and so a lot of companies like Apatche,
Occidental and others have gone from high yield into investment grade.
(14:44):
A lot of people, myself included, seem to think that
if we're going to have another downturn and energy, that
that least in the high yield side, provides some cushion.
I'm curious from the supply side overall, how much from
what you've seen, I've just following energy, but from the
broader market, how much of the smaller or stagnant high
yield supply is deals going to the private market or
going to the leverage little market versus maybe upgrades other
(15:07):
sector has been following the same trend, And does that
help provide some cushion if there's a downturn, or as
you said, is it just kind of doesn't really matter.
Speaker 3 (15:14):
Well, it's a good question. I never really got onto
the analysis. Sam Deroza Farag, who was at Credit Swiss
in the old days, used to do a very detailed
analysis of exactly what you're describing. Where the supply came from,
where it went, and so on. What I can tell
(15:34):
you is that what I have looked at is you
have a runoff of something on the order of twenty
or twenty five percent per year in high yield outstandings,
a combination of defaults, upgrades to investment grade retirements, including calls,
and those bonds may or may not get replaced with
(15:56):
high yield bonds, or may not get replaced at all.
The company is reducing that, as you say, in the
energy sector and batically, I think there's been some movement
you know better than I companies saying well, maybe raising
more money and investing at the when cruit is at
one hundred dollars a barrel isn't really the best way
(16:17):
to serve shareholders. Maybe we should return that capital to
the shareholders and you know, invest when prices are at
and more modest levels rather than peak levels, and not
get into situations where we're going to be sort of
exploiting very high cost reserves that won't ultimately be profitable.
(16:40):
But as they say, there's about a you know, twenty
or twenty five percent runoff in the outstanding amount, So
you have to have new issuance each year just to
stay even. And I think that's that's the real issue
to me, you know, the specific breakdown of where it goes. Again,
it's a combination of factors, but the key thing is
(17:02):
you have to have the new issuance coming. And we
haven't seen the growth in the new issue market that
we had historically seen going way back to the really
beginning in the late nineteen seventies, you had had a
very steady growth, but it's kind of leveled off in
more recent years.
Speaker 2 (17:20):
So sticking with energy, so my understanding is your view
recently at least has been that energy is one of
the sectors that might be cheap on a rating for
rating basis. I'm just kind of curious given the volatility
we've seen. I mean, I've seen some bonds widened by
well over one hundred basis points in the last couple
of weeks, and they've tightened by thirty or forty since then.
(17:40):
What's your view on energy or any of the other
industries right now that might be standouts as either relatively
cheap to their peers or conversely overpriced.
Speaker 3 (17:50):
Yeah, well, energy stands out, as you mentioned, it widened
recently and this was even before my gibvious update on
the industry relative value. So in a period from the
end of March through April twenty fourth, whereing the high
(18:10):
Yield Index as a whole widened by just eighteen basis points,
energy widened by seventy seven basis points. We also talk
about paper if we have time, which was the other
standout in that, But that was attributable, I believe to
the expectation that with a contraction of global trade, commodity
(18:33):
prices in general would come under pressure. Crude oil prices
did decline in that period, and there was also a
statement by Saudi Arabia that they were going to punish
some of these cheaters in OPEC plus who had been
exceeding their quotas by stepping up the Saudi production. So
(18:54):
that puts some further downward pressure. So energy is one
that's attractive, And let me describe what that means. You know,
if you say industry X, which has a lot of
triple c's, is that a wider spread than industry WHY,
which is mostly double bees. It's kind of a meaningless
statement because of course you're talking about the difference in
(19:17):
ratings mix rather than how that industry is perceived. So
with help of a research assistant, I do this very
laborious process, going through bond by bond in each of
the twenty largest industries represented in the High Old Index
and normalize for that difference in ratings mix, so that
(19:38):
we can say if they were if they all had
the same ratings mix, given how double bees within Energy
are trading compared to double b's in the peer group,
how single bees are trading, and so forth, then you
can see on a rating for rating basis, this industry
is rich or cheap, and by construction, half of them
(19:58):
are wider than the peer group and half of them
are narrower. But I also look at a separate dimension,
which is what do the rating agencies say about that
industry's ratings prospects? Because they put out rating outlooks for
every company in the speculative grade range that they rate,
(20:19):
saying that the rating is likely to remain stable, or
it's likely to decline or likely to improve, and they
don't put a specific timeframe on that, but people generally
feel about eighteen months or so is the horizon that
they're looking at. Well, Energy is in this kind of
anomalous position of being cheap relative to its ratings even
(20:43):
though the rating agencies are telling you that those ratings
are likely to improve. You'd expect the ones that are
trading cheap to their ratings to be the ones where
they say the ratings are likely to decline. That would
make sense that they would then be cheap relative to
the ratings. So energy is in that category and attractive again.
(21:03):
You know, if you say to me, I have a
crystal ball that says the crude oil price is going
to drop another ten percent next week, I'd say, well,
wait until another week before you buy them. But on
a fundamental kind of value basis, it is one of
five industries in that category currently. The others are diversified
(21:24):
financial services that excludes banks, thrifts, insurance companies, but leasing
companies and other other kinds of finance companies. Energy is one. Healthcare.
The retailers that's not the food or drug retailers, but
department stores, discounters, especialties stores, and utilities within high yield,
(21:47):
those are not typically the usual regulated electric power companies,
but more of the merchant power producers. But those five,
and it's unusual they have as many as five. Sometimes
you have only one out of the twenty that's in that.
If you picture that as a diagram, it's in the
northeast quadrant of the diagram, improving ratings and cheap relative
(22:13):
to the rating.
Speaker 2 (22:14):
Yeah, I just a quick comment. I'll hand it back
to James. I know he has a question, but for
me following energy can't help but think some of the
investors in the market are having sort of post traumatic
flashbacks to twenty twenty in twenty fifteen sixteen, and assuming
that that may play out again. As you mentioned, ratings
trend has been positive within energy, there's a lot less
debt within high heeled energy. Feels to me like you know,
(22:36):
downturn would certainly be painful, but perhaps less painful than
it was in twenty twenty. But wondering if that's knee
jerk reaction from the market.
Speaker 3 (22:43):
No, not at all. I mean, take a step back.
I'm very proud of the fact that in all the
years that I worked on Wall Street, the phrase our
chief economist says never once appeared in my research. And
it wasn't that I didn't have respect for them, but
my feeling was that for the people received our research,
half agreed with our chief economists and half disagreed, and
(23:05):
hence the market was where it was at. I mean,
that's the equilibrium that separation of opinion occurs. I didn't
want my research to be useful only to half of
the audience, so that's why I emphasize things like the
fair value analysis. And it's quite appropriate to have an
overlay of a house view about the direction of oil
(23:26):
prices or the direction of interest rates, whatever it might be.
And I think the combination of those two is the
way you get to, you hope, superior risk adjusted returns
over time. So I'm not at all discounting any of
those factors you say. But by the same time, by definition,
(23:48):
half of the market is more optimistic than the view
you've described. Hence we're at the oil price and the
spread on energy index that we're currently at.
Speaker 1 (24:00):
Looking of PTSD, which Spencer just built up. My PTSD
is more about to two thousand and eight, in which
the rating agency has just got coot wrong too slow.
Is there any chance in any of this analysis that
the rating agencies just aren't fast enough to act and
you know, on a broad scale, or is that just
not going to happen?
Speaker 3 (24:19):
Well, it's a big question. I've written quite a bit
about the rating agencies, not because I have a brief
to defend them or anything, but people sometimes lose sides
the fact that the rating agency say explicitly that ratings
are not investment recommendations, they're not price recommendations. Within a
(24:43):
rating category, you have quite a wide range and overlap
among the rating agencies, and that sometimes interprets me, oh, well,
they're wrong. Well, you know, what the ratings address is
probability of default and expected recovery in the event of default,
(25:03):
and to some extent, covenants are reflected in the ratings
as well. They don't address the liquidity of the issue,
which can be quite important at times, and they certainly
don't attempt to move ratings up and down on a
week to week or even a six months to six
(25:24):
month kind of basis. In high yield, they are they
strive to be more sensitive to changes in the environment
than would be the case in investment grade, where they
really will take a longer view. Stepping back from all that,
the portfolio managers, I don't think you can find anyone
in high yield who will say, oh, yeah, we just
(25:46):
rely on the ratings. That's how we make our decisions.
Not that they ignore that, it's not that they don't
see useful input. But really the great achievement of the
rating agencies is that the default rate over one year,
five years, ten years, whatever horizon is higher on double
a's than it is on triple as, higher on single a's,
(26:07):
and it is on double a's and higher all the
way down to the alphanumeric you know, triple C minus,
you know, higher than on triple C plus, And that
that is useful that they're giving you that kind of
assessment of default risk, which doesn't really change as dramatically
as the spreads do in response to short term development.
(26:33):
So I think if you look at ratings in their
proper role and as they're used by investors, I'm not
losing sleep about Oh well, well, you know, the spread
on some particular bond go from five hundred to seven
hundred without a signal from the rating agencies that it
has changed. It may go back to five hundred, and
(26:53):
then they'll say, oh, well, you forced me, by your
rating change to sell that bond, and now I have
to buy it back at a higher price they have.
I've gotten exactly that kind of criticism in the past.
So it's a no win proposition if the rainy agencies
were to say, oh, well, we accept all of the
responsibility that people putting on us, as opposed to here's
what we actually do. Here's how you should use the ratings.
(27:15):
If you choose not to do that, that's on you.
Speaker 2 (27:18):
Quick quick question. Since we've been sort of talking a
little bit here about distressed and post traumatic stress disorder,
et cetera, I'm curious what your view is on the
distressed market these days. My understanding, as you see, the
distressed ratio is a bit low relative to historical standards.
Obviously there's a lot of you know, with the volatility
in the market and concerns, there's probably a lot of
(27:38):
people out there trying to position themselves or thinking that,
you know, distressed investment opportunities may climb in the future years.
So just general overview, what's your expectations or outlooks for
the distressed market, and then also how is that influenced,
if at all, based on the amount of money that's
out there specifically earmarked for distressed investments. I just recall
some of the power downturns. You see the economy heading south,
(28:02):
people start to think there's going to be a lot
of stressed investment opportunities, so a lot of money gets raised,
and that money gets put to work, and then bonds
that normally might be trading at forty fifty cents on
the dollar trading at eighty cents on the dollar because
there's just so much money trading chasing so few distressed opportunities.
So I just kind of curious what your thoughts are
that dynamic and what your expectations might be.
Speaker 3 (28:23):
Yeah, the most recent calculation in the last few days,
the distress ratio came to six point seventy three. Now,
for those who may not be familiar, the distress ratio
is the percentage of issues in the high Old index
that are quoted at a thousand basis points are more
above treasuries. And that was a cutoff that I came
(28:45):
up with, you know, many years ago, and has been
widely adopted. There are some who say, well, we really
look at distressed at two thousand over, so we consider
a thousand stressed, But the terminology has been adopted by Otherstually,
it's not the kind of thing you can patent. So
I'm just proud that you know that without having exclusive
(29:07):
rights to the intellectual property. I've made some contribution to
the field in that way. But yeah, that's six point
seven percent compares with a median over time of eight
point three so it is a little bit low by
that standard. During recessions, it typically goes to thirty percent.
(29:27):
During that two thousand and eight two thousand nine that
was causing so much stress from memories for James, it
went to believe or not eighty seven percent. And that
was certainly a time when you didn't have to worry
about too much capital being thrown at distress that I mean,
there really were giveaways. I mean, if you talk to
(29:48):
people in mister stress market at that time, they said
they couldn't believe the opportunities that were there. Bonds that
certainly certainly didn't deserve to be training at distress level,
that had just been thrown out. You know, the baby
with the bath water. You know, people kind of get
carried away with that kind of metaphor sometimes, but that
was certainly an error where it was possible. Now there
(30:10):
there is a very definite asset class of distress debt.
There's money that's allocated to that that may not always
be in line with the supply, you know. Right now,
I think you have to be pretty selective, you know.
I think the opportunities are in very idiosyncratic companies where
(30:31):
investors have gotten dis enchanted, the stock market has said
given up on them, and so on. But when you
look more closely, they're pretty likely to continue paying their interests.
They may have the interest actually fairly well covered. They
have sufficient asset value where you can be comfortable on
the debt, particularly on you know, some bonds that are
(30:53):
maturing only two or three years out. Very unlikely now,
it would be rare to find something like that trading
it fifty cents on the dollar, but you can get
some pretty good returns on selected situations like that. So
I think that right now a distressed manager has to
be careful not go chasing something that is really kind
(31:17):
of a coin flip, whether it's going to make it
or not. But if some of the negative factors in
the economy and the financial markets that have been talked
about during this conversation, if those come to pass, you'll
certainly see the distress ratio rise get back to at
least a sort of a median historical level, and likely
(31:40):
beyond that. And then there'll be more opportunities to look at.
Speaker 1 (31:45):
On a related note, March the default rate. I'm interested
in your view that not only a sort of projection.
I know you have mentioned how dangerous it is to forecast,
and how it's probably illegal in this city, but I'm
going to ask you for a forecast. But besides that,
how do you even see it? Because on the one hand,
you've got liability management lemes which are kind of concealing
(32:06):
a lot of this, and on the other you've got
private credit where a lot of this stuff's going, so
you won't see it either. So how much of that
is playing into the default rate? And what do you
expect the default rate to be?
Speaker 3 (32:16):
Well, you know, great questions. I attended not very long
ago the Wharton Restructuring Conference dealing with distressed debt, and
it was interesting that LME was the byword this year.
Really the majority, by far of the sessions were one
way or another about liability management exercises, to a point
(32:39):
where frankly, I found that there wasn't really enough to
sustain that many different variations of the topic. But be
that as it may, what came up consistently in those
sessions was that the default rate on deals that have
been patched up with ls is fairly high. You know,
(33:01):
you get some that really do buy some time the
company is able to turn it around, but in others,
in other cases, many other cases, you're just postponing the inevitable.
So as far, it's not as if the lmes eliminate
default risk, certainly entirely may have some modifying effect. As
(33:22):
far as the private credit, you know, like some other
markets that have come before it, it has not yet
been tested by a really serious downturn, at least in
its modern current manifestation of having graduated to these larger
companies and a lot of capital has been thrown at
that sector. So that raises concerns. Are deals getting two
(33:45):
lacks the standards? You know, we'll find out, you know,
hard to assess for sure in advance. So with all that,
I'd say, I wouldn't expect to see radical, radically different
default results. That's always a great story for people whose
job is to raise money for high old managers. Oh,
(34:05):
we don't have to worry about default rates. I've heard
that in every cycle since the beginning, and it has
never really panned out. I mean, default continue to occur Now,
Moody's doesn't put out a specific US speculative grade bonds
only forecast. They do report a figure, but I have
(34:27):
to kind of back into what that figure would be
based on their US bonds and loans figure versus the
bond's only figure that they do produce, and my best
estimate of that is two point one six percent as
a base case, and I would say that their base
case is a pretty good analysis. I sort of stopped doing,
(34:52):
you know, trying to come up with an improved default
rate forecasting model, which I think would be legitimate. It
wouldn't be predicting the future. It would be saying, you know,
based on experience is you know, and the factors that
influence the default rate. But I think it's a pretty
good model. Now I also look at what is the
market saying. And let me just say that this is
(35:16):
not a break even analysis. I've written essentially to show
how if you take this spread versus treasuries, adjust for
recoveries in default, and then subtract that, you know that, no,
that is not a good measure of the expected default
rate in the market. The real way to do it
(35:36):
is to look at the distress ratio, because Essentially, all
defaults occur in bonds that have been at a thousand
or more over treasuries well before they default, back when
you had more financial reporting fraud, before sarabainez Oxley, there
was a greater likelihood of a bond trading at a
decent level and then all of a sudden being in default.
(35:59):
That's highly unlikely today. So the number, then there's a
quantitative of a formula that I won't go into detail here,
but the bottom line on it is that that currently
indicates that the market is expecting a default rate on
US speculative grade bonds of three point eight percent, So
(36:20):
you're well over a percentage point greater. And for what
it's worth, the distress market has tended to perform quite
well when there's a gap of one percentage point or more,
much less one point six percentage points. So we'll see
if the market is better. You know, again, Moody's has
an optimistic and a pessimistic scenario, so they're not ignoring
(36:46):
the possibilities, but they're basically saying, our base case is
sort of a consensus forecast of the economy right now.
If it turns out that that consensus is too optimistic,
then you know, maybe the default rate really really will
be more in line with that three point eight and
that's over the next twelve months.
Speaker 1 (37:03):
Are you surprised though, that the credit markets have functioned
so well and you know, the spreads haven't moved very
much until you know, it strikes me that credit markets
don't seem to believe that the tariffs will stick, or
the trade will end in a bad outcome, or you know,
all of these extreme policies will actually go through.
Speaker 3 (37:21):
Well. Yeah, I think there's been some mirroring of the
equity market, which since April second have had five hundred
and one thousand down days and five hundred thousand up
days as well. And I think that the initial response
was quite appropriate to say, if we're really going to
go to one hundred and forty five percent tariff on
(37:42):
China and we're going to throw up the tariff barriers
to Canada and Mexico that had been talked about and
really throw out our historical alliances with the NATO countries,
that's that's pretty dire and was appropriate that the spreads
did widen by one hundred bases points are more initially,
(38:05):
and it's appropriate that they have come back. As Trump
has talked back. Scott Bessened in particular has been saying, well,
I haven't talked to Trump. I don't know if he's
talked to the Chinese about this. He ought to know,
one would think, but this isn't sustainable that we continue
at this kind of a level. And that has provided
some reassurance to the market, and Trump himself has kind
(38:28):
of walked back this, Well, can't get rid of Jerome
Powell soon enough to saying well, I'm not playing to
fire him. Now. You have to wonder how much of
that is a real change of heart, how much of
that is Oh, the stock market reacted very poorly. A
lot of people have four oh one k's and we
have midterm elections coming up. I don't want to be
(38:48):
too cynical about this, but whatever the motivations for these
changes were, I think the market is I think correctly
sensing some change of aggressiveness, swiftness of change and so on. So,
you know, doesn't rule out that if trade talks come
to a standstill, of China just digs in its heels
(39:12):
in the US digs in its heels feeling and maybe
appropriate to use the phrase and dealing with China that
the US wants to save face not be seen as
backing down. Yeah, you could see the situation worsening again,
and I would expect the hyld market to reverse course
again and widen out very substantially. If we see.
Speaker 1 (39:32):
That, worries you most about the outlook for the next
six months.
Speaker 3 (39:37):
I think the trade situation has to be at the
top of the list, because you know, we're used to
dealing with recessions. Recessions come along, and we might have
been due for a recession without any of that. If
someone else other than Donald Trump had been elected, or
if Trump had been elected and decided to focus on
(39:58):
one of his other many issues rather than putting tariffs
at the forefront, we might have been in a recession
before the end of twenty twenty five. Anyway, Recessions do
come along periodically, and if you consider that the twenty
twenty recession really was triggered by the pandemic, which was
a sort of out of nowhere kind of development, then
(40:19):
we've gone since two thousand and nine without a real,
real recession, if you want to put it that way.
So perhaps we were due anyway, But I think that
people know how to deal with that in dealing with
a portfolio, they say, well, okay, we can look at
nineteen ninety ninety one, we can look at two thousand
and one. Maybe we throw out two thousand and eight,
(40:39):
two thousand and nine, but we do have the most
recent experience of twenty twenty, you know, just two months worth.
But we know what to expect. We can differentiate between
cyclical and well, there may not be any completely non
cyclical companies and certainly no countercyclical companies out there, but
(41:01):
we can adjust, and despite the bad mouthing of the
rating agencies, sometimes here maybe we will pay some attention
to how many triple c's we have in the portfolio,
even though you know, we like some of them, and
maybe we'll hold on to some of them, but we're
probably going to upgrade the portfolio in light of that expectation.
(41:23):
So I think that does really have to be until
we can get to a point where we say, okay,
at least we know where we stand. Maybe we are
going to have ten percent tariff that is going to
have some adverse effect on global trade, but at least
we know where we stand. I think, you know, it's
(41:44):
not only the impact of tariffs, but the huge uncertainty
that continuing to surround them.
Speaker 1 (41:52):
But also if there is a recession, then the HILD
spread needs to be double or more where it is now.
Speaker 3 (41:57):
Oh yeah, again, I just don't buy this story that
you only have to go to seven or eight hundred
bases points. That's the maximum we'll go to. Now, there
is a story, I think a legitimate one. One of
the seal side shops put out a piece recent They said, well,
you know there's a FED put and no, that's a
debatable point. But you know, I think it's plausible to say, well,
(42:17):
we can count on the FED despite all its other mandates,
you know, the two actual legal mandates of stable prices
consistent with full employment. The law doesn't say that the
FED is supposed to be concerned about the trade exchange
value of the dollar or the value of the stock market. Realistically,
they start to feel some pressure from Congress, you know,
(42:38):
when those things fall out of bed. But even with
all that, maybe the FED does pay attention to where
the high yield spread is. It is concerned about availability
of credit for companies that don't qualify for the very
top credit ratings, and so maybe you can say oh,
at some point, and the figure I saw in research
(42:59):
was seven hundred and twenty basis points. Don't interpret that
is meaning that's where the spread stops. Again mentioning Milton Friedman,
he famously said that FED policy operates monetary policy operates
with a lawn lag. So if the Fed starts to
(43:20):
ease credit in response to a widening of the high
old bond spread, which ninety percent of the population has
no idea what you're talking about, but let's grant the
premise that it will jump in at that point. It's
not going to stop on a dime. You'll see the
spread continue to widen from there, and I have high
confidence that we will get back to a thousand basis
(43:40):
points on the high Old index as a whole at
the worst point of the next recession, whenever that occurs.
Speaker 1 (43:47):
Great stuff, Marti Fritz and chief executive officer of Fritz
and Vision High Yield Strategy. It's been a pleasure having
you on the Credit Edge Money.
Speaker 3 (43:53):
Thanks really been a pleasure to speak with you and.
Speaker 1 (43:55):
To Spencer Cuts up with Bloomberg Intelligence. Thank you very
much for joining us today.
Speaker 2 (43:58):
Thank you my pleasure.
Speaker 1 (44:00):
Even more great credit market analysis Read all of Spencer's
great work on the Bloomberg Terminal. Bloomberg Intelligence is part
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(44:22):
on Apple, Spotify, and all other good podcast providers, including
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pleasure having you join us again next week on the
Credit Edge
Hello, and welcome to the Credit Edge, a weekly markets podcast.
My name is James Crumbie. I'm a senior editor at Bloomberg.
Speaker 2 (00:23):
Hi, this is Spencer Cutter. I'm a senior credit analyst
with Bloomberg Intelligence. And today we are thrilled to have
with us a legitimate fixed income legend, mister Marty Fritzen.
He's the youngest person ever to be inducted in the
Fixed Income Society Hall of Fame. Marty's Wall Street fixed
income background Drake dates back to the nineteen seventies and
includes stints at such firms as Solomon Brothers, Morgan Stanley,
(00:44):
and Merrill Lynch, where he was instrumental in the development
of Merrill's highield bond Index. He's since gone out on
his own and now runs fritz en Vision, which provides
empirically based, value focused investment recommendations.
Speaker 1 (00:55):
Yes, Spencer, As you mentioned, global markets are being royal
by trade wars and concerns about Federal Reserve independence. US
equity markets and the dollar have both dropped. Bond yields
are also higher this month. There's no safe haven bid
for treasuries as there has been another periods of prior
volatility and global investors are trying to find alternatives to
US assets As the storm rages on, Analysts meanwhile slashing
(01:17):
earnings estimates, fearing that a severe economic slowdown is coming
as a result of tariffs, and the risk of stagflation,
which would be very bad for corporate borrowers, is rising.
Despite all of this, the credit market reaction has been
relatively muted. So given a very troubling macro and geopolitical outlook,
we do expect to see a repricing wider in credit,
(01:37):
especially in high yeld bonds and loans. I do want
to start there, Marty, because one of the data sets
you are known for is a model of high yield
bond fair value. What do all the data tell us
about high yield bond fair value right now?
Speaker 3 (01:50):
Well, there's a lot wrapped up in that question. When
you talk about fair value, you're not really that's sure
making a market forecast. If the economy goes into recession,
particularly in a way that's not anticipated for an advance,
(02:13):
high old will perform poorly. It's and I think there
is a kind of a false confidence about how far
it can fall. Notion is that well, the credit mix,
the ratings mix, of the High Old Index is close
to the best it's ever been. That comparison really is
(02:37):
fairly strong. If you look at the history of the
High Old Index going back to nineteen eighty six, or
where you get a more specific rating breakdown from nineteen
ninety six onward, it hasn't changed all that much in
the last decade. And we had a recession in twenty twenty.
(03:00):
The spread on the High Old Index, and I use
here the option adjusted spread on the ice B of
a US High Old Index that did get to over
one thousand, close to eleven hundred in that very brief
recession of twenty twenty. The percentage of double b's is
(03:23):
a little bit higher than it was there the inconveniently
for those making such arguments, the triple C and lower
component is also slightly higher than it was when you
net it all out. If the spreads on the rating categories,
which weighted by those their representation in the High Held Index,
(03:48):
produce the spread on the index as a whole, you'll
get to about the same actually a few basis points
higher by my calculation than in the two So this
idea that well, we've had this radical improvement in the
quality of the index, and you can throw out all
history as far as how far spreads can go. Now
(04:10):
that is, does assume that a double bee of today
is similar to a double bee of just five years ago.
I mean, if you were to say, oh, well, let's
compare it to double b's of twenty five years ago,
I'm not sure there would be a big difference, but
at least that might be a plausible argument. But certainly
over the last five years there hasn't been some radical
(04:33):
change in rating standards, so I think there is some
false confidence out there. You mentioned the point about the
private credit, which is very important. The supply of highial
debt is no higher than it was ten years ago.
(04:53):
If you look at the face amount of bonds in
the that ic B of a us hilde so I mentioned,
it's essentially flat from a decade ago. And you can
assume that wealth has increased, investible funds allocations to the
demand for high old debt has increased. So we went
(05:14):
through quite a long period up until this recent sell
off started on Liberation Day on April second, where the
spreads were persistently too tight relative to fair value, which
talked about how I get to that fair value estimate.
(05:36):
That problem has been corrected by a substantial widening of
the spread since then, so we're close to fair value now.
But again, if you take the view within your shop
that we're on the verge of recession, yeah, you can
expect spreads to widen quite a bit from the four
(05:58):
to five hundred to where they'll reach in at the
maximum during the recession.
Speaker 2 (06:03):
Following up on your points of fair value and the
credit rating metric, our standards haven't really changed, and a
lot of the analysis is looking you know, as a
very empirically based, so you know, looking at just the
numbers where we are today versus where we've been. It
feels like for many of us, you know, part of
that is saying, well, this time it's not different, and
(06:24):
maybe it's not. Maybe it is, but we're now in
a position where global alliances are being reshuffled. The US
dollars position is a safe haven is you know, still there.
But it's being questioned. We saw the outflows of the
United States altogether. How much does that impact the empirical
analysis that that you're doing. Can you adjust for that
(06:46):
or do you feel like this time is really not
that different? It's different factors driving the volatility and sell
off today versus twenty twenty when oil prices briefly went,
you know, down to zero or negative. That was a
different driver. But the market's still the market, and fair
value is still fair value today versus five years ago.
Speaker 3 (07:06):
Yeah. Well, especially you can bring in all sorts of
predictions of the future. Keep in mind that there's a
ring of hell in Dante's Inferno reserved for fortune tellers.
Predicting the future for pay is illegal in New York City.
When the mayor finally starts to enforce that law, a
lot of people are going to be in serious trouble.
(07:28):
So I don't do that. I have views about all
those things you've mentioned, and investors should certainly take that
into account. But the as far as to say what
has driven spreads over time, they are really four factors
(07:49):
in my model that are not related or the views
on those things are subsumed in them. So one is
the most powerful factor is credit availability, and I use
for that a survey that's done quarterly by the Federal
(08:10):
Reserve of Senior Loan officers at banks and ask are
you currently tightening or easing your standards for companies to
qualify for loans, So it's not the rate that they're setting,
but the standard to qualify. Now, one limitation of that
is that it's done only once a quarter, and unfortunately
we're currently close to getting a new update. It was
(08:35):
mildly in the direction of net tightening a quarter ago
when the last survey was done. You would think that
if it's going to go in any direction from there,
it's going to be more in the direction of tightening
rather than easing in light of some of the factors
you've stated, So that could result in the fair value
(08:57):
spread going somewhat higher than it is and putting the
current spread back not necessarily an extreme relative to the
fair value that would cause you to make a significant
asset reallocation, but toward the tight side relative to fair value.
The other factors in the model, industrial production turns out
(09:18):
to be the most useful economic indicator. People sometimes say
to me, well, why not unemployment or GDP, and I say,
this is not Marty Fritzen's subjective view of how the
world ought to work. You know, basically, we take a
lot of things and throw them against the wall and
see what sticks. And capacity utilization and industrial production have
consistently over the years been the best economic indicators for
(09:41):
the high yield spreads. Specifically, the spread is also inversely
correlated with the underlying yield. The five year yield is
the closest to the average maturity for the high Yield index,
So the lower the treasure yield, the fair value spread.
(10:01):
And then I do bring in ratings mixed because over
a very long term there have been significant changes in
the breakdowns between double B single b's and triple C
and lower. So the triple C percentage specifically is the
best proxy for rating change. So that is taken into
account in my fair value estimate.
Speaker 1 (10:21):
But last time I looked at the model, Marty. And
also we should mention that the Bank of America indices
that you mentioned on high Yield, you were instrumental in
setting those up. You essentially created those.
Speaker 3 (10:33):
Well, no, I don't want to take unfair credit. I
did have some role in setting up the industry breakdowns,
and when payment and kind bonds and zero coupon bonds
came along, I encouraged them to bring that in. Those
bonds had not been included in the previous version of
(10:53):
the index. But Phil Galdy, who ran that operation Preston
Peacock along with him other ones. It's a tremendous, tremendous tool,
and I don't want to take on Dreker, but thank
you for mention. I did have some role.
Speaker 1 (11:10):
In it, a huge innovator. But going back to your model,
the last time I looked at it, the CIR called
fair value was let's say, I'm guessing about four twenty
five basis points over treasuries. We kind of went above
that in the volatility posts Tariff's announcements, but now we're back.
I'm looking at our own Bloomberg indext but we're now
back at three sixty, so, you know, closer to what
(11:32):
I think you were previously calling overvalue, maybe not extremely overvalued.
But it also seems to me things have only gotten
a lot worse since I last looked at the model.
So you know, to me, it would it would it
would imply in my head that fair value must be
a lot higher in terms of the high yield spread.
Speaker 3 (11:47):
Yeah, no, I think it's a valid point. The likelihood
is divergence in both directions. The spread because of the
credit availability measure, likely to go somewhat while and as
you say, the spreads have come in after that initial reaction,
and I think that that is related to the as
(12:09):
I mentioned, the supply has not grown because the issuance
has been diverted in large measure initially to the leverage
loan market, and more recently the private credit market has
been so successful that the lenders there who were previously
(12:31):
focused on small and medium enterprises have graduated to being
able to compete in the market for even the large
issuers that have access to the public hig bond market.
So we have a kind of a crowned shortage of supply.
And you can look at that in two ways to say, well,
that's a technical factor that supports and justifies spreads wherever
(12:54):
they are, or you can say, well that's a vulnerability
because it won't matter when a fault risk starts to
escalate significantly and investors will really be concerned and looking
to safety and not as an alternative to go into
private credit, but to go into treasury bonds or even
treasury bills if they're concerned enough about the outlook.
Speaker 1 (13:17):
But if you run the model today, what would it
give you as a fair value spread behind yield? Where
should we be based on all of the inputs you have.
Speaker 3 (13:24):
Well, it's a little hard to say. We're a little
ways away from getting an update on the credit availability measure,
so probably we're looking at moving somewhere upwards from four
hundred and fifty or so.
Speaker 2 (13:38):
Quick follow up question on the supply point that you
brought up, as mentioned earlier, I follow the energy sector,
and I've clearly noticed that same trend within energy if
you go back to twenty fifteen when we probably peaked
in terms of high old energy supply, and then where
we are today. I haven't done the analysis recently, but
(13:59):
I looked at like high yield independent energy debt outstanding
in the Bloomberg Index, and it's we're back down to
kind of where we were, as you mentioned ten, if
not fifteen years ago, from an energy standpoint. A lot
of that was bankruptcies that you know, companies went bankrupt
in twenty sixteen again twenty twenty, so those bonds disappeared
and they wrote off, you know, billions and billions of
dollars worth of debt, and then some of it was
(14:20):
also credit rating upgrades. Since twenty twenty, a lot of
the oil and gas companies, not just the producers, but
even the midstream companies which were relatively safe havens within
energy have been very focused on paying down debt, generating,
focusing on free cash flow, and you've seen leverage metrics
come down, and so a lot of companies like Apatche,
Occidental and others have gone from high yield into investment grade.
(14:44):
A lot of people, myself included, seem to think that
if we're going to have another downturn and energy, that
that least in the high yield side, provides some cushion.
I'm curious from the supply side overall, how much from
what you've seen, I've just following energy, but from the
broader market, how much of the smaller or stagnant high
yield supply is deals going to the private market or
going to the leverage little market versus maybe upgrades other
(15:07):
sector has been following the same trend, And does that
help provide some cushion if there's a downturn, or as
you said, is it just kind of doesn't really matter.
Speaker 3 (15:14):
Well, it's a good question. I never really got onto
the analysis. Sam Deroza Farag, who was at Credit Swiss
in the old days, used to do a very detailed
analysis of exactly what you're describing. Where the supply came from,
where it went, and so on. What I can tell
(15:34):
you is that what I have looked at is you
have a runoff of something on the order of twenty
or twenty five percent per year in high yield outstandings,
a combination of defaults, upgrades to investment grade retirements, including calls,
and those bonds may or may not get replaced with
(15:56):
high yield bonds, or may not get replaced at all.
The company is reducing that, as you say, in the
energy sector and batically, I think there's been some movement
you know better than I companies saying well, maybe raising
more money and investing at the when cruit is at
one hundred dollars a barrel isn't really the best way
(16:17):
to serve shareholders. Maybe we should return that capital to
the shareholders and you know, invest when prices are at
and more modest levels rather than peak levels, and not
get into situations where we're going to be sort of
exploiting very high cost reserves that won't ultimately be profitable.
(16:40):
But as they say, there's about a you know, twenty
or twenty five percent runoff in the outstanding amount, So
you have to have new issuance each year just to
stay even. And I think that's that's the real issue
to me, you know, the specific breakdown of where it goes. Again,
it's a combination of factors, but the key thing is
(17:02):
you have to have the new issuance coming. And we
haven't seen the growth in the new issue market that
we had historically seen going way back to the really
beginning in the late nineteen seventies, you had had a
very steady growth, but it's kind of leveled off in
more recent years.
Speaker 2 (17:20):
So sticking with energy, so my understanding is your view
recently at least has been that energy is one of
the sectors that might be cheap on a rating for
rating basis. I'm just kind of curious given the volatility
we've seen. I mean, I've seen some bonds widened by
well over one hundred basis points in the last couple
of weeks, and they've tightened by thirty or forty since then.
(17:40):
What's your view on energy or any of the other
industries right now that might be standouts as either relatively
cheap to their peers or conversely overpriced.
Speaker 3 (17:50):
Yeah, well, energy stands out, as you mentioned, it widened
recently and this was even before my gibvious update on
the industry relative value. So in a period from the
end of March through April twenty fourth, whereing the high
(18:10):
Yield Index as a whole widened by just eighteen basis points,
energy widened by seventy seven basis points. We also talk
about paper if we have time, which was the other
standout in that, But that was attributable, I believe to
the expectation that with a contraction of global trade, commodity
(18:33):
prices in general would come under pressure. Crude oil prices
did decline in that period, and there was also a
statement by Saudi Arabia that they were going to punish
some of these cheaters in OPEC plus who had been
exceeding their quotas by stepping up the Saudi production. So
(18:54):
that puts some further downward pressure. So energy is one
that's attractive, And let me describe what that means. You know,
if you say industry X, which has a lot of
triple c's, is that a wider spread than industry WHY,
which is mostly double bees. It's kind of a meaningless
statement because of course you're talking about the difference in
(19:17):
ratings mix rather than how that industry is perceived. So
with help of a research assistant, I do this very
laborious process, going through bond by bond in each of
the twenty largest industries represented in the High Old Index
and normalize for that difference in ratings mix, so that
(19:38):
we can say if they were if they all had
the same ratings mix, given how double bees within Energy
are trading compared to double b's in the peer group,
how single bees are trading, and so forth, then you
can see on a rating for rating basis, this industry
is rich or cheap, and by construction, half of them
(19:58):
are wider than the peer group and half of them
are narrower. But I also look at a separate dimension,
which is what do the rating agencies say about that
industry's ratings prospects? Because they put out rating outlooks for
every company in the speculative grade range that they rate,
(20:19):
saying that the rating is likely to remain stable, or
it's likely to decline or likely to improve, and they
don't put a specific timeframe on that, but people generally
feel about eighteen months or so is the horizon that
they're looking at. Well, Energy is in this kind of
anomalous position of being cheap relative to its ratings even
(20:43):
though the rating agencies are telling you that those ratings
are likely to improve. You'd expect the ones that are
trading cheap to their ratings to be the ones where
they say the ratings are likely to decline. That would
make sense that they would then be cheap relative to
the ratings. So energy is in that category and attractive again.
(21:03):
You know, if you say to me, I have a
crystal ball that says the crude oil price is going
to drop another ten percent next week, I'd say, well,
wait until another week before you buy them. But on
a fundamental kind of value basis, it is one of
five industries in that category currently. The others are diversified
(21:24):
financial services that excludes banks, thrifts, insurance companies, but leasing
companies and other other kinds of finance companies. Energy is one. Healthcare.
The retailers that's not the food or drug retailers, but
department stores, discounters, especialties stores, and utilities within high yield,
(21:47):
those are not typically the usual regulated electric power companies,
but more of the merchant power producers. But those five,
and it's unusual they have as many as five. Sometimes
you have only one out of the twenty that's in that.
If you picture that as a diagram, it's in the
northeast quadrant of the diagram, improving ratings and cheap relative
(22:13):
to the rating.
Speaker 2 (22:14):
Yeah, I just a quick comment. I'll hand it back
to James. I know he has a question, but for
me following energy can't help but think some of the
investors in the market are having sort of post traumatic
flashbacks to twenty twenty in twenty fifteen sixteen, and assuming
that that may play out again. As you mentioned, ratings
trend has been positive within energy, there's a lot less
debt within high heeled energy. Feels to me like you know,
(22:36):
downturn would certainly be painful, but perhaps less painful than
it was in twenty twenty. But wondering if that's knee
jerk reaction from the market.
Speaker 3 (22:43):
No, not at all. I mean, take a step back.
I'm very proud of the fact that in all the
years that I worked on Wall Street, the phrase our
chief economist says never once appeared in my research. And
it wasn't that I didn't have respect for them, but
my feeling was that for the people received our research,
half agreed with our chief economists and half disagreed, and
(23:05):
hence the market was where it was at. I mean,
that's the equilibrium that separation of opinion occurs. I didn't
want my research to be useful only to half of
the audience, so that's why I emphasize things like the
fair value analysis. And it's quite appropriate to have an
overlay of a house view about the direction of oil
(23:26):
prices or the direction of interest rates, whatever it might be.
And I think the combination of those two is the
way you get to, you hope, superior risk adjusted returns
over time. So I'm not at all discounting any of
those factors you say. But by the same time, by definition,
(23:48):
half of the market is more optimistic than the view
you've described. Hence we're at the oil price and the
spread on energy index that we're currently at.
Speaker 1 (24:00):
Looking of PTSD, which Spencer just built up. My PTSD
is more about to two thousand and eight, in which
the rating agency has just got coot wrong too slow.
Is there any chance in any of this analysis that
the rating agencies just aren't fast enough to act and
you know, on a broad scale, or is that just
not going to happen?
Speaker 3 (24:19):
Well, it's a big question. I've written quite a bit
about the rating agencies, not because I have a brief
to defend them or anything, but people sometimes lose sides
the fact that the rating agency say explicitly that ratings
are not investment recommendations, they're not price recommendations. Within a
(24:43):
rating category, you have quite a wide range and overlap
among the rating agencies, and that sometimes interprets me, oh, well,
they're wrong. Well, you know, what the ratings address is
probability of default and expected recovery in the event of default,
(25:03):
and to some extent, covenants are reflected in the ratings
as well. They don't address the liquidity of the issue,
which can be quite important at times, and they certainly
don't attempt to move ratings up and down on a
week to week or even a six months to six
(25:24):
month kind of basis. In high yield, they are they
strive to be more sensitive to changes in the environment
than would be the case in investment grade, where they
really will take a longer view. Stepping back from all that,
the portfolio managers, I don't think you can find anyone
in high yield who will say, oh, yeah, we just
(25:46):
rely on the ratings. That's how we make our decisions.
Not that they ignore that, it's not that they don't
see useful input. But really the great achievement of the
rating agencies is that the default rate over one year,
five years, ten years, whatever horizon is higher on double
a's than it is on triple as, higher on single a's,
(26:07):
and it is on double a's and higher all the
way down to the alphanumeric you know, triple C minus,
you know, higher than on triple C plus, And that
that is useful that they're giving you that kind of
assessment of default risk, which doesn't really change as dramatically
as the spreads do in response to short term development.
(26:33):
So I think if you look at ratings in their
proper role and as they're used by investors, I'm not
losing sleep about Oh well, well, you know, the spread
on some particular bond go from five hundred to seven
hundred without a signal from the rating agencies that it
has changed. It may go back to five hundred, and
(26:53):
then they'll say, oh, well, you forced me, by your
rating change to sell that bond, and now I have
to buy it back at a higher price they have.
I've gotten exactly that kind of criticism in the past.
So it's a no win proposition if the rainy agencies
were to say, oh, well, we accept all of the
responsibility that people putting on us, as opposed to here's
what we actually do. Here's how you should use the ratings.
(27:15):
If you choose not to do that, that's on you.
Speaker 2 (27:18):
Quick quick question. Since we've been sort of talking a
little bit here about distressed and post traumatic stress disorder,
et cetera, I'm curious what your view is on the
distressed market these days. My understanding, as you see, the
distressed ratio is a bit low relative to historical standards.
Obviously there's a lot of you know, with the volatility
in the market and concerns, there's probably a lot of
(27:38):
people out there trying to position themselves or thinking that,
you know, distressed investment opportunities may climb in the future years.
So just general overview, what's your expectations or outlooks for
the distressed market, and then also how is that influenced,
if at all, based on the amount of money that's
out there specifically earmarked for distressed investments. I just recall
some of the power downturns. You see the economy heading south,
(28:02):
people start to think there's going to be a lot
of stressed investment opportunities, so a lot of money gets raised,
and that money gets put to work, and then bonds
that normally might be trading at forty fifty cents on
the dollar trading at eighty cents on the dollar because
there's just so much money trading chasing so few distressed opportunities.
So I just kind of curious what your thoughts are
that dynamic and what your expectations might be.
Speaker 3 (28:23):
Yeah, the most recent calculation in the last few days,
the distress ratio came to six point seventy three. Now,
for those who may not be familiar, the distress ratio
is the percentage of issues in the high Old index
that are quoted at a thousand basis points are more
above treasuries. And that was a cutoff that I came
(28:45):
up with, you know, many years ago, and has been
widely adopted. There are some who say, well, we really
look at distressed at two thousand over, so we consider
a thousand stressed, But the terminology has been adopted by Otherstually,
it's not the kind of thing you can patent. So
I'm just proud that you know that without having exclusive
(29:07):
rights to the intellectual property. I've made some contribution to
the field in that way. But yeah, that's six point
seven percent compares with a median over time of eight
point three so it is a little bit low by
that standard. During recessions, it typically goes to thirty percent.
(29:27):
During that two thousand and eight two thousand nine that
was causing so much stress from memories for James, it
went to believe or not eighty seven percent. And that
was certainly a time when you didn't have to worry
about too much capital being thrown at distress that I mean,
there really were giveaways. I mean, if you talk to
(29:48):
people in mister stress market at that time, they said
they couldn't believe the opportunities that were there. Bonds that
certainly certainly didn't deserve to be training at distress level,
that had just been thrown out. You know, the baby
with the bath water. You know, people kind of get
carried away with that kind of metaphor sometimes, but that
was certainly an error where it was possible. Now there
(30:10):
there is a very definite asset class of distress debt.
There's money that's allocated to that that may not always
be in line with the supply, you know. Right now,
I think you have to be pretty selective, you know.
I think the opportunities are in very idiosyncratic companies where
(30:31):
investors have gotten dis enchanted, the stock market has said
given up on them, and so on. But when you
look more closely, they're pretty likely to continue paying their interests.
They may have the interest actually fairly well covered. They
have sufficient asset value where you can be comfortable on
the debt, particularly on you know, some bonds that are
(30:53):
maturing only two or three years out. Very unlikely now,
it would be rare to find something like that trading
it fifty cents on the dollar, but you can get
some pretty good returns on selected situations like that. So
I think that right now a distressed manager has to
be careful not go chasing something that is really kind
(31:17):
of a coin flip, whether it's going to make it
or not. But if some of the negative factors in
the economy and the financial markets that have been talked
about during this conversation, if those come to pass, you'll
certainly see the distress ratio rise get back to at
least a sort of a median historical level, and likely
(31:40):
beyond that. And then there'll be more opportunities to look at.
Speaker 1 (31:45):
On a related note, March the default rate. I'm interested
in your view that not only a sort of projection.
I know you have mentioned how dangerous it is to forecast,
and how it's probably illegal in this city, but I'm
going to ask you for a forecast. But besides that,
how do you even see it? Because on the one hand,
you've got liability management lemes which are kind of concealing
(32:06):
a lot of this, and on the other you've got
private credit where a lot of this stuff's going, so
you won't see it either. So how much of that
is playing into the default rate? And what do you
expect the default rate to be?
Speaker 3 (32:16):
Well, you know, great questions. I attended not very long
ago the Wharton Restructuring Conference dealing with distressed debt, and
it was interesting that LME was the byword this year.
Really the majority, by far of the sessions were one
way or another about liability management exercises, to a point
(32:39):
where frankly, I found that there wasn't really enough to
sustain that many different variations of the topic. But be
that as it may, what came up consistently in those
sessions was that the default rate on deals that have
been patched up with ls is fairly high. You know,
(33:01):
you get some that really do buy some time the
company is able to turn it around, but in others,
in other cases, many other cases, you're just postponing the inevitable.
So as far, it's not as if the lmes eliminate
default risk, certainly entirely may have some modifying effect. As
(33:22):
far as the private credit, you know, like some other
markets that have come before it, it has not yet
been tested by a really serious downturn, at least in
its modern current manifestation of having graduated to these larger
companies and a lot of capital has been thrown at
that sector. So that raises concerns. Are deals getting two
(33:45):
lacks the standards? You know, we'll find out, you know,
hard to assess for sure in advance. So with all that,
I'd say, I wouldn't expect to see radical, radically different
default results. That's always a great story for people whose
job is to raise money for high old managers. Oh,
(34:05):
we don't have to worry about default rates. I've heard
that in every cycle since the beginning, and it has
never really panned out. I mean, default continue to occur Now,
Moody's doesn't put out a specific US speculative grade bonds
only forecast. They do report a figure, but I have
(34:27):
to kind of back into what that figure would be
based on their US bonds and loans figure versus the
bond's only figure that they do produce, and my best
estimate of that is two point one six percent as
a base case, and I would say that their base
case is a pretty good analysis. I sort of stopped doing,
(34:52):
you know, trying to come up with an improved default
rate forecasting model, which I think would be legitimate. It
wouldn't be predicting the future. It would be saying, you know,
based on experience is you know, and the factors that
influence the default rate. But I think it's a pretty
good model. Now I also look at what is the
market saying. And let me just say that this is
(35:16):
not a break even analysis. I've written essentially to show
how if you take this spread versus treasuries, adjust for
recoveries in default, and then subtract that, you know that, no,
that is not a good measure of the expected default
rate in the market. The real way to do it
(35:36):
is to look at the distress ratio, because Essentially, all
defaults occur in bonds that have been at a thousand
or more over treasuries well before they default, back when
you had more financial reporting fraud, before sarabainez Oxley, there
was a greater likelihood of a bond trading at a
decent level and then all of a sudden being in default.
(35:59):
That's highly unlikely today. So the number, then there's a
quantitative of a formula that I won't go into detail here,
but the bottom line on it is that that currently
indicates that the market is expecting a default rate on
US speculative grade bonds of three point eight percent, So
(36:20):
you're well over a percentage point greater. And for what
it's worth, the distress market has tended to perform quite
well when there's a gap of one percentage point or more,
much less one point six percentage points. So we'll see
if the market is better. You know, again, Moody's has
an optimistic and a pessimistic scenario, so they're not ignoring
(36:46):
the possibilities, but they're basically saying, our base case is
sort of a consensus forecast of the economy right now.
If it turns out that that consensus is too optimistic,
then you know, maybe the default rate really really will
be more in line with that three point eight and
that's over the next twelve months.
Speaker 1 (37:03):
Are you surprised though, that the credit markets have functioned
so well and you know, the spreads haven't moved very
much until you know, it strikes me that credit markets
don't seem to believe that the tariffs will stick, or
the trade will end in a bad outcome, or you know,
all of these extreme policies will actually go through.
Speaker 3 (37:21):
Well. Yeah, I think there's been some mirroring of the
equity market, which since April second have had five hundred
and one thousand down days and five hundred thousand up
days as well. And I think that the initial response
was quite appropriate to say, if we're really going to
go to one hundred and forty five percent tariff on
(37:42):
China and we're going to throw up the tariff barriers
to Canada and Mexico that had been talked about and
really throw out our historical alliances with the NATO countries,
that's that's pretty dire and was appropriate that the spreads
did widen by one hundred bases points are more initially,
(38:05):
and it's appropriate that they have come back. As Trump
has talked back. Scott Bessened in particular has been saying, well,
I haven't talked to Trump. I don't know if he's
talked to the Chinese about this. He ought to know,
one would think, but this isn't sustainable that we continue
at this kind of a level. And that has provided
some reassurance to the market, and Trump himself has kind
(38:28):
of walked back this, Well, can't get rid of Jerome
Powell soon enough to saying well, I'm not playing to
fire him. Now. You have to wonder how much of
that is a real change of heart, how much of
that is Oh, the stock market reacted very poorly. A
lot of people have four oh one k's and we
have midterm elections coming up. I don't want to be
(38:48):
too cynical about this, but whatever the motivations for these
changes were, I think the market is I think correctly
sensing some change of aggressiveness, swiftness of change and so on. So,
you know, doesn't rule out that if trade talks come
to a standstill, of China just digs in its heels
(39:12):
in the US digs in its heels feeling and maybe
appropriate to use the phrase and dealing with China that
the US wants to save face not be seen as
backing down. Yeah, you could see the situation worsening again,
and I would expect the hyld market to reverse course
again and widen out very substantially. If we see.
Speaker 1 (39:32):
That, worries you most about the outlook for the next
six months.
Speaker 3 (39:37):
I think the trade situation has to be at the
top of the list, because you know, we're used to
dealing with recessions. Recessions come along, and we might have
been due for a recession without any of that. If
someone else other than Donald Trump had been elected, or
if Trump had been elected and decided to focus on
(39:58):
one of his other many issues rather than putting tariffs
at the forefront, we might have been in a recession
before the end of twenty twenty five. Anyway, Recessions do
come along periodically, and if you consider that the twenty
twenty recession really was triggered by the pandemic, which was
a sort of out of nowhere kind of development, then
(40:19):
we've gone since two thousand and nine without a real,
real recession, if you want to put it that way.
So perhaps we were due anyway, But I think that
people know how to deal with that in dealing with
a portfolio, they say, well, okay, we can look at
nineteen ninety ninety one, we can look at two thousand
and one. Maybe we throw out two thousand and eight,
(40:39):
two thousand and nine, but we do have the most
recent experience of twenty twenty, you know, just two months worth.
But we know what to expect. We can differentiate between
cyclical and well, there may not be any completely non
cyclical companies and certainly no countercyclical companies out there, but
(41:01):
we can adjust, and despite the bad mouthing of the
rating agencies, sometimes here maybe we will pay some attention
to how many triple c's we have in the portfolio,
even though you know, we like some of them, and
maybe we'll hold on to some of them, but we're
probably going to upgrade the portfolio in light of that expectation.
(41:23):
So I think that does really have to be until
we can get to a point where we say, okay,
at least we know where we stand. Maybe we are
going to have ten percent tariff that is going to
have some adverse effect on global trade, but at least
we know where we stand. I think, you know, it's
(41:44):
not only the impact of tariffs, but the huge uncertainty
that continuing to surround them.
Speaker 1 (41:52):
But also if there is a recession, then the HILD
spread needs to be double or more where it is now.
Speaker 3 (41:57):
Oh yeah, again, I just don't buy this story that
you only have to go to seven or eight hundred
bases points. That's the maximum we'll go to. Now, there
is a story, I think a legitimate one. One of
the seal side shops put out a piece recent They said, well,
you know there's a FED put and no, that's a
debatable point. But you know, I think it's plausible to say, well,
(42:17):
we can count on the FED despite all its other mandates,
you know, the two actual legal mandates of stable prices
consistent with full employment. The law doesn't say that the
FED is supposed to be concerned about the trade exchange
value of the dollar or the value of the stock market. Realistically,
they start to feel some pressure from Congress, you know,
(42:38):
when those things fall out of bed. But even with
all that, maybe the FED does pay attention to where
the high yield spread is. It is concerned about availability
of credit for companies that don't qualify for the very
top credit ratings, and so maybe you can say oh,
at some point, and the figure I saw in research
(42:59):
was seven hundred and twenty basis points. Don't interpret that
is meaning that's where the spread stops. Again mentioning Milton Friedman,
he famously said that FED policy operates monetary policy operates
with a lawn lag. So if the Fed starts to
(43:20):
ease credit in response to a widening of the high
old bond spread, which ninety percent of the population has
no idea what you're talking about, but let's grant the
premise that it will jump in at that point. It's
not going to stop on a dime. You'll see the
spread continue to widen from there, and I have high
confidence that we will get back to a thousand basis
(43:40):
points on the high Old index as a whole at
the worst point of the next recession, whenever that occurs.
Speaker 1 (43:47):
Great stuff, Marti Fritz and chief executive officer of Fritz
and Vision High Yield Strategy. It's been a pleasure having
you on the Credit Edge Money.
Speaker 3 (43:53):
Thanks really been a pleasure to speak with you and.
Speaker 1 (43:55):
To Spencer Cuts up with Bloomberg Intelligence. Thank you very
much for joining us today.
Speaker 2 (43:58):
Thank you my pleasure.
Speaker 1 (44:00):
Even more great credit market analysis Read all of Spencer's
great work on the Bloomberg Terminal. Bloomberg Intelligence is part
of our research department, with five hundred analysts and strategists
working across all markets. Coverage includes over two thousand equities
and credits and outlooks on more than ninety industries and
one hundred market industries, currencies and commodities. Please do subscribe
to The Credit Edge wherever you get your podcasts. We're
(44:22):
on Apple, Spotify, and all other good podcast providers, including
the Bloomberg Terminal at b pod Go. Give us a review,
tell your friends, or email me directly at Jcromby eight
at Bloomberg dot net. I'm James Cromby. It's been a
pleasure having you join us again next week on the
Credit Edge
Host
James Crombie
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