Caution to the wind

It’s an age-old statement uttered by drunks and investors everywhere: “I can’t believe I did that”.

“We’re in a part of the credit cycle where people believe that they’re being fairly compensated,” Steve Tananbaum of Golden Tree Asset Management told those in attendance at the Milken Institute’s Global Conference last week. “That’s going to be in contrast – I believe – in a couple years if the cycle runs how it usually runs to: ‘I can’t believe I did that’.”                         

In his remarks at the “Credit Markets: What’s Next?” panel, Tananbaum indicated investors believe they are being fairly compensated because high yield bonds are being offered with expected default rates at 2 percent, but implying 3.33 percent. Sounds good, right? But Tananbaum’s worry is that those implied default rates are leading investors to take on more – and potentially too much – risk.  

“There’s more risk that’s being taken … Debt to EBITDA is increasing in 2013,” he added.

Near-term default risk will likely increase from 2 percent this year to 5 or 6 percent in 18 to 24 months, he predicted. So although opportunities still remain, the window may be closing. 

There are plenty of investors and advisors playing Cassandra right now, nervous at what many believe is a high yield bubble.

The ‘dash for trash’ that has seen investors eagerly build exposure to junk bonds in the US in particular as sovereign debt yields have plummeted. Default rates may be low for junk bonds, but the level of appetite has driven yields down to a level where the risk / return profile starts to look questionable. Average junk bond yields in the US have plummeted by more than 100 bps to just 4.97 percent earlier this week, according to Barclays. In Europe, the average yield stood at 5.68 percent earlier today, according to Markit. 

This isn’t limited to Western markets either. High yield bond issuance in Asia this year to date is already triple the full year total for 2012 according to press reports.   

Some have questioned whether investors in high yield are simply ignorant of the risks, or willfully ignoring them.

There’s not much you can do about the latter, but if ignorance is the issue, then it raises an interesting opportunity for private debt fund managers.

A meeting earlier this week with one fledgling manager revealed the lengths to which the firm had gone to develop a platform that would allow LPs to keep tabs on the various risk management measures it employs. Their investor portal will allow LPs to drill down to a frightening level of detail in each investment. The fund believes it will be a USP as they look to raise capital. 

And it’s on the fundraising trail that private debt GPs are best able to educate the market as to the merits of accessing the debt markets through expert managers rather than through high yield. We wrote several weeks ago that debt remains a dirty word, and managers speaking to prospective LPs have encountered a similar view. So making the case for private debt funds – with their exhaustive risk management protocols, expert origination and structuring – has never been more important.