Nine years into a bull market for financial assets, we are seeing an increasing number of investors continuing to prioritize a return or income objective over the risk required to achieve that return.
For stock investors, that typically means chasing what is hot today. For fixed-income investors, that means venturing more heavily into more speculative issuers and instruments.
In our view, long-term investing is best done through the framework of prospective risk and potential return, while taking into consideration the role a particular investment or strategy plays in a more broadly diversified portfolio. We consider these things in relation to one another, along with the possible constraints an investment might have.
Over the last several years, as yields on high-quality issues have remained low, massive amounts of money have plowed into the more speculative areas of credit: high yield, bank loans and hybrid securities. There is more yield and less interest-rate risk in these areas, but more economic, credit and liquidity risk.
Right now that is a trade investors seem willing to make, but do they truly appreciate the risk they are taking and the amount that risk has increased recently?
Investor interest has driven the spread that a high-yield instrument pays over a comparable term treasury to very low levels, a little more than 3.3 percent, which is bumping along a 10-year low. The ravenous appetite for bank-loan products has borrowers going back to banks and renegotiating the terms of their loans, lowering spreads and dropping interest rate floors. As a result, interest rates are finally rising and investors are coming to learn that there isn’t the pickup they’d expected because the issuer negotiated a better deal.
All this is happening at a time when protections for lenders to those issuers — the investors — are getting worse. Covenants are getting dropped and weakened significantly. Further, measures of profitability for purposes of the covenant compliance are getting more and more contrived.
As an example, last month a high-profile issuer invented a metric no one had even heard before — “Community Adjusted EBITDA” — which essentially added back almost all of their expenses. (EBITDA is earnings before interest, taxes, depreciation, and amortization, and is a metric for understanding a business’s ability to generate cash flow for its owners and for judging a company’s operating performance.)
Moody’s recently opined that covenant quality is the weakest it has ever seen, while pondering if anyone is actually reading the documents.