Fridson Sees High Yield Going Distressed in Recession

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.

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 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, 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?

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. 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 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, 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 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 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. 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 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. 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 to five hundred to where they'll reach in at the maximum during the recession.

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 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.

into account. But the as far as to say what has driven spreads over time, they are really four factors 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 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 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 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 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 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.

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.

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.

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 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

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 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.

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

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.

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 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.

where it went, and so on. What I can tell 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 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

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. 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 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.

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.

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 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 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

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 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 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, 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 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.

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 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, 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 to the rating.

debt within high heeled energy. Feels to me like you know, 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.

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 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, 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.

they're wrong. Well, you know, what the ratings address is probability of default and expected recovery in the event of default, 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

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 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, 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. 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 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.

If you choose not to do that, that's on you.

Obviously there's a lot of you know, with the volatility in the market and concerns, there's probably a lot of 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, 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.

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 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. 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 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 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 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 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 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

beyond that. And then there'll be more opportunities to look at.

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?

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, 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 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 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, 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 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, 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 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 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.

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 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 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.

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 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,

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 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 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 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.

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 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, 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 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. 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 not only the impact of tariffs, but the huge uncertainty that continuing to surround them.

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, 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 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 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 points on the high Old index as a whole at the worst point of the next recession, whenever that occurs.

to The Credit Edge wherever you get your podcasts. We're 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