Icahn’t Believe It’s Not Better (The Yield On HYG)

This article was originally published on on July 27th at 1:00pm EDT

The lurking dangers of junk bonds have found their way into the headlines. Carl Icahn’s conversation with crucifixion of Blackrock’s Larry Fink last week certainly didn’t help matters. The entire exchange can be found here.

People are pretty worked up. So what’s the big deal?

The big deal, as Icahn would have you believe, is that index funds and ETFs (exchange traded funds) have made it far too easy for all investors to access the junk high yield bond market—a market that isn’t anywhere near as deep as the rest of the corporate fixed income market.

This will shock no one, but Icahn’s interests in this debate seem entirely self-serving. He is not worried about the little guy. He is worried about the rate of return on his loan portfolio.

Icahn is an activist in both the stock and bond market, and activists like to take large stakes in companies that are in distress—in many cases providing emergency funding at loan shark rates. My contention is that Icahn doesn’t like the idea of his own portfolio of junk being tied to an index over which retail investors now have influence.

If I’m Carl Icahn, and I’m preparing to loan a few hundred million to a struggling energy company, secured against the company’s assets, I want to earn a good return in exchange for the risk I’m taking. Probably in the 9-10% range, depending on the company’s creditworthiness, assets, etc. But Blackrock and other firms that offer easy access to the high yield market are setting the price for these loans much lower. The iShares High Yield Corporate Bond Index (HYG), for instance, currently yields just 5.46%—down from over 10% during the height of the financial crisis. That’s nowhere near enough to wet Carl’s beak.

If access to this market were not so easy and affordable, such loans would command much more onerous terms for the borrower (and much more attractive terms for the lender).

So, if I’m the struggling energy company…..Why do I need Carl Icahn?

Carl’s supposed concern is that high yield spreads (the difference between the yields on junk over Treasury Bonds) will “blow out,” sending interest rates in the space sky high and putting pressure on the entire group—even those who don’t deserve it (read: the bonds he owns). He is making the argument that once a selloff in the high yield market starts, there won’t be enough smart money to come in and lend support. I think this is where he is wrong.

Going back to a point we made here in January, it’s my feeling that lower long term Treasury rates may prove helpful in enticing investors—both retail and institutional—back into the high yield space before rates get too high (and bond prices get too low).

The chart above is a depiction of high yield spreads (over Treasuries) versus the yield of the 30 year Treasury. You can see that at the beginning of 2014, the spread was equivalent to the 30 year yield—meaning, you earned exactly twice the annual interest of a long-dated Treasury Bond by taking on the risk of buying a basket of high yield bonds.

Today, the spread is north of 5% and the 30 year offers significantly lower annual interest than it did at the start of last year, at just 3%. A high yield spread above 5% is not abnormal by historical standards, but consider that a 5% spread is pretty meaningful when the 30-year Treasury is at 3%. Implied returns for high yield bonds over the Treasury at current levels is 275% (8.25% / 3.00%). Implied return over the Treasury just a year and a half ago was 100% (7.50% / 3.75%).

Institutional fixed income investors can most certainly make that risk worth their while. Add in just the teeniest bit of leverage and you’ve got an asset class that looks pretty good over a 3-5 year timeframe.

Of course Icahn is also voicing concern about the inevitability of rising rates, and what should happen to the high yield market if investors can earn a more comparable return by investing in Treasury Bonds after the Fed hikes a couple of times. I think this fear is misplaced. Even if Yellen is able to hike the Fed Funds rate more than once, I am not convinced that the only pressures on the long end of the curve will be to the upside (in yield).

The Fed hiking short term rates could, in fact, simply serve to further strengthen the dollar, whereby attracting more foreign investment in Treasury Bonds all the way out the curve. The logic for this argument is explained in much more detail here.

So I understand why Icahn is making a stink, I just don’t think we need to take it too seriously.

If you have questions about your investment portfolio, would like a second opinion, or wish to engage us in a dialogue, please don’t hesitate to ask.

Adam B. Scott
Argyle Capital Partners, LLC
10100 Santa Monica Blvd, #300
Los Angeles, CA 90067
(310) 772-2201 – Main

Adam Scott’s profile on RealMoney can be found here.

Leave a Reply

Your email address will not be published. Required fields are marked *