As credit markets have opened up, we’ve seen a number of companies refinance their bank debt for more speculative, high-yield debt. At first glance this may not make sense, because the cost of capital in this kind of transaction can rise sharply — from 3% to 7%, for example. But high-yield debt gives companies two things the banks can’t: longer maturities and less restrictive covenants. These two features give leveraged companies the breathing room they need to execute their business plans and grow asset values without having to repay principal right away. Generally, the more predictable the cash flow a company has, the more debt it can support. Companies that have chosen to use high-yield debt are in many cases better off today because they have renewed flexibility.
When considering investing in leveraged companies, do high-yield bonds represent the most attractive opportunities across a company’s capital structure?
Not necessarily. I continue to find equities more compelling than either bank loans or high-yield bonds. One of the metrics I use to compare equities with debt is the free cash-flow yield. Today, equity free cash-flow yields are in the low double digits. By comparison, high-yield bonds offer yields in the mid single digits, and bank loans are priced off of a LIBOR rate of essentially zero. So, among fixed-income securities, I currently favor high-yield bonds.
What is your outlook for leveraged companies?
Putnam Capital Spectrum Fund and Putnam Equity Spectrum Fund were launched in May 2009, a time when capital markets were just coming out of severe crisis mode and the economy was still in recession. There was a great deal of uncertainty. Since that time, the environment for leveraged companies has improved dramatically. Although access to credit remains tight by historical standards, it has loosened materially during the past year. For companies without attractive alternatives, access to debt opens up a different set of opportunities.
The U.S. economy clearly experienced a deceleration in growth in recent months. This decline understandably led to the market correction we saw in the spring and summer because profit expectations were too high, in my view. Going forward, I’m optimistic. I don’t believe another recession is likely at this point. And with interest rates at historic lows, leveraged companies are in a good position with the ability to refinance, pay down debt, and borrow additional funds.