Managing Defaults

Fitch reported that the trailing 12-month default rate remained flat in April at 1.9%, as the month produced two defaults. The recent bankruptcy filings by mortgage lender Residential Capital (ResCap) and aircraft maker Hawker Beechcraft added $3.4 billion to the April year-to-date default tally of $5.8 billion. Fitch Ratings projects the default rate will top 2% in May—the highest level since October 2010.

There is a lot of talk about how the default rate will pick up and how high yield should be either avoided or the allocation should be lowered.  I don’t necessarily disagree with this take if you are getting exposure to the high yield asset class through the largest ETF’s (HYG and JNK) or the large mutual funds, via the likes of Loomis, Alliance or Putnam.  All of these funds are huge in size and generally own the same securities that are in the high yield index, and as I write this, all in fact own Residential Capital, with the exception of JNK.  JNK may have previously held ResCap too prior to the BK, as many index funds are required to sell as soon as a BK is initiated.

The difference between the index funds/large mutual funds and an actively managed strategy is that the index and large funds have no ability to avoid these types of companies that are potential defaults.  JNK and HYG have to own the whole index, whether it is a solid credit or not.  The mutual funds own many of these same names because they are so big they have to buy all new issues in order to get any allocations and own many of the largest credits because they need liquidity for redemptions.  An actively managed strategy is one where you actually look at the cash flow statement and work your way back to the balance sheet to make sure you have a margin of safety built in.

Will defaults rise going forward?  This could be a real possibility if some of these companies can’t maintain their business in the current economic environment.  This is why you pay an active manager, with many years of experience in analyzing companies and investing client money, to work to avoid these defaults.  Over time, we believe that if you can avoid defaults through an actively managed strategy, you should outperform the other strategies that don’t have this sort of flexibility.

For further details on Peritus’ actively managed strategy, visit www.advisorshares.com/fund/hyld.

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