Our Active Strategy in High Yield Debt

As we wrote earlier this year in our piece “Pricing Risk and Playing Defense,” we are not believers in a significantly higher interest rate environment.  The global economy is simply too weak to tolerate higher rates.  The Fed will raise rates in 2017, as they started to do last week, however we believe the increase will be moderate and gradual.  As we began 2017, the bond market was already anticipating and pricing in at least two, 25 basis point increases in the Federal Funds rate and with any action they do take, we don’t expect the medium and long end of the curve to do much.

While the financial market enthusiasm over the last four months has been in anticipation of a domestic demand improvement, we have still not seen that materialize, as evident by the Fed’s comments last week.  Leading up to last week’s Fed meeting, in the days prior we saw the 10-year Treasury yield hit the December 2016 high on an expectation that the Fed may be more aggressive in its action, only to quickly decline back to around 2.5% once the Fed released their comments on Wednesday.  The Committee clearly remains “data dependent” and does not share the market’s optimism.

Given that we have yet to see any substantial pro-growth policies come to fruition, and it looks like Congressional approval on items such as tax cuts and infrastructure spending may take a while to actually happen, if they can get there at all, we do believe the equity markets have gotten ahead of themselves.  However, we continue to see demand for one important investment characteristic—yield.  We believe that a tight and thoughtful portfolio within the high yield bond and loan markets can provide that yield for investors.  With both the potential change in policy and interest rate backdrop, we view our asset classes much more favorably than other fixed income areas.  We believe that high yield debt is positioned to outperform the longer duration and lower yielding fixed income cousins such as investment grade corporates, munis, and mortgages in 2017.

While 2016 seemed to be dubbed the year of indexing by financial commentators, we believe 2017 will prove to be the year of active management.  We believe volatility will return to markets and what you don’t own will be as important as what you do.  As we look at our own strategy, we are working to manage technical and liquidity risk very deliberately by using our strategic new issue allocation, by which we purchase newly issued bonds.  This allocation is focused on market technicals and includes tight sell parameters and a shorter term holding period.  Regardless of interest rate views, floating rate loans serve to reduce portfolio duration (interest rate sensitivity) and can allow investors to participate in a more senior part of the company’s capital structure.  We will continue include an allocation to loans within our strategy.  The focus of our strategy will remain on our core, value-based bond holdings, and as industry themes or asset class opportunities present themselves, we will use proceeds from the new issue allocation to redeploy into such alpha-generating investments.  These core, fundamentally-driven holdings are complemented by our new issue allocation, allowing us to take advantage of the opportunities we see from both a fundamental and technical side of the market.  Our end goal is to compile a portfolio with greater stability, while working to generate alpha for investors.

We believe it is time to play a good defense and we will work to do just that while also capitalizing on the select value-based opportunities within today’s high yield market.  To read more on our take on interest rates, the global outlook, and our investment strategy in this environment, see our recent writing “Pricing Risk and Playing Defense.”

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