Off the Sidelines

Over the past months and years, the financial media and market commentators are constantly questioning whether the markets can continue their upward trend.  For instance, just a few month ago the concern was heating up with historically high valuations in equities and yields nearing multi-year lows for high yield bonds, along with the intensification of the North Korean rhetoric and political infighting, many believed that once everyone returned from summer, we’d see the perceived investor complacency replaced with volatility and potentially a leg down in “risk” assets.  Yet, this September proved to be one of the least volatile on record in some asset classes.

The fact is markets are unpredictable and timing the markets has often provide futile, and market-timing is getting all the more difficult as algorithms play a larger and larger role in dictating buy and sell decisions.  Yes, you may be able to avoid some losses if you time things right, but if not, you can miss on months and even years of upside.  In the high yield market, this is especially important as so much of the return generated comes from the income these bonds pay via the coupon payments.  But if you aren’t invested, you aren’t accruing this daily income, and over the years this income has proved to be a major contributor to total return.1

Looking back over the last 30 years, all of the return and then some has come from the coupon return, while the price return has been slightly negative.  So we read this as it pays to be invested.  There may be noise along the way, but over the long-term, the coupon income provided by high yield bonds is a major source of return.  This largely makes sense as most bonds are issued right around par ($100) and are generally called, tendered, or mature at par or above, with defaults or exchanges the primary outliers too this.

Not only does it pay to be invested, but we believe the coupon income you are getting also matters.  Yes, coupons/yields are below historical averages, but given we are nearly 10 years into this low rate environment, with the 10-year Treasury bond yield still sub-2.5%, these historically lower yields are understandable.  But in many cases, we are seeing corporate bond yields move down to levels that we believe don’t justify the risk.  Just this past week we were hit with headlines that BB spreads were at lows not seen in over a decade and 55% of the high yield universe trades at a yield under 5%.2

This is where we believe active managers such as Peritus can differentiate themselves and work to generate alpha for their investors.  A large portion of the high yield market is at these very low yields, but the entire market is not.  While the passive index-based high yield bond funds track their underlying index, and with that includes many of these very low yielding securities in their portfolio, we are not obligated to invest in securities where we see downside or a lack of value.  We can focus on what we see as attractive coupons and yields.

Bond prices go up and down, just as stock prices do.  But unlike with equities, bonds pay regular coupons to help cushion any downward price movement.  There have been many people over the past few years expressing concern as to whether the positive trend in high yield bonds can continue, and investors who might have already gone to the sidelines are losing on months and years of tangible coupon returns and income.  Yes, we certainly can’t say today’s high yield market as a whole is cheap, but we can say we believe there is still solid income and yield being generated by certain credits within the market and do not see any immediate catalysts to cause the market to hiccup.  But if and when there is a hiccup, we still have the coupons to cushion us leading to lower volatility than equities over the years.3

1  Bloomberg Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt.  Data for the period 9/30/87-9/30/17, using the price return, coupon return and total return, source Barclays Capital.
2  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 10/10/17, https://markets.jpmorgan.com.
3  Volatility as measured by the standard deviation for the Bloomberg Barclays High Yield Index versus the S&P 500 index, see our piece “High Yield Investing: Corporate Bonds versus Equities” for actual data.
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