Opportunities for Active Management in the High Yield Debt Market

Equity market volatility has re-emerged so far in 2018.  However, in the midst of this, the high yield market has held in fairly well.  We are seeing more attention being paid to credit fundamentals, which we would certainly embrace as an active manager, but we are definitely not seeing the extent of the volatility we have seen in the equity markets.

We believe the current high yield market environment is positioned well for active managers versus passive/index-based products, as we work to continue to separate ourselves as an active manager. Default rates remain and are expected to remain below historical averages this year but have actually ticked up in the past few months.  The default rate is up nearly 1% since December to 2.36% currently and is expected to end 2018 around 2.5% according to J.P. Morgan.1  However, the increase so far this year is largely due to one issuer, iHeart Communication.  To put this in context, $17.4bn in high yield bonds have defaulted so far in 2018 and over half, or $9.4bn, of that is related to just this one issuer.2  Additionally, the entire increase in projected default rates from an actual rate of 1.45% at the end of 2017 to the expected rate of 2.5% as we close out 2018 is related to expected defaults in this one and a couple other large capital structures.3  Why does this matter?  Because large capital structures generally mean these are well represented credits in the indexes and passive products that track them, as well as some other quasi-index products.  However, as an active manager, we have the flexibility to avoid these large structures as we evaluate credit risk relative to the value.  So while the large issues/issuers are often part of the indexes and products that track them, we don’t have to include them in our strategy.

Flexibility in our active strategy is also providing us another benefit right now.  We have the ability to include floating rate loans as we look to invest in high yield debt.  These loans are tied to LIBOR and their rates generally reset every one to three months.  While the 10-year Treasury yield did see a jump earlier this year and has since largely leveled out, we have seen and continue to see a steady and significant move up in LIBOR.4

This in turn can led to higher yields/rates on floating rate loans, with the caveat that we’ve seen a massive wave of repricings over the last year, including these first few months of 2018.  With the wave of repricings seen in the broader loan market, much of that LIBOR benefit is being eaten up by the lower spreads that generally come as part of the repricings of these loans.  With our flexibility as to what we own in the loan space, versus tracking an index that often again focuses on the largest loans outstanding for the passive loan products, we can selectively find loans that are not subject to repricings and where we see the yield benefit from the rising LIBOR rate playing out.

We believe this sort of flexibility creates the opportunity for active managers in high yield debt as they work to generate alpha versus their passive counterparts.  With our own active strategy, we continue to focus on value relative to risk in both the high yield bond and loan market as we work to generate steady income with the potential for capital appreciation.

1  Acciavatti, Peter D., Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “Default Monitor,” J.P. Morgan, North American High Yield and Leveraged Loan Research, April 2, 2018, p. 2, https://markets.jpmorgan.com.
2  Acciavatti, Peter D., Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “Default Monitor,” J.P. Morgan, North American High Yield and Leveraged Loan Research, April 2, 2018, p. 2, https://markets.jpmorgan.com.
3  Acciavatti, Peter D., Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “Default Monitor,” J.P. Morgan, North American High Yield and Leveraged Loan Research, April 2, 2018, p. 3, https://markets.jpmorgan.com.
4  Based on the 3 month LIBOR rates for the period 1/1/18 to 4/4/18.  Data sourced from Bloomberg.
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