The Bloomberg Barclays US High Yield Index was up 0.05% yesterday.1 High yield bonds, mainly the large on-the-run index names, are a bit weaker today as it is a bit of risk off day. Backing this thesis is the 10-year Treasury yield fading to 2.85% from 2.88% yesterday. Today will mark 21 straight trading days in the 2.80% – 2.89% range if this level holds.
Outflows from index tracking funds and the asset class overall are putting pressure on the secondary market and there are only a few new-issues on the forward calendar with two pricing yesterday for ~$1.2B. Loans funds continue to see inflows and Lipper is anticipating the largest inflow in six weeks, but we believe investors need to beware.
There have been a ton of investors throwing cash at the floating rate loan market this year. We think one of the biggest problems this cycle will be the collateralized loan obligations (CLOs). While we see many attractive opportunities in the off the run loan market (which we view as a less efficient market, with more “orphaned” credits that aren’t widely followed), loans overall have been very popular and are sporting far more leverage than in past cycles. The value of having a first lien in a 5-6x levered company may not be worth that much if it is the only debt outstanding, and for those credits that are impaired, the recovery rates may be well below historical averages. So this potentially may be a far bigger mess down the road, and may create even more opportunity once it begins to unravel. We see a good amount of “research” discussing moving senior into loans but that is a misnomer in many cases. Tourists in that asset class need to be aware. Loans are simply another great opportunity set; there are lots of good ones and lots of bad ones.
There is always value in the market but we believe that where we are in the cycle, investors should be bond/loan pickers. According to JP Morgan, there are $381bn of high yield bonds callable over the next year, but only $57bn of that is now trading above its call price.2 That means there is ~$330B trading below call prices and it is the job of the high yield manager to find these securities and determine which of those are attractive holdings, thus allowing for coupon income as well as potential capital appreciation. There are many different reasons these are not trading at the call levels and the expertise is to find the ones where it a situational reason rather than a bigger fundamental reason.