Today’s High Yield Market

During October, we saw the general high yield market hit multi-year lows on spreads; however, in the first part of November, we have seen that reverse.  Over the first half of November, some softness has emerged in the high yield market, as money has flowed out of the space and spreads and yields have moved higher, and with it discussion in the financial media as to whether there are real issues within the high yield market, positioning it for a sustained fall, and if this is a precursor to an equity decline (as high yield is often seen as a leading indicator).

We have seen these periods of high yield market weakness and the same sort of discussion several times already this year—first this past March and again in August.  The stories were the same, outflows, followed by a back-up in spreads/yields, and financial commentators worrying “the end” is near, only to have the weakness be met with buying after a few weeks and the high yield market resume its move up.  Will this time be the same and we’ll see a fairly quick reversal with buyers coming back in, or are there real, fundamental issues within the high yield market?

Ironically, I think our answer is yes to both questions.  As active player in the market, we see that the general fundamentals remain solid and we don’t see any pervasive cracks emerging within the broad high yield market.  However, there are problems in specific industries and companies.  The recent weakness we have seen has been largely centered in certain industries, namely healthcare and telecom.  Over the past few weeks we have seen weak earnings reports from a few large high yield debt issuers in these industries, as well as company specific news such as a failed merger in one high profile issuer.  The market is punishing companies for weak results or unfavorable news, which we believe makes active investing all the more important.  But it is important to note that we are NOT seeing widespread fundamental cracks in the high yield market or systemic overhangs as we have seen in prior cycles (such as the massive deals getting done and levering up of companies as we saw prior to the 2008 crash).

Overall, we see the recent weakness in the high yield market as an indication of a healthy market.  Yes over the past few years, spreads and yields in the high yield market have been run up as investors search for yield, creating overvalued situations in many cases, but the last few weeks have demonstrated that we are still seeing some of the ups and downs that you’d expect in a market where investors are rationally making decisions.  Below we outline some of the relevant considerations that we believe are significant for investors as they look at the high yield market—from market technicals, such as money flows and new issue activity, to market fundamentals, including default rates/outlooks, credit metrics, and credit liquidity:

  • Money Flows: We have seen weeks when money has flowed into the market and weeks when money has flowed out, and in total, the market has seen outflows of over $8bn so far this year from mutual and exchange traded funds, which would indicate to us that this isn’t a market that is being blindly “chased.”  Investors are not just throwing money at the asset class.
  • New Issue Activity: Even in the midst of the recent weakness in the high yield market and outflows, we are not seeing new issue activity abate.  Deals across the credit spectrum and for various use of proceeds are getting done.  A couple companies pulled deals because the market was demanding too high of an interest rate for their liking, but this indicates to us that the market is acting rational and not just waiving in deals at any price.  On the flip side, the strength of the new issue market indicates that there is still demand for these deals by investors, at the right price, and that companies still have access to capital to address a variety of needs, including refinancing, mergers and acquisitions, and investments in growth.
  • Default Environment: Default risk is one of the most important risks for high yield bond investors.  Default rates are well below historical average and are expected to remain low in the year ahead.  According to JP Morgan, the trailing 12 month default rate is 1.3% and is expected to remain low, around 2%, in the year ahead versus a historical average over nearly twenty years of 3.7%.1  Notably, nearly half of the defaults over the past year have come from three sectors: energy, retail, and healthcare.
  • Credit Metrics: Credit metrics as a whole are solid, with EBITDA and margins improving and coverage (EBITDA/Interest expense) and leverage (debt/EBITDA) reasonable.  For instance, the average quarterly leverage multiple over the last 10 years has been 4.3x, and currently we are at 4.1x.2   Again, we are not seeing the massive multiples being paid for deals or companies levering up as we saw prior to the 2008 credit crisis.
  • Liquidity/Maturities: As noted above, we have seen solid market technicals in terms of new issues, which is important in how it translates to individual company fundamentals.  Access to capital is essential in providing company’s liquidity and allowing them to address maturities.  With the persistent low rate environment and open new issue market, we have seen companies proactively addressing their maturities coming up in the next few years.  We are now left with a “manageable” 15.8% of the high yield bond and loans maturing in the next three years3—certainly not any sort of “maturity wall” that is of concern. Notably the Liquidity Stress Index, as measured by Moody’s, continues to trend downward, indicating liquidity strength among issuers.  A lack of liquidity and/or an upcoming maturity being unable to be refinanced can trigger a default in a security in many cases, thus we feel our current positioning bodes well for the continued low default rates.

Yields and spreads are widening.  In some cases, rightfully so.  We are seeing the market punish credits for bad numbers.  We are seeing prices fall in some of the more challenged industries.  But largely speaking, we believe the fundamentals within the high yield market remain intact.  The last couple weeks have proved to investors that fundamentals do matter and, accordingly, we see that as proving that active management is critical in the high yield market.

We believe that an active portfolio within the high yield market can offer investors attractive yield.  Additionally, we believe it pays for investors to be invested to continue to generate this yield—no matter what the price movement is for a security, corporate bonds are accruing interest/yield daily.  Timing the market has proven to be difficult, and this income can help offset price declines, and if we see a repeat of what we saw in March and August, we may well see the market quickly rebound and resume its upward move.

1  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 11/3/17, https://markets.jpmorgan.com.  Current default rate as of October 2017.  Historical default rate for the period December 1998 to October 2017.  Default rates include distressed exchanges.
2  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 9/26/17, https://markets.jpmorgan.com.  Based on quarterly leverage multiples for the period Q1 2008 to Q2 2017, and current leverage as of Q2 2017.
3  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 11/14/17, https://markets.jpmorgan.com.

 

Posted in Peritus

Finding Value

As an active manager, our investment strategy involves actively working to find value, rather than tracking a broad underlying index (passive management).  But just what does finding value entail?  We see a couple key areas where we see inefficiencies within the high yield market and where we feel we can find that value.  With our active strategy, we can pick and choose what we want to hold, in what portfolio allocation we want to hold it, and when we want to buy and sell.  We also believe on doing our own credit work and financial assessment of the core, alpha-focused securities in which we invest.

Just like there are popular names in the equity market, we see the same sort of market dynamic in high yield investing.  For instance, there are large, well-covered companies within the high yield sector that often have several tranches of bonds outstanding at any time, which can total billions of dollars in outstanding debt for just one company.  Research from the investment banks and other credit research providers often focuses on the larger issuers within the high yield market.  Smaller credits or companies new to the high yield market (first time bond issuers) tend to have few or even no one covering the security, leaving them “orphaned.”  Some high yield issuers also have public equity, while many do not and are private companies issuing public bonds.  Public bond issuers are required to provide their investors financials but these are not always publicly available as they are for equity issuers.  Getting information can involve tracking down the underwriter or calling the company to get on a private website to get that bondholder information.

Thus, not only does it involve time and energy to analyze the financial and company information, but it can even take time and energy to track down the credit information in the first place.  If an investor or manager is relying on the research put out by the investment banks and credit research providers, they could completely miss these off-the-run names.  Yet through our history we have found value in a number of these overlooked credits.

This certainly doesn’t mean that we are entirely focused on small credits that no one else has ever heard of—we have and do invest in credits across the tranche size spectrum, which includes many $500mm+ tranches.  But we are also open to finding value in areas others aren’t and don’t weight our allocations toward the largest issuers in the high yield market.  For instance, within the index, it is generally the companies that are the largest high yield bond issuers that weigh the most in the indexes (though there is sometimes a cap, such as 2%, of the index).  And with these large issuers weighing on the index, we see the same problem for many of the high yield index-based, passive products tracking the high yield indexes.  Amplify this with the fact that some of the larger passive high yield funds (such as the largest passive high ETFs), have size constraints per the underlying index that eliminate credits with a tranche size under $500mm or $400mm/$1bn in total debt outstanding.  So as these sorts of funds gain a larger share of the high yield bond retail market that can mean less interest in the credits that don’t fit these size parameter, which we believe further creates opportunities for active managers such as Peritus.

Additionally, we find value across the ratings spectrum.  We have learned over our decades of experience to place little credence in the ratings assigned to a credit by the ratings agencies.  Either a credit is “AAA,” and is money good, regularly paying its coupon and paying the investor the par back upon maturity, tender or call, or it is not and it is a “D” credit.  By looking behind the curtain into the company’s business and financials, we determine for ourselves if we believe the credit is money good and if the credit’s yield being offered to us compensates us properly, and invest accordingly.  Just because a credit is rated highly, doesn’t make it an attractive investment.  For instance, the headlines hit in early October that BB credits were trading well through the lowest spreads seen in over a decade.1  These low BB spreads are reflected in the low yields on many of the high yield indexes/sub-indexes with a high BB concentration, and passive strategies that follow these indexes. Yet, there are still many B and CCC credits that we view as money good and offering investors what we would see as attractive, reasonable yields.  As an active manager, we are not forced to invest in less desirable securities either from a very low yield perspective or from a credit concern perspective.

Investors need yield, especially with the low rates currently offered through the rest of the fixed income market (investment grade corporates, Treasuries, munis, etc.) and high valuations on dividend equities.  We believe that our active strategy of finding value without having to take on what we see as excessive risk can work to provide that yield for investors.

1  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 9/20/17, https://markets.jpmorgan.com.
Posted in Peritus

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.
Posted in Peritus

High Yield Investing: Corporate Bonds versus Equities

A company can issue debt (bonds) or equity (stock) as they look to gain access to capital markets.  Investors then have the options to buy either the bonds or stock.  It often seems that novice investors immediately think of stocks when they think of the concept of investing, but it is also important to understand just what a corporate bond is and how it is structurally different than equities.  And with those differences, we see certain advantages of high yield corporate bond versus stock investing.

A bond is a loan.  A bond investor is akin to a bank, giving the company money now with the expectation of getting paid back at a certain date in the future and earning an interest rate for loaning the money over the outstanding period.  But instead of this loan staying in the hands of one entity, it is then routinely divided and traded among investors over the life of the loan.  Equity, on the other hand, is ownership in the company, but doesn’t include an obligation to return the money paid for it in the future.

This US corporate bond market is a huge market, nearly $9 trillion1, with about $1.5 trillion of that in the high yield bond (non-investment grade) category.  If you include the large numbers of companies based overseas that issue US dollar bonds, the US dollar high yield bond market is nearly $2 trillion.2  And even if corporate bonds are not the first thing one thinks of when investing, this is an easily accessible market.  While high yield bonds have an active secondary market of trading, it is not done over an “exchange.”  Rather, bonds trade in a negotiated market, where trading relationships are important for managers in sourcing product.  Bonds generally trade in larger increments, thus, it can be hard to trade smaller batches of bonds, and investors won’t necessarily get the best pricing.  Because of this, pooled vehicles, such as high yield bond mutual funds and exchange traded funds, have become popular means by which retail investors can gain access to the asset class, with the funds holding a diversified underlying portfolio of individual bond holdings.

As follows, there are a number of structure features and benefits investors should be cognizant of as they consider the right asset mix between equity and corporate bond holdings:

  • Consistent Income: Corporate bonds have a set maturity date and an interest rate upon issuance, creating a contracted stream of income for bondholders.  Bonds typically pay this interest twice per year but trade with accrued interest, meaning that a buyer can buy the bond anytime before the paydate but would have to pay the seller the accrued interest up to that point.  Equities aren’t required to pay dividends—most actually don’t pay a dividend leaving investors to entirely rely on the stock price movement to create value/returns.  And for the stocks that do pay dividends, these dividends can be cut or eliminated by the company at any point as they are not contractual obligations but rather decisions subject to the Board’s discretion.
  • Finite Exit Strategy: Bonds are issued with a maturity date, which is the date at which the issuer is obligated to pay the bondholder back the “par value” of the bonds.  This finite exit strategy via maturity is one of the greatest features that we see for bonds versus equities, especially for value investors.  If you are an active investor and identify a security as undervalued, you aren’t left waiting in perpetuity for the market to realize that value.  With a bond, barring a default, you know that the maturity date gives you a final date at which point you’d realize that value, and that value may even be realized earlier via the call dates as we discuss below.
  • Capital Gains Potential: If a bond is purchased/trading at a discount to the par value, it may appreciate in value as it moves toward that maturity date, providing investors with capital gains opportunity.  However, most of the time investors don’t have to wait until maturity for a bond to be paid back. Companies generally choose to refinance or redeem their bonds at some point prior to that maturity date, but must typically pay the bondholder a “call premium” above par (pre-payment penalty) to do so.  This provides the opportunity for investors to earn a price even above par.  A potential investment return can be easily calculated for a bond using the interest rate and maturity date or earlier call dates and prices, so investors can have a clearer picture of their potential return prospects.
  • Priority Capital Structure Ranking: The debt/bonds rank ahead of stock/equity in a company’s capital structure.  This ranking means that bondholders have a priority claim on the company’s assets and get paid first in the event of a default or bankruptcy.  With this priority, the debt in a given company is considered less risky than the stock of the company.
  • Historically Lower Volatility/Risk Adjust Outperformance: As noted above, high yield bonds benefit from their consistent income and capital gains potential and the historical return profile of high yield bonds has been similar to that of equities but with 30-40% less risk (as measured by standard deviation), leading to the high yield bond market’s risk adjusted outperformance versus equities.3

Corporate bonds are a huge market, and high yield bonds are a sizable portion within it.  High yield bonds generated consistent, tangible yield for investors which can’t be easily cut or eliminated, have a finite exit strategy allowing the path to generating value to be more clearly ascertained, have a priority in the company’s capital structure, and historically have outperformed equities on a risk adjusted basis.  Equities aren’t the only game in town for generating return, as evidenced by the high yield bond market’s historical return profile above.  We believe that including an actively managed high yield bond fund that is focused on finding the value this asset class has to offer as part of your portfolio can provide attractive yield and return potential for investors.

1  From the publication “Outstanding U.S. Bond Market Debt” release by SIFMA, data as of 12/31/16
2  US High Yield Market size as of 11/30/16 from Acciavatti, Peter D., Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “2016 High-Yield Annual Review,” J.P. Morgan, North American High Yield and Leveraged Loan Research, December 30, 2016, p. 279, https://markets.jpmorgan.com.
3  Bloomberg Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). The S&P 500 Index is a broad-based, unmanaged measurement of changes in stock market conditions based on the average of 500 widely held common stocks. S&P 500 index data sourced from Bloomberg, using a total return including dividend reinvestment. Annualized Total Return and Standard Deviation calculations are based on monthly returns. Return/Risk calculated as the Annualized Total Return divided by Annualized Standard Deviation. Data as of 6/30/17.

 

Posted in Peritus

Time to Pay Attention

The talk of changes in the retail sector over this year has been unending.  Be it the “Amazon Effect” being amplified by the acquisition of Whole Foods and how that will change the grocery industry, how the societal effects of the “shared economy” or the aging demographics will impact consumption trends, or the continued weakness in retail sales and string of bankruptcies, most recently with Toys R Us filing last week, it is clear that there are systemic shifts going on in the retail sector.

As an investor, do you think there is no reason to pay attention to any of these changes?  An entire industry—and an industry as a whole that is a massive employer in the United States—is in the midst of transformation and it doesn’t matter in terms of the securities you are buying?  It may sound silly to frame the question that way, but in essence, that is what passive investing entails.  With passive investing, the manager does not have the mandate to pay attention to changes in industries, society, demographics or the economy and consider how those changes will impact individual holdings.  Instead they are modeling/tracking a broad index for a certain asset class.

Yes passive investing involves lower fees and in certain market environments and periods, we do see passive investing outperforming active investing.  But we believe that over the long run, active management can provide alpha to investors by capitalizing on and adapting to these changes.  There are winners and losers, and there have been over the history of markets.  Today, we are in the midst of major changes in terms of politics, regulation, fiscal policy, societal behavior, and demographics, among others, and we believe this is the sort of environment where it pays to be paying attention and have the flexibility to adapt, especially in the high yield market in which we operate as an active fund manager.

Posted in Peritus

Understanding an Index

So much has been made of indexing/passive-investing over the past several years.  Investors are often enticed by the lower fees and broad exposure, and often the perception that there is lower risk via the thought it that you won’t underperform the index.  But in fact, many passive products do underperform their benchmark and we believe the restrictions put in place with tracking an underlying index, or sub-index in many cases, can put passive funds at a disadvantage.

It can be hard to replicate an index, especially in the high yield bond market.  Once issued, high yield bonds have an active and liquid secondary market, much like stocks.  However the difference is that bonds don’t trade on an “exchange” like stocks do.  Instead, bonds trade over the counter, in negotiated transactions among buyers and sellers.  Trading relationships are important for sourcing secondary bonds as well as getting allocations for newly issued deals.  Be it supposed ease in sourcing product or the perception that size equates to liquidity, some of the larger passive funds, such as the two largest in the high yield ETF world, focus only on larger issues, as we discuss below.

But just what does a broad high yield bond index look like?  Two of the more widely followed high yield bond indexes are the BofA Merrill Lynch High Yield Index and the Bloomberg Barclays High Yield Index.  The BofA Merrill Lynch US High Yield index includes 1,877 issues with a market value of $1.3 trillion.  The index currently carries a yield to worst of 5.61%, yield to maturity of 6.10%, average coupon of 6.44%, duration of 3.64yrs, and average price of $101.36.1  The Bloomberg Barclays US High Yield Index, which includes 2,024 issue and $1.3 trillion in market value, carries a yield to worst of 5.61%, yield to maturity of 6.09%, average coupon of 6.44%, duration of 3.84yrs, and average price of $101.43.2   It is important to understand what is in an index and how that is reflected in these average statistics.  For instance, yield is a key statistic that investors pay attention to, and as we look at the BofA High Yield Index, 27% of the issues trade at a yield to worst of under 4% and over half of the issues trade at a yield to worst under 5%.3

Again, as we look at some of the larger index-based vehicles, they cover a subset of the broader index.  For instance, the two largest high yield bond ETFs track sub-indices that have minimum tranche size constraints, (i.e., $500mm for one and $400mm per tranche/$1bn in total debt for another).  These sub-indices have 700-1,000 issues, so about half or less of the total number of issues in the broad high yield index.  We believe these size constraints put investors at a disadvantage as it is often in the issues/tranches that do not meet these size minimums that we have historically seen the most value.

Understanding an index and vehicles that track them helps us understand where active managers may have the ability to create value for their investors.  The most basic mandate of a passive, index-based vehicle it to track the underlying index or sub-index.  Be it size constraints or having to largely include what is in the underlying index without focus on the yield generated or the credit’s prospects, we believe arbitrary restrictions put investors at a disadvantage.  Rather our goal as an active manager is to generate a higher yield and higher total return than the high yield indexes and passive products.

We work to achieve this by being selective as to the securities that we own and focusing on where we see value in the market.  For instance, we aren’t forced to fill half of our portfolio with very low yielding securities, or buy the credits where we see clear credit and/or default risk.  We are able to focus our strategy on higher yielding securities where we see value.  It should be noted that we don’t believe we are getting aggressive in terms of credit quality (or lack thereof) in stretching to garner yield.  Because we do not set limits on the size of an issue as many of our competitors do, we are able to find plenty of value in off the run names.  In addition, we are able to look for discounts to par or to call prices, which we believes gives us the ability to generate some potential capital appreciation.  Furthermore, we have the flexibility to allocate a portion of our strategy to floating rate loans, which serves to expand our investment universe as we look for that value.

As an active manager, we are selective as to what securities we own and focus on where we see value relative to the risk in the market, as we work to generate consistent tangible income and potential alpha for investors.

1  The BofA Merrill Lynch US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market (source Bloomberg).  Yield to Worst is the lowest, or worst, yield of the yield to various call dates or maturity date. Duration is the change of a fixed income security that will result from a 1% change in interest rate. The duration calculation is based on the yield to worst date, using Modified duration to worst. Data is as of 8/31/17 and is the weighted averages.
2  Bloomberg Barclays US Corporate Investment Grade Index consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements, source Barclays Capital.  The duration calculation is based on the Macaulay duration to worst.  Data is as of 8/31/17 and is the weighted averages.
3  Based on the index constituents for the BofA Merrill Lynch US High Yield Index, source Bloomberg.  Percentages based on the number of individual issues in each yield bracket as a percentage of total number of issues within in the index.  The BofA Merrill Lynch US High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market.
Posted in Peritus

Lower for Longer

Today we saw the 10-year yield hit its lowest rate since November.  While some of the pressure is related to the tensions with North Korea, if markets were really fearful the worst would become reality, we’d see a full “risk on” trade, with equities taking a big and sustained hit, but we aren’t seeing that on the equity side.  Rather, these tensions are merely adding to already existing factors weighing on interest rates.

The inability for rates to sustain a move higher is no surprise to us, as we have written for years about the long-term drags we see on global rates, specifically the aging population and the long-term demand implications.  Here are some excerpts from our writing, “Pricing Risk and Playing Defense,” from early this year:

We believe that the biggest surprise awaiting investors in 2017 involves bond yields and interest rates…With Trump’s election, it is now “consensus” that the Federal Reserve is going to raise rates another three times in 2017. I question this assumption.  In fact, we may have already seen the highs on the 10-year Treasury in mid-December 2016 as it breached 2.6%.  Global growth has not changed since Trump was elected. The Euro Zone remains a complete mess and Brexit is not going to help.

Demographics and a massively levered global economy continue to be the dominant themes. The world is aging and this has enormous economic ramifications, including a shrinking labor force in the richest, most developed countries, swelling pension burdens, and slowing consumption. According to Pew Research, “Growth from 1950 to 2010 was rapid—the global population nearly tripled, and the U.S. population doubled. However, population growth from 2010 to 2050 is projected to be significantly slower and is expected to tilt strongly to the oldest age groups, both globally and in the U.S.”1

Again, we expect these demographic trends to have a continued and lasting impact on economic growth and final demand, and in turn, with lower demand we expect constrained interest rates.

Over the past nearly five years we have seen periods of spikes in 5-yr and 10-yr Treasury rates, only to see them fall again.  For instance, the 10-year Treasury surpassed 3% in 2013 on the “Taper Tantrum” as the Fed reduced the amount it put into the economy (QE).  But that was quickly followed by longer term rates returning to a downward path through 2014 and into 2015.  We saw rates move up some in the second half of 2015 as we prepared for the first Fed Funds rate hike in eight years, only to fall again after that December 2015 rate hike.  Rates spiked following the Presidential election, and surpassed 2.6% level on the 10-year, as the Fed also made a December 2016 and March 2017 rate hike, but again fell back even while the Fed continued with a June 2017 rate hike.  In 2017, as we had expected, we have seen a tightening of the yield curve, as the 2-yr rate moves up on rate hikes but the longer-term 5-year and 10-year don’t follow suit.

What the last five years have shown is that despite four Fed rate increases and all of the “tapering” and ending of QE that has been done along the way, the 10-year today sits at the same level it was in May 2013, and we have seen it revisit this level numerous times over this period.

Many have seemed to abandon their expectation for a September Fed Funds rate increase, with many now even doubting we’ll see the Fed move in December, as inflation remains persistently below the 2% target level.   The Fed is expected to start reducing their balance sheet in the coming months, but the expectation is that they will make it a priority of reducing large mortgage holdings before Treasury holdings, and anything done will be gradual, thus we don’t anticipate significant pressure on Treasury rates.

Just as we have stated for the last several years, we don’t expect to see a sustained and significant move higher in interest rates.  Aging demographics will continue to weigh on global demand and consumption. We are also seeing societal and behavioral shifts on the younger generation, with the shared economy and consumption trends across a variety of areas impacted. The political situation domestically remains a mess, with political infighting putting the expected tax cuts and infrastructure spending that promised growth in question, or if it is able to get through Congress, will likely be muted. Thus, we don’t see that as a big drive of GDP growth.

As we look at just what this means for us in the high yield market, we expect the low rate environment to continue.  So despite the fact that we have seen compression in yields within the high yield space over the last year and a half, relative to other fixed income options we still believe high yield bonds and loans remain an attractive option for investors that are looking for tangible income generation and yield.  While we are seeing yields (yield-to-worst) of around 6% for the various high yield bond indexes, we believe an active and thoughtful portfolio of high yield bonds has the ability to produce yields higher than that of the market indexes, as well as the potential for some capital appreciation.

1  From the piece, “Pricing Risk and Playing Defense,” http://www.peritusasset.com/wp-content/uploads/2017/03/Pricing-Risk-Peritus-Letter-Final.pdf.  “Global Population Estimates by Age, 1950-2050.” Pew Research Center, Washington, D.C. (January 30, 2014). http://www.pewglobal.org/2014/01/30/global-population/.
2 Data from 1/1/13 to 8/28/17 sourced from the Federal Reserve and Department of Treasury websites, https://www.federalreserve.gov/monetarypolicy/openmarket.htm and https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yieldYear&year=2013.
Posted in Peritus

The Earnings Opportunity

Starting in late July and continuing through the first half of August is earnings season for most of our credits, which is a very important and busy time for us.  As active managers, we not only evaluate a credit as we make an initial purchase—our alpha-focused bond and loan credit strategy involves a thorough fundamental review—but we also continuously monitor  credits once they are  held.  Earnings season is an important time because it gives us a look at whether or not the credit has met our initial expectations and investment thesis.  While top line performance (sales) is of note, we generally pay particular attention to the company’s EBITDA, FCF generation/use, leverage, and liquidity position, as well as the outlook going forward.

As we process all of this data, we evaluate whether any change in the investment thesis is warranted.  While in most cases there is no change, our earnings evaluation can result in a sell or an increase in position sizes.  For instance, if the company is underperforming and we see further downside exposure relative to the security’s price, we may choose to sell.  On the flip side, if we see the security as significantly undervalued, with a disconnect between the credit fundamentals and the credit’s yield/price, we may choose to add to an existing position.

Furthermore, earnings season can create a variety of opportunities for new investments.  Often we see a security’s price taken down/yield widen on the company missing expectations or giving an unfavorable outlook, yet we may believe the market is overreacting to the news or the issue causing the weakness is just temporary.  This can create an undervalued situation and what we see as an attractive buy-in price—these are the sort of opportunities we look for as a value-focused manager.  Or we may have a security that we are watching but as an extra layer of caution want to see how the company is recently performing before we pull the trigger to make an investment, and the earnings announcement allows us to do just that.

This is just part of the merit and worth we see in active management.  We are intentional about what we hold and why we hold it.  In the high yield market, earnings surprises often have an impact on security prices, so we don’t believe blinding holding something no matter the valuation or outlook is the answer.  Per our strategy, we target about 70-100 credits within a portfolio, which we believe does allow us enough diversification to moderate our security specific risk and keeps position sizes relatively low, but also gives us a limited enough number of securities that we are able to evaluate what we hold.  In times like this, we believe it is very important to have an active manager monitoring what securities are held and how a portfolio is constructed.

Posted in Peritus

Where We’ve Been and Where We Are Now

To understand where you are in the high yield market, it is helpful to take a look at where we have been.  People talk about how we are 8+ years into this “cycle” and are express concerns about valuations.  We believe this is a valid concern for certain market sectors, primarily equities.  From early 2009 through mid-2017 we have seen a virtual straight line up in equity prices with only minor corrections along the way.1

We are sitting at record price levels in the S&P 500, DOW, and Nasdaq, with many questioning investor complacency and valuations.

While these concerns have spread across a variety of financial sectors beyond just these equity indexes, we view the high yield market a bit differently.  Yes, there are credits that are overvalued within this market, but there are still some bonds and loans that we see as fairly and even undervalued.  Yes, yields are low relative to historic levels, but this is in a context of persistently low rates around the world.  Spread levels are still well above historical lows.

Looking at recent history, we don’t believe we can say that high yield investors are complacent.  It hasn’t been a straight upward move over this market “cycle” as we have seen with equities.  In fact, if you look at the chart of spreads within the high yield market, we have seen this market go through its own cycle of sorts.2

Almost a year and a half ago we saw spreads widen to over 900bps, hitting 919 bps on February 11, 2016.3  While this is nowhere near the spread widening we saw in 2008/2009, which is certainly the outlier as reflected in the chart above, the spread highs that we saw in early 2016 were near the spread highs that we saw during the prior spread peak during the Telecom, Media, and Technology (TMT) collapse of 2001/2002, when spreads topped out right around 1,000bps.  There is even high yield data going back to the early 1990’s, when the country was in the midst of the recession, and we saw spreads peak then again right around that 1,000bps level.4

It is important to understand some of the factors that were present going into the declines at the turn of the century, 2008, and even 2015/2016 as we evaluate where we are today.  As we closed out the 1990s, we were in the midst of the internet/technology bubble.  Telecom, media, and technology were going to revolutionize the world and financial markets were wide open to these companies seeking money to establish their businesses, with investors hoping to grab a piece of the pie.  Just as we were seeing companies with little the way of actual revenues, much less profits, able to generate equity proceeds via IPOs, we were seeing similarly relaxed issuance standards during this time in the high yield market.  Media and Telecom (Broadcasting, Cable/Wireless, and Wireline and Wireless telecommunications) accounted for 45% of all high yield bond new issuance in 1999 and 57% in 2000.5  Telecom alone was 20% of the high yield market by August 20006, and add media and technology and these three high flying areas were a significant piece of the high yield market.

As the internet bubble burst, and the events of September 11th hit in the midst of this, we started seeing default rates accelerate.  Total default rates moved up from about 4-5% in the years prior to 9-10% in 2001 to mid-2002.7  Media and telecom defaults accounted for 44% of all defaults in 2001 and 65% in 2002.8

The issues that preceded the decline early 2008, before the full scope of the financial crisis hit, were also related to relaxed issuance standards.  But here it wasn’t a specific industry that caused the problem; but rather three letters—LBO.  Leveraged buyouts have always been part of the high yield market and in many cases have created value for investors along the way.  LBOs in and of themselves weren’t the problem; rather, it was a massive wave of LBOs that hit during 2005-2007 and were being done at high multiples with very thin equity allocations committed to the deal.  This meant these new structures were left to be heavily financed with debt.  Acquisition financing in the high yield bond market grew from 13% of total new issuance volumes in 2003 to 51% in 2007.9  Higher leverage multiples were widely accepted as leverage on the index grew from an average of 4.5x in 2003 to 5.4x at the end of 2007.10

High multiples and heavy debt loads proved to be a toxic mix as the financial crisis hit in the latter part of 2008.  The premise of the elevated multiples and large debt financing was that these companies would grow into their capital structures.  But as the “Great Recession” hit, those hopes for growth evaporated in many cases.  Default rates across the high yield market spiked in late 2008 and early 2009, and these highly levered LBOs weighted on the market and default rates for years to come.

Moving to the more recent history, the market disruption in 2015-early 2016 was similar to what we saw in 2001/2012, where specific industries were of issue.  This time it was energy and commodities (metals and mining), which by mid-2014 were about 23% of the high yield index.11  We saw the “contagion” spread to the broader high yield market as investors became concerned about high yield in general given the energy concentration, which lead to selling and pricing pressure and spread widening across the high yield market.  Default rates did accelerate, but it was contained to the problem industries of energy and commodities.  In 2016, these two industries accounted for a staggering 81% of all default volume.12

But this cycle it was much shorter lived as those problem industries were a smaller portion of the high yield market than the telecom, media and technologies companies were back in 2000.  Additionally, we saw commodity and energy prices move up from the bottom and largely stabilize, easing much of the market overhang and uncertainty.

So as we circle back to today, where does that leave us?  Defaults are the major risk for high yield investors and on that front, we have seen the weaker energy and commodity players largely already dealt with and restructured (cleaned up their balance sheets and eliminated debt), and given we haven’t seen a rapid rise in energy prices (oil is still half of where is was in the summer of 2014), we don’t see another collapse brewing.  We also aren’t seeing aggressive issuance in the energy space, with energy at 14.7% of YTD issuance, exactly in line with the sector’s weight within the high yield index.13  But just because the energy concerns have moderated, are there any other problem industries on the horizon?  We’d certainly argue that retail has clearly become a challenged space, but this sector only accounts for under 4% of the high yield bond index.14  Of note, other than energy, no other industry comprises more than 10% of the high yield index.  Default rate expectations remain below historical levels for the foreseeable future.15

Looking at the broader high yield market fundamentals, aggressive issuance has gotten this market in trouble before, but YTD issuance has been well disciplined.  While issuance proceeds are up 8% versus last year, non-refinancing volume is at its lightest pace since 2011, with refinancing dominating the primary market at 64% of total YTD issuance, with merger and acquisition issuance at just 17%.16  Investors certainly don’t seem to be complacently just waiving in the deals.  Leverage statistics within the market are reasonable and still well below what we saw in 2007, currently at 4.4x, and interest coverage is strong at 4.1x17 indicating to us that management teams are continuing to exert caution as they look at empire building and growth opportunities (or lack thereof) going forward.

So again, while some may argue investor complacency in other markets, we don’t feel the same holds true for high yield.  Investors haven’t fallen asleep at the wheel over this cycle, as evidenced by the spread widening we saw just a year and a half ago.  Market technicals remain disciplined, as we see issuance dominated by refinancing and two way fund flows within the market.  Credit fundamentals remain reasonable, as evidenced by the leverage and coverage stats.  Moody’s recently reported their measure of liquidity stress was at a record low, as corporate liquidity has improved.  Defaults are tame and expected to remain so for the next couple years.

As we look at today’s high yield market caution is warranted, yes, but we certainly don’t believe it is time to run for the exits as investors may well miss out on valuable yield by doing so.  There are overvalued and very low yielding securities within the high yield market, or certain cases where we believe investors are overlooking key risks for specific credits. For instance, over 30% of the high yield index trades at a YTW of 4% and under18, which certainly doesn’t indicate value to us.  We believe investors should exercise caution by actively not passively participating in the high yield market—putting together an active portfolio versus buying a passive, index-based product—rather than avoiding the high yield market altogether.  Relative to the other fixed income options or equity valuations, we believe there is still attractive yield to be had by in investing in high yield bonds, but that value has certainly become less pervasive over the last year requiring investors to avoid aggressively stretching into credits we would classify as overly risky or to accept the very low yields offered by a notable portion of the market, which can create risks of their own via pricing risk if the security is trading above call prices or higher interest rate risk.  There is value but we believe investors should actively search for that value on a credit by credit basis.

1  The S&P 500 Index is a broad-based, unmanaged measurement of changes in stock market conditions based on the average of 500 widely held common stocks.  Data sourced from Bloomberg for the period 1/1/2007 to 7/17/17.
2  The J.P. Morgan Domestic High Yield Index is designed to mirror the investable universe of the US dollar domestic high-yield corporate debt market, including issues of US and Canadian domiciled issuers.  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 5/17/17, 6/30/17, and 7/28/17, https://markets.jpmorgan.com/?#research.na.high_yield.  Spread is the month-end average spread to worst for the period 1/31/1994 through 7/27/17.
3  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High Yield Market Monitor,” J.P. Morgan North American High Yield Research, March 1, 2016, p. 1.
4  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 5/17/17, 6/30/17, and 7/28/17.  Spread is the month-end average spread to worst for the period referenced.
5  Acciavatti, Peter, Tony Linares, Nadia Nelson, and Moliehi Pefole, “2002 High-Yield Annual Review,” J.P. Morgan Global High Yield Research, January 2003, p. 63.
6  Acciavatti, Peter, Tony Linares, Nadia Nelson, and Moliehi Pefole, “2002 High-Yield Annual Review,” J.P. Morgan Global High Yield Research, January 2003, p. 12.
7  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 6/1/17.
8  Acciavatti, Peter, Tony Linares, Nadia Nelson, and Moliehi Pefole, “2002 High-Yield Annual Review,” J.P. Morgan Global High Yield Research, January 2003, p. 12.
9  Acciavatti, Peter, Tony Linares, and Nelson Jantzen, “2008 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 2008, p. 55.
10  Acciavatti, Peter, Tony Linares, and Nelson Jantzen, “2008 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 2008, p. 56.
11  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High Yield Market Monitor,” J.P. Morgan North American High Yield Research, July 1, 2014, p. 20.  Data based on the percentage of the JP Morgan US High Yield Index, with Energy 18% and Metals and Mining 5%.
12  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Default Monitor,” J.P. Morgan North American High Yield Research, January 3, 2017, p. 4.
13  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High Yield Market Monitor,” J.P. Morgan North American High Yield Research, p. 15, 20.
14  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High Yield Market Monitor,” J.P. Morgan North American High Yield Research, p. 20.
15  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 6/1/17, 6/19/17.
16  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High Yield Market Monitor,” J.P. Morgan North American High Yield Research, August, 1, 2017, p. 8.
17  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 7/17/17.  Acciavatti, Peter, Tony Linares, and Nelson Jantzen, “2008 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 2008, p. 56.
18  The Bank of America Merrill Lynch US High Yield Index monitors the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.  Index data sourced from Bloomberg, constituents as of August 1, 2017.
Posted in Peritus

High Yield Morning Update

High yield bonds were better yesterday and today is opening slightly better too.  Three new issues priced yesterday for $1.55B in proceeds with three more on the docket for today.  The default risk in high yield bonds still remains low, as Moody’s reported a Q2 default rate of 3.8% versus 4.7% for Q1.  It appears that corporate America’s CEO’s haven’t gone stupid by making expensive acquisitions or adding a bunch of capacity anticipating growth as they understand it is not there.  The Bloomberg Barclays High Yield Index’s yield-to-worst hit a three year low yesterday, now at 5.36%, though we certainly are able to find better yielding opportunities as an active manager.

Bloomberg Barclays US High Yield Index covers the universe of fixed rate, non-investment grade debt.  Index data sourced from Bloomberg.
Posted in Peritus