Floating Rate Bank Loans: Rising Rates, Re-pricings, and the Real Income

Investing in floating rate bank loans has been a popular strategy this year given investor’s concern about higher rates.  We have seen positive fund flows into floating rate loan mutual and exchange traded funds in 15 of the last 16 weeks, and so far this year $8.1bn of inflows to loan mutual and exchange traded funds.1

At face value this seems like a “no brainer” trade, and many have embraced it as such, but the actual numbers tell a bit of a different story.  For instance, 2013 was the last annual period in which we saw a meaningful increase in US Treasury rates, and during this period a whopping $63bn flowed into floating rate loan mutual and exchange traded funds.2  However, in 2013 floating rate loans returned 5.3% versus 8.2% for high yield bonds.3  So even with the 10-year Treasury yield increasing by over 1.2% and the 5-year Treasury increasing over 1.0% (both over 50% from their respective yields at the beginning of year)4 and a massive amount of inflows into the loan space in 2013, the high yield market, helped by higher initial starting yields, still outperformed the loan market, despite the fact that the high bond market saw slightly negative net outflows for the year.5

Another consideration when investing in the loan market must be an understanding of what the “floating” rate is tied to.  Bank loans are generally based on short-term LIBOR rates, which doesn’t necessarily tie closely to longer term 5- and 10-year Treasury rates, which are the more relevant rates for high yield bond investors.  For instance all through 2013-2015 LIBOR was virtually flat, while Treasury rates surged.  Then in 2016, we saw LIBOR increasing while Treasuries fell.  It has only been over the last year and a half that LIBOR and the 5-year have been both moving upward.6

The relevant interest rate is important but so is understanding how the actual spread over that base rate works.  Loans differ from bonds in that bonds are generally issued with a non-call period covering the first several years after issuance, and then have a set call schedule indicating premium prices at which the company can redeem the bonds over subsequent years.  Depending on the term of the bond, this often provides the investor call protection for much of the term of the security.  However, with floating rate loans, that call protection is generally much shorter.  With a newly issued loan, you may have a non-call period for the first six months to a year, but many loans are issued with no call protection. Given the supply and demand imbalance in favor of issuers of late, there is often no call  protection for loan investors at all.

Why does this matter?  Because the very minimal call protections can lead to constant “re-pricing” activity.  This means that the issuer approaches the investor to lower the interest rate on the loan.  The loan remains outstanding but now the investor is faced with a lower rate.  So while investors have to approve the repricing, in times of high demand, it isn’t hard for issuers to get the repricing activity through (as the alternative is that they call the loan altogether and the investor loses the holding).  Over the past couple years we have seen a huge wave of repricings.  In 2017, 45% of the $974bn in gross new issuance volume was related to repricings and so far in 2018, 48% of the $304bn in gross new issuance is related to repricings.7

Index-based/passive bank loan funds track a specified index and thus largely hold the securities in that index.  When a security is repriced and remains outstanding and part of the index, then these funds would be subject to a lower total coupon rate on that security.  In a period such as we are seeing now, interest rates can be rising via the LIBOR increase, so the base rate on the loan is increasing, but with the repricings that spread over the base rate can be falling, meaning the actual total coupon rate the investor receives may be actually falling, or at least going up much less than the LIBOR move would indicate.

An additional note, the general perception seems to be that loans are always less risky than bonds.  However the reality is that many companies have debt financing that consists entirely of loans and some of those loans are still part of capital structures that are very highly levered.  We continue to see the envelope being pushed by loan issuers with many so-called “1st liens” being levered north of 5x EBITDA.

We believe that investors need to make sure they understand what they are purchasing in this space on both the credit and the coupon side.  While we do currently see an opportunity in the floating rate bank loan market as a supplement to an existing high yield bond allocation, we believe this opportunity is for active investors who are able to decide what credits they want to own.  Active investors in the loan market are able to consider and invest according at the credit fundamentals and the security metrics.  That flexibility can also allow the active investor to take advantage of the higher rates by investing in loans where they are not seeing repricing activity eat away the benefit of the LIBOR move.

So for investors concerned about rising rates, we continue to see the high yield bond market as an attractive place to be positioned but do see the opportunity to supplement that bond allocation with an active allocation to the floating rate loan market, whereby investors can expand their opportunity set, take advantage of where in the capital structure they want to be positioned, and potentially benefit from the rising floating rates.  For more on investing in high yield debt in a rising rate environment, see our recent piece, “Strategies for Investing in a Rising Rate Environment.”

1 Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 5/11/18, https://markets.jpmorgan.com.
2 Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 5/11/18, https://markets.jpmorgan.com.
3 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Leverage Loan Market Monitor,” J.P. Morgan North American High Yield and Leveraged Loan Research, January 2, 2014, p. 1.
4  Data sourced from the U.S. Department of Treasury website, Daily Treasury Yield Curve Rates, comparing 12/31/12 to 12/31/13.
5 Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 5/11/18, https://markets.jpmorgan.com.
6 Data for the period 5/15/13-5/14/18, LIBOR and Treasury data sourced from Bloomberg.
7 Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 5/2/18, https://markets.jpmorgan.com.
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What History Tells Us About Investing in High Yield Bonds in the Face of Rising Rates

Looking at where we were just a year ago, we have seen a notable move upward in US Treasury yields, with the 2-year yield going from 1.29% at the at the end of April 2017 and nearly doubling to the current level of 2.49%, while the 10-year was at 2.35% a year ago and has now surpassed the 3% level.1

Of note, most of the move in the longer end of the curve, the 5-yr and 10-yr, has come in just the past six months.  These rate moves have left many questioning just what that means for fixed income investors, especially those in the high yield corporate bond world.

If we look to history, that should give us some comfort as we face the potential of higher rates.  In the over 30 years of data, since 1986, Treasury yields have increased (i.e., interest rates rose), in 15 of those calendar years.  In all but one of those 15 years, high yield has outperformed the investment grade bond market.  The long-term numbers show that over those 15 years when we have seen Treasury yields/interest rates increases, high yield had an average annual return of 12.4% (or 9.2% if you exclude the massive performance in 2009).  This compares to only a 4.4% average annual return (or 3.4% excluding 2009) for investment grade bonds over the same period.2

So the data is clear that the high yield bond market has historically not only provided investors with solid returns during years in which we see interest rates increase, but has also dramatically out performed its investment grade counterpart.

Looking at this is a different way, below we lay out the historical returns for the high yield index during periods of rising rates.  Here we specifically look at how the index performed prior to and following periods when rates rose 30bps, 50bps, 70bps, and 100bps over certain periods of time.3

So it isn’t just full year periods where we see positive returns, but this data demonstrates that we have also historically seen positive returns in the months during which interest rates are increasing and the months after those increases have occurred.

As we have noted in some of our recent writings, this historical performance does makes sense given the high yield bond market’s lower duration and the fact that high yield performance seems to be much more tied to credit quality and default rates.  We generally see rates rising in the face of economic strength—which also happens to be the premise for the current argument for rates to go higher—and economic strength generally leads to stable and/or low default rates, benefiting high yield bonds.

For more on how the high yield market has historically performed during periods of rising rates and various investment strategies in the face of potentially higher rates, see our recent piece “Strategies for Investing in a Rising Rate Environment.”

1 2-year, 5-year, and 10-year US Treasury yield for the period 4/25/17 to 4/25/18.  Data sourced from the U.S Treasury Department, https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield.
2 Bloomberg Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). 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).  Covers annual, calendar year returns from January 1986 to December 2017. 5-yr Treasury data, 2008-2012 sourced from Bloomberg (US Generic Govt 5 Yr), 2013-2017 data from the Federal Reserve website.
3  Data analyzing the month end levels of the 10-yr US Treasury yield versus the monthly returns for the Bloomberg Barclays High Yield Index, looking specifically at performance for the High Yield Index during periods when the 10-year yield moved above the noted thresholds from one month end to another. Intra-month data was not analyzed. Trailing performance numbers are for the prior 6 months and 3 months before the month end in which we saw the Treasury yield cross the threshold, for the current month in which is crossed threshold and for the one, three, and six month periods after the calendar month in which Treasury yields cross the threshold. Bloomberg Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt. Data sourced from Barclays and Bloomberg and covers the period of 12/31/1986 to 12/31/2017.
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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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The New Case for High Yield: A Guide to Understanding and Investing in the High Yield Market

Throughout its history spanning over three decades, the high yield market has often been viewed as a confusing or an alternative asset class.  However, the reality is that this is a large, developed and liquid asset class.  We have provided this “owner’s manual” for those investing in the high yield market, to shed some light on this often misunderstood market.  In it we detail the history and development of the space, discuss the legislation and ratings methodologies that have created what we see as opportunities in the marketplace, and compare historical risk adjusted returns with other asset classes.  Additionally, we describe our own investment philosophy and approach to the high yield market.  We believe that the benefits from investing in the high yield market are undeniable.  Click here to view our updated piece, “The New Case for High Yield: A Guide to Understanding and Investing in the High Yield Market.”

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Volatility: High Yield Bonds versus Equities

Volatility has once again returned to financial markets over the last couple months, most visibly with wild equity price movements that we saw in February and again over the last week. While the high yield bond market certainly has not seen the extent of the volatility the equity markets saw, the rise in the 10-year Treasury yield has been an overhang in high yield as many are concerned about interest rate risk for fixed income securities.  While we believe this concern is valid for lower yielding, longer duration sectors (like investment grade corporate or municipals), high yield bonds have historically performed well in rising rate environments, helped by the fact rate increases generally correspond with improving economies.  This tends to alleviate credit risk, and high yield bonds benefit from their shorter maturity and higher yield, thus lower duration versus other fixed income alternatives (see our writing “Strategies for Investing in a Rising Rate Environment” for further detail).  Generally speaking, fundamentals for corporate credit remain solid and default rates are expected to remain low over the next couple years, which we feel positions the high yield market nicely.  Thus these periods of volatility like we have seen over the last couple months can create opportunities when they aren’t driven by a weakening credit environment/elevated credit risk.

Additionally, as investors look at how to navigate this return to volatility in financial markets, it is worth noting that over its history, the high yield bond market has had less volatility (as measured by the standard deviation) than the equity market, with a relatively similar returns profile.1

Within our own strategy, just over two years ago, we adjusted our strategy to deliberately include new and newly issued bonds.  Our goal with this strategic allocation was to reduce volatility and improve liquidity, as our experience had been, and market research supported, that high yield bonds tend to be even more liquid in the initial period following issuance as underwriters often support their deals and high yield managers look to add new bonds to their portfolios.

Volatility is a key measure of risk used by investors, and for those investors that are looking to reduce volatility versus equities while still generating income and potential upside, we believe that an actively managed high yield strategy can be an attractive alternative for investors.

1  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 2/28/18.
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Credit Risk versus Interest Rate Risk

As we brace for another FOMC meeting and an expected rise in the Federal Funds Rate, we continue to hear investors express concerns about how the high yield market will fare in the face of rising rates.  Looking back over the past two plus decades of the high yield market, we see that the prices of high yield bonds have historically been much more linked to credit quality than to interest rates.  Historically, interest rates increase alongside a strengthening economy and a strong economy is generally favorable for corporate credit and equities alike.  Due to the nature of the high yield bond market, the major risk on the minds of investors tends to be default risk (not interest rate risk), causing them to be much more concerned with the company’s fundamentals and credit quality than interest rates.  When the economy is expanding, profitability, financial strength, and credit metrics generally improve.

The move higher in longer-term Treasury yields that we have seen during the first couple of months of 2018 has been tied to expectations that the improved economic growth will give the Fed the fuel they need to continue with rate increases. As we look at the history of the high yield market, we have seen a negative correlation between the Federal Funds Rate and high yield bond default rates, which makes sense—if the economy is improving, the Fed is increasing rates, and simultaneously default rates are falling due to the stronger economy.  On the flip side, if the economy is weakening, we generally see the Fed easing and default rates often increasing.  The chart below demonstrates this historical relationship.1

High yield default rates have been below historical averages over the past several years, with the exception of 2016 when we saw default rates temporarily increase due to the collapse in energy and other commodity prices (as a reminder, energy and commodities were a significant portion of the index at the time).  We have seen a few high profile defaults over the past few months, with Toys R Us and Claire’s on the retail side, and iHeart Communication on the media side, but those have been overlevered companies for years and on the short list of problem credits, so by no means an indication to us that the default rates are set to spike.  Rather, we have even seen expectations for default rates to decline further from the current level (which is already low by historical measures) as we proceed through the year.  As we look forward, we are generally seeing stable fundamentals for high yield issuers and the expectation is for default rates to remain low over the next couple years.2

So as we hear today on the next rate increase and may get a clearer indication of whether we may actually see four rate increases this year, not three, we feel investors should focus on the reason behind these rate moves:  economic improvement.  A stronger economy would undoubtedly be a positive from a credit perspective and would likely indicate lower default rates, meaning likely improved credit prospects for the high yield issuers and the high yield market.

For more on how the high yield market has historically performed in the face of rising rates, see our recent piece “Strategies for Investing in a Rising Rate Environment.”

1 High yield bond default data and Federal Fund Rate data from Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 2/16/18, https://markets.jpmorgan.com, data used for the final month of each indicated quarter.  GDP Change data sourced from Bureau of Economic Analysis, U.S. Department of Commerce, www.bea.gov.
2 Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 2/6/18, https://markets.jpmorgan.com.

 

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Strategies for Investing in a Rising Rate Environment

Accurately calling interest rate moves has proved to be a difficult, and futile, task for investors over the past several years as we have seen wild moves and really no sustained direction.  While the only aspect of rates that can be accurately predicted seems to be volatility, many are left wondering if the swift move in rates that we have seen in the first two months of 2018 is the beginning of a sustained move upward.  As we look forward, we know the Fed has stated their intention to raise the Federal Funds Rate at least another three times this year, but just what does that mean for Treasury yields?  And if rates do rise materially from here, what does that mean for the high yield market and the various “strategies” out there to deal with rising rates?

Click here to read our piece, “Strategies for Investing in a Rising Rate Environment,” where we look at just how the high yield market has historically performed in the face of rising rates and examine some of the high-yield debt based investment strategies to address interest rate risk.

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The High Yield Market Outlook

As we start the new year, much of the focus has been on interest rates.  We’ve seen the Fed moving up the Fed Funds rate up for the last two years, all the while the 10-year Treasury yield hit the 3% level in early 2014 and has been trending under that ever since.  Is 2018 finally the year we see the 10-year Treasury yield move up and sustain that upward momentum and if so, what will that mean for fixed income?  While we continue to see constraints to a big spike in Treasury yields, including global rates (relative yields on sovereign debt around the world) and global demographics (an aging global population and continued demand for yield), we have clearly seen the upward trend in yields across the Treasury curve so far this year.

High yield bonds have historically performed well in rising rate environment.1  Yet the gut reaction with rising rates seems to be concerned about anything fixed income related.  And for some long duration, low yielding securities (investment grade corporates and municipals as an example), that concern makes sense.  If interest rates rise 1% in a year that will certainly matter a lot more for 10-year security that is yielding 3% versus a 5-year security that is yielding 7%.  Duration is a measure of interest rate sensitivity incorporating maturities/calls and yields, the higher duration the more theoretical interest rate sensitivity.  High yield bonds carry a much lower duration than many other alternatives in the fixed income space.  For instance the duration on the investment grade index is 7.56 years while the duration on the high yield index is 4.0 years, indicating a much higher interest rate risk for investment grade debt.2  Within the high yield debt market, our active strategy focuses on maximizing yield relative to risk, and with that, our strategy tends to carry a higher yield than the high yield bond index and we additionally invest in floating rate loans, both of which allow us to target a duration even lower than that of the high yield index.

Keep in mind that the high yield indexes include securities across the ratings spectrum, from what we would call the “quasi-investment grade” BB names all the way to the C bonds.  Often higher rated securities have smaller coupons (similar to what you would see in the investment grade world).  If this rising rate environment persists, that can change the incentive for companies to refinance or call the low coupon debt early because the interest rates on new debt issuance will have to adjust for higher rates, thus could raise interest costs for these companies.  We believe that the prices on many of these securities trading above their call prices may have to adjust to this fact, so that is something for investors to be aware of as they look at the broader indexes.

But it’s also important to keep in mind the reason that interest rates are currently increasing—a stronger economy.  Historically rates increase in the face of a stronger economy, and stronger economic activity is undoubtedly a positive for corporate credit, as well as a positive for default rates.  Historically, elevated credit and default risk are the biggest negatives for high yield debt.  Default rates are expected to remain historically low and economic activity pick up, which creates a favorable credit backdrop for corporate issuers.

So we don’t feel that a higher interest rate environment and increasing treasury yields is the death nail for high yield.  Nor do we see any systemic issues on the horizon that pose a massive risk to the downside.  Many market prognosticators have been calling for coupon-like returns in high yield for 2018.  We don’t disagree, though we may see some blips of volatility along the way just as we saw in 2017, and in each case of volatility in the high yield market last year that was ultimately met with buying.  On the index level, spreads are relatively tight compared to historical levels.  While there may be some room for further spread compression (price upside) we believe that is much more limited on the index-level, where many bonds are trading at or above their call prices, and as we noted above, if higher rates persist, we may even see some price widening for the very low yielding credits within the index that are trading to call prices.  At the same time, we see an environment of improving corporate fundamentals, generally good liquidity and reasonable leverage at the individual company level, and the default rate to continue to trend well below historical averages, and we believe these fundamentals matter and will provide price support for the market.

If we are looking at coupon like returns for the year, the starting coupon is an important consideration.   With our focus on yield and finding value, our strategy targets producing a yield that is higher than those offered by the high yield index and many of the index-based products.  Additionally, we look for value and with that, our goal is to provide the potential for additional capital gains upside to further support returns.  As we look at the year ahead, we believe that an actively managed, value-oriented high yield debt allocation can offer an attractive place to be positioned for yield seeking investors.

1  For data and further details on the high yield market’s performance during rising rate environments, see our piece “High Yield in a Rising Rate Environment,” http://www.peritusasset.com/2018/01/high-yield-in-a-rising-rate-environment-7/ and “Strategies For Investing in a Rising Rate Environment,” http://www.peritusasset.com/wp-content/uploads/2013/02/Strategies-for-Higher-Rates-Update-June-2016-Final.pdf.
2  Bloomberg Barclays U.S. Corporate High Yield Index covers the universe of fixed rate, non-investment grade deb.  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.  Macaulay duration to worst is used, based on the yield to worst date.  Source Barclays, data as of 1/31/18.
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The Return of Volatility

Today, people are left trying to make sense of yesterday’s wild ride in the equity market in the hour before the market close, followed by the quick move down (even into “correction” territory on the Dow) and subsequent reversal this morning.  There have been a number of “causes” offered by the market commentators, everything from blaming it on the computers/algorithms to inflation concerns to too many leveraged and inverse products (ie., ETFs with two and three times leverage or inverse ETFs).  One of the statements we have heard this morning that has most resounded with us is one commentator saying we have created a “bubble” called “passive investing” over the last several years and that bubble is in the process of bursting.  While this commentator was referring to the equity market, we believe it translates to a variety of asset classes.

Passive investing has certain been widely embraced over the last several years, as money has poured into passive vehicles.  And it has worked for these investors as many asset classes have been trading virtually in a straight line up, with little in the way of volatility.  Investors have seemingly been lulled into complacency and the belief that markets always move up, but this certainly isn’t always the case, as the last several days have demonstrated.

We are not passive investors, rather we are an active manager within the high yield debt market, and are managing our holdings on a daily basis.  We are making buy and sell decision based on our determination of specific credits and how we want to position ourselves.  We don’t see volatility as a reason to panic; rather, we view it as an opportunity to look for credits that may have been hit for the wrong reasons, creating an attractive buy-in.  Nothing has changed fundamentally in the companies in which we invest over the last week.  We own what we own for a reason, rather than owning a security just because we are tracking an underlying index.  Furthermore, credit fundamental remain intact as largely companies have liquidity, corporate leverage isn’t accumulating, and we don’t see a default spike on the horizon.

Interestingly, despite all of the volatility we have seen in equities, the high yield market has been relatively tame over the past several days—we aren’t seeing a big sell-off in credit markets.  While two days of performance by no means makes a trend, it is worth looking at the declines over the past couple days.  From Thursday’s close through Monday’s close, we saw the S&P 500 Index return -6.13%, the Dow Jones Industrial Average -6.98%, and the NASDAQ composite -5.19%, while the Bloomberg Barclays US Corporate Investment Grade Index has returned -0.26% and the Bloomberg Barclays US Corporate High Yield Index -0.52%.1

We don’t see the current market conditions as a reason to panic.  Equity valuations have gotten ahead of themselves and now are adjusting, yet credit markets seem to be holding in as we aren’t seeing big declines in corporate credit.  Volatility in financial markets has returned and we’d view it as an opportunity for active managers.  Investors are waking up to the fact that markets don’t always move up, and re-evaluating if passive is best.  We have maintained that the high yield debt market warrants active management, and believe this active approach is all the more relevant and essential in today’s market.

1  Performance for 2/1/18-2/5/18.  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).  Bloomberg Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital).  Past returns are no indication of future results.
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High Yield in a Rising Rate Environment

The widely held expectation is that the Fed will raise rates at least three times again this year.  The question becomes what does this mean for fixed income markets?

  • Investors often seem to be under the notion that anything “bond” related is highly interest rate sensitive and will take a hit if rates rise—yet history has proven otherwise for certain fixed income asset classes.
  • Looking at the actual returns for the high yield asset class, in the 15 calendar year periods since 1986 where we saw the 5-year Treasury yield increase (rates rise), high yield bonds posted an average annual return of 12.4% over those periods (or 9.2% if you exclude the massive performance of 2009).1

Higher coupons and yields in the high yield space help cushion the impact of rising interest rates.

  • The higher the starting yield, the less impact we would expect to see from a move in interest rates.

High yield bonds have shorter durations than other asset classes in the fixed income space.

  • Duration is a measure of the price sensitivity of a bond to changes in interest rates, which incorporates the coupon, maturity/call date, and price.
  • High yield bonds are typically issued with five to ten year maturities and are generally callable after the first few years, as well as offer higher coupons, providing the high yield sector with a shorter duration, thus theoretically less interest rate sensitivity versus other asset classes.2

High yield bond returns are slightly positively correlated with changes in Treasury yields.3

  • Certain asset classes, such as investment grade bonds have a negative correlation to changes in Treasury yields.  This means if rates (yields) increase in Treasury bonds, we have historically seen investment grade returns move in the opposite direction (decline).
  • However, high yield bonds are slightly positively correlated to Treasuries, so historically as Treasury rates increase, high yield bond prices and returns have seen little impact to an increase.

The price of high yield bonds have historically been much more linked to credit quality than to interest rates.

  • Historically rates rise during a strengthening economy, and a stronger economy is generally favorable for corporate credit, as profitability and credit fundamentals often improve and default risk declines.

Rather than just assuming all fixed income products will be highly sensitive to interest rate moves, investors need to consider starting yields, durations, and correlations of assets, as well as the broader economic environment, as they assess interest rate risk and build portfolios.  Should a higher interest rate environment persist this year in the face of a stronger economy, we would expect the high yield bond market to be positioned well.

1  Bloomberg Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). 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).  Covers annual, calendar year returns from January 1986 to December 2017. 5-yr Treasury data, 2008-2012 sourced from Bloomberg (US Generic Govt 5 Yr), 2013-2017 data from the Federal Reserve website.
2 U.S. 5 Year Treasury Note is the on-the-run Treasury (source Bloomberg).  Barclays Municipal Bond Index covers the long-term, tax-exempt bond market. Data as of 12/31/17 for the various Barclays indexes, source Barclays Capital, and U.S. 5 Year Treasury Note, 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 is the Macualay duration to the yield to worst date for the various Barclays indexes and Bloomberg calculated duration to workout for 5-Year Treasury.
3 25-year correlation for the period 12/31/1992-12/31/2017, data sourced from Barclays Capital and Bloomberg.
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