Understanding Risk in High Yield Bonds: A Look at Volatility

The high yield market, also known as the “junk bond market” seems to be considered by many to be a risky and volatile, niche market.  The reality is that there are nearly $2 trillion US dollar, non-investment grade bonds globally.1

So certainly not a tiny, niche market.  This is a large and growing market, owned by retail (mutual fund and exchange traded fund) and institutional investors, insurance companies, pension funds, and foreign investors.

On the volatility side, yes high yield bonds are more volatile than their investment grade corporate debt counterpart, thus would be considered more “risky,” however, with that comes the higher yield (as the name suggests) and historically better return profile for high yield bonds, or non-investment grade bonds, versus investment grade2.  However, high yield bonds have historically had significantly less volatility/risk than equities.  For instance, last Wednesday, when we saw equity markets take a hit, with the S&P 500 down -1.79%, the high bond index was down -0.11%.3

While one day certainly doesn’t paint a complete picture, we have a 30 year history that does.  Over various periods over this 30 years, we have seen a much lower volatility (standard deviation) for the high yield bond market versus equities (as represented by the S&P 500 index), all the while with a similar return profile.4

With this, high yield bonds have outperformed equities over these various periods on a risk adjusted basis (Return/Risk).

We believe that investors do themselves a disservice by dismissing the high yield market as “too risky” or “too small” and not considering including this market as part of the asset mix in their portfolio.  Investors need to keep in mind the true risk profile of the high yield market as they consider their investment options.

1 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, January 6, 2017, p. 41.
2  Looking at the return of the Bloomberg Barclays US High Yield Index versus the Bloomberg Barclays US Corporate Investment Grade Index for the 30 year period ending April 30, 2017.  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).
3  Bloomberg Barclays US High Yield Index versus the S&P 500 Index for the day period of May 17, 2017.
4  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 for the trailing periods ending 4/30/17.
Posted in Peritus

High Yield Morning Update

The high yield secondary bond market is opening up higher today, as the new-issue calendar continues to be light, forcing buyers into the secondary market.  Only eight deals for $3.685B in proceeds priced last week, the slowest week this month.  Given Memorial Day is a week away, we expect that this week will be much the same. Month-to-date issuance is only $14B versus a $34B average over the past four years in May.  Oil is higher on OPEC talk of extending the output curbs through 2018, but the shale drillers keep increasing output as they bring on more and more wells.  Default estimates in this industry are predicted to remain low.  Lipper reported an inflow of $649M in the week ended May 17th into high yield bond mutual and exchange traded funds after two weeks of outflows totaling $2.1B.  With the light new-issue calendar this pushes buyers into the secondary market as the new-issues that do come are often well oversubscribed and everyone is getting smaller allocations.

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The Middle Ground

We are hearing concerns from some about valuations within the high yield market.  Spread levels are one way we assess value within this market and current spread levels are below historical medians and averages.1

We believe this makes sense given the stable fundamentals and below average default outlook for the next couple years.  But as we assess these spread levels and valuations, there are a few important factors to keep in mind that we have learned over our decades of investing high yield bonds.  Just because spreads are low, it doesn’t mean that they can’t compress further.  Looking over the past twenty years, the all-time low in spreads is 244 bps in October 1997, and then a close second of 252bps in June 2007, well tight of where we currently are.  Tighter spreads can continue for months and years.

Additionally, the income this market generates matters in terms of total return.  In fact, over the past nearly 25 years, the price return has been slightly negative for the high yield market, but the total return has been 7.8%, indicating the return came from the coupon income this market generated.2  Again, markets can stay “tight” for years, and if you are sitting on the sidelines, you are losing valuable income during that time.

However, we also feel it isn’t wise to sit blindly by, just buying an index-based fund and hoping for the best.  As we look at the high yield market, we do see a lot of expensive merchandise, with many securities trading at sub-5% and even 4% yields.  In fact looking at the index, nearly 25% of the individual issues trade a yield-to-worst of 4% or less and about 50% of individual issues trade at a YTW of 5% or less.3  For those that believe rates are going higher, these very low yielding credits, many of which have longer maturities due to the big refinancing wave we have seen over the past several years, will be more interest rate sensitive.  And then there are credits with really juicy yields, but in many cases you are really stretching for that yield in terms of the credit risk you are taking on.  We certainly believe this is not the type of market in which you stretch for yield, as if things turn, we would expect those sort of names to experience more volatility.

But there is a middle ground, and this is where Peritus operates.  There are still reasonable yields to be had within the high yield market where you don’t have to take on what we would see as aggressive risk, but also don’t have to just accept yields as low as 3% or 4%.  We also complement our core, alpha focused bond and loan holdings with an allocation to newly issued bonds, as we have discussed before.  We believe these securities have a benefit in terms of better liquidity than more seasoned credits and we would expect lower volatility in the event of a downturn due to the liquidity benefit and the fact that in order to issue bonds, companies typically have to go through a vetting process and present their business and financials to potential investors.  While not a true “hedge” in the sense we are taking any offsetting positions to lower risk, we do see this strategic allocation as a way to lower volatility within the strategy.  Furthermore, if we see the market back up and spreads widen, creating what we see as attractive entry points into a number of credits, we have the ability to sell our new issue names and redeploy proceeds into more alpha focused credits.

An investor can try to time the market, but we’d see it as nearly impossible to do with consistent success because markets aren’t rationale.  And there are so many points over the years that investors may have thought things were getting tight and got out, but then missed months and years of what we see as the high, tangible income the asset class has historically generated.  We are still seeing selective individual securities that we believe are undervalued or fairly valued and we believe the current environment favors active managers like Peritus who can focus on finding that value and positioning their portfolio for the current market.

1 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. Spread referenced is the spread-to-worst, covering the period 12/31/1996 to 4/30/1995, with average and median numbers based on daily spread-to-worst levels.
2  Returns for the Bank of America Merrill Lynch US High Yield Index, for the period 8/31/1992 to 4/30/2017, based on monthly total returns and price returns.  Data sourced from Bloomberg.
3  Based on the constituents for the Bank of American Merrill Lynch US High Yield Index, data as of 4/30/17, data sourced from Bloomberg.
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High Yield Morning Update

Investment grade and high yield credit rallied modestly following the French election and the release of solid economic data. The VIX is at or near all-time lows, even when many are saying high yield is overvalued.  Many also say that rates are going to rise, in which case we believe investors should stay away from long duration assets like investment grade. Yesterday’s PPI numbers fueled the rising rates thesis but then the CPI numbers are out today and rates are easing.  Demographics are still the animal in the room as the world population is aging and will be the enormous force against anything the government can or will do to stoke the economic engine.  The new-issue market brought two new deals yesterday for $605M in proceeds, bringing the monthly tally to 21 deals for $10.15B in proceeds.  The new issue deal flow is 35% above 2016 year-over-year.  Lipper reported a $1.7B outflow from high yield mutual and exchange traded funds for the reporting week ended May 10th.  This is the second consecutive week of outflows.  The key 10-Year US Treasury yield fell back below the 2.37% resistance level it breached earlier in the week.

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The Pillars of the Peritus Strategy

Currently 23% of the domestic high yield bond market trades at a yield-to-worst under 4%.1  So on nearly a quarter of the market, investors are currently making what they might traditionally expect from investment grade debt.  This is exactly why we believe active management is essential in the high yield market.  We see active management as capitalizing on the structural limitations that exist within passive, index-based products and having the flexibility to deliberately and selectively allocate your investment dollars.

The high yield market has seen a big move up since the recent February 2016 lows, causing compression in spreads and yields, leading to what we see as many over-valued securities.  As we sit today, the ability to “say no” and exclude certain securities is all the more essential.  Over-valuation can take many forms, including those securities offering very low yields or credits where we see downside/where investor are not being compensated for the credit’s risk.  We are big believers in purchasing a security at the right price and getting paid for whatever risk you are taking on.  What you don’t buy is as important, if not more, than what you do buy, and we believe there is much to avoid in today’s markets.

The pillars of the Peritus investment strategy include the following:

  • Security/Industry Selection: Rather than investing in hundreds of securities held by an underlying index irrespective of the credit’s value and forward expectations, Peritus focuses on the securities we believe offer the best return/risk, leading to a focused but diversified portfolio.  Our portfolios aren’t weighted by the largest issuers or the largest industries in the market.  Rather, we go where we see value from both an industry and security specific perspective.
  • Fundamentally-Driven Analysis: We believe fundamental analysis is necessary to assess the credit’s viability and future prospects, and to position the portfolio for a given economic outlook.  For our prospective core, alpha-focused credits, we do a thorough review before purchasing the security, assessing both the company’s history and future, as well as financial viability and valuation.  Once an alpha-focused security is purchased, we continue to monitor the credit’s fundamentals to identify any change in the investment thesis.
  • Sell Discipline: Having the ability to sell securities is necessary in high yield investing—we don’t believe just putting them in a portfolio and passively holding no matter what is the best way to participate in the high yield market. We are continually monitoring our credits to identify downside exposure and have a price threshold that triggers re-evaluation of the credit and potential sale based on our analysis.  We are also continually evaluating upside movement and assessing the security price versus any event driven expectations (i.e., a call of the bonds, sale of the company, etc.) and will sell if the yield to our expectations becomes too low versus our portfolio target and/or other investment opportunities in the market (opportunity cost of holding).
  • Unconstrained Investing: Flexibility is important in managing high yield debt, allowing investors to take advantage of the various opportunities the market has to offer:
    • Avoiding Size Constraints and Other Arbitrary Restrictions: Certain funds have mandates to primarily only purchase securities that are of a certain minimum tranche size (for instance, some large exchange traded high yield funds have tranche size limitations of $500mm per tranche or $400mm per tranche/$1bil in total debt).  However, this can eliminate a large portion of the market and it is often in these overlooked, average-sized credits that we have historically found the best investment value. We also avoid other common restrictions such as ratings and subordination.  Value can often be had in “under-owned” credits, and for us this involves looking in areas other aren’t and not setting arbitrary restrictions that force us to invest in the same, often largest, issues everyone else chasing.
    • Floating Rate Loans: By including floating rate loans in addition to high yield bonds, Peritus is able to expand our investment universe (as some companies only issue loans and not bonds) and invest where in the company’s capital structure we see the best risk/return prospect. Loans, via the floating coupon, can also serve to lower portfolio duration, thereby reducing interest rate risk.
    • New Issue Allocation: In order to proactively work to address liquidity and dampen volatility within our investment strategy, Peritus includes a strategic allocation to new and newly issued bonds. Market data, as well as our own experience, has shown that newly issued bonds are more liquid/trade more frequently than the general secondary market in the months immediately after issuance, as the banks often support their deals and buyers (such as passive products) look to add the bonds to their portfolio.  This is a more technically driven, short-holding period strategy, whereby we focus on newly issued bonds with yields over a minimum threshold and we continually sell prior new issues, often at a premium, and rotate into newer issued bonds. We believe that including this strategic allocation can help to provide investors with greater liquidity and lower price volatility, while still capitalizing on the yield this market offers.

We believe that active management, and the flexibility this affords in terms of what is purchased and what is avoided or sold, is essential in high yield investing.  With our value-based, active credit approach, Peritus is able to take advantage of the variety of opportunities the market has to offer and position our portfolio for a given market environment.  In today’s market, this involves bridging the gap of the very low yielding securities and some of the very high yielding securities that we believe carry aggressive risk profiles, as we work to be more disciplined and defensive while still targeting to generate what we see as attractive yield and upside potential.

1 Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leveraged Loan Morning Intelligence,” J.P. Morgan North American Credit Research, May 1, 2017.  The market is non-defaulted Domestic, US$ high-yield bonds.
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Floating Rate Loans: Inflows, Issuance, and Income

The floating rate bank loan market has been a popular area for investment post the election.  We have seen inflows into the space in 37 of the last 38 weeks, with $30bn coming into the retail loan funds (mutual funds and ETFs) over that time.  YTD, we have seen $15bn flow into the retail loan funds, while we have seen $7.5bn flow out of high yield mutual and exchange traded funds.  AUM for the retail leverage loan mutual fund base is now $136nn versus $92bn in February 2016.1  AUM in floating rate loan ETFs has increased from $14.3bn at the end of 2016 to $17.4mm as of mid-April.2

With all of this interest in the loan space, we are seeing strong new issue activity, as evidenced by the fact that seven of the year’s 16 weeks so far rank among the 10 largest weekly issuance totals on record. In terms of monthly issuance levels, March’s gross institutional loan issuance was the third highest monthly total on record, with February the fourth highest and January the highest on record.  Year-to-date, loan new-issue volume totals $381.2bn, which already ranks as the fifth highest annual total on record and we are not even half way through the year.  This issuance number includes a large amount of repricings and refinancings.  Repricing has accounted for 48% of this issuance number and refinancing 32% of issuance.3  So a whopping 80% is coming from these two areas.  To put this in perspective, over the past 6 months, we have seen $246bn reprice alone, which accounts for 27% of loans outstanding.4

With the huge wave of repricing activity in the loan market currently underway, we expect that to weight on yields/income generated going forward, as generally companies are looking to reprice the loan at a lower rate, anywhere from 50bps to a couple hundred basis points lower in terms of the spread. Loan spreads are generally priced off of LIBOR and the vast majority of loans have LIBOR floors, with most of those floors at 1%.  So with LIBOR currently at 1.15%, we have only seen a 15bps increase in coupon income for most loans. While LIBOR rates are going up for the time being (with the increase starting last summer due to changes in money market rules), we don’t see them increasing enough to more than offset the spread cuts we are seeing in many of these repricings.  For instance, since the election, we have seen LIBOR increase only 27bps, while other rates have increased much more (such as Federal Funds Target Rate and various Treasury rates).  Some repricings are even eliminating LIBOR floors, meaning there could be even further yield downside should we at some point see LIBOR retreat again and stay at those low levels as we have seen for much of the last nine years.

We are seeing selective opportunities in the loan market, for instance, we are seeing some high yield bond issuers refinance their bonds with loans.  But by and large, with the huge interest in and inflows into the loan space, we believe the index-based trade is overplayed and see the high yield bond market as better positioned for returns going forward.  Loan ETFs have been a popular area for investment and the largest loan-based ETF tracks the S&P/LSTA Leveraged Loan 100 Index, which is designed to reflect the performance of the largest 100 facilities in the leveraged loan market, based on par amount outstanding.  The nominal spread on this index is L+362 and yield to maturity is 4.5%5, versus a yield to maturity of 6.17% for the Bloomberg Barclays High Yield Index6.  The YTD return is 1.45% for S&P/LSTA Leveraged Loan 100 Index versus 3.2% for the Bloomberg Barclays High Yield Index. The 10yr return is 4.37% for the S&P/LSTA Leveraged Loan 100 Index versus 7.46% for the Bloomberg Barclays High Yield Index.7

Our own active strategy is focused on high yield bonds but has the flexibility to include floating rate loans.  We believe is a great option in environments such today, whereby we can expand our investment opportunity set to include both markets, can choose where in the capital structure (secured loans or senior bonds) we want to be positioned, and pick and choose the best yield opportunities relative to risk that we see in both the high yield bond and loan markets, all the while working to avoid the overvalued merchandise.

1 Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leveraged Loan Morning Intelligence,” J.P. Morgan North American Credit Research, April 21, 2017.
2 Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leveraged Loan Morning Intelligence,” J.P. Morgan North American Credit Research, April 10, 2017.
3 Peter Acciavatti, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “Credit Strategy Weekly Update,” J.P. Morgan North American Credit Research, April 21, 2017.
4 Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leveraged Loan Morning Intelligence,” J.P. Morgan North American Credit Research, April 10, 2017.
5 Data from LCD, S&P Global Market Intelligence, as of 4/21/17.
6 Bloomberg Barclays US High Yield Index covers the universe of fixed rate, non-investment grade debt, source Barclays Capital.  Data as of 4/21/17, source Barclays Capital.
7 Returns data for the period ending 12/31/16-4/21/17 for YTD period and 10 year period ending 3/31/17.  S&P/LSTA Leveraged Loan Index data from LCD, S&P Global Market Intelligence, and S&P Indicies.  Bloomberg Barclays US High Yield Index data from Barclays Capital
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Return, Risk, and Diversification

When assessing a portfolio and determining their asset class mix, investors often allocate large portion to equities as this is believed to have a much better longer-term investment return profile than fixed income securities (bonds, loans), while fixed income is generally considered to be less risky and offers a diversification benefit to a portfolio.  Balancing return, risk, and diversification are import factors.  As we look at today’s investment landscape, for those concerned about escalating equity valuations (see our piece, “A Look at Valuations: Corporate Bonds and Equities”), we believe that high yield bonds may offer investors a viable alternative for a piece of their equity exposure.

Though high yield bonds are fixed income securities, it is important for investors to understand that over their history, they have had a similar return profile as equities (as measured by the S&P 500) but with significantly less risk.1

Here we are measuring risk as volatility, or the standard deviation of returns.  Looking back over the high yield market’s 30 year history of existence, the return/risk metric above demonstrates that the high yield market has significantly outperformed equities on a risk adjusted basis over various historical periods, providing a higher return per unit of risk.

Diversification is also a consideration, and one way to analyze that is to look at the correlation of various asset classes.2

As the chart indicates, high yield bonds and equities are positively correlated, but certainly not perfectly correlated, so there a benefit to including high yield bonds along with equities in terms of reducing a portfolio’s diversifiable risk.  Additionally, high yield bonds have an even lower correlation to investment grade bonds, and a very slight to zero correlation to changes in 5 and 10 Treasury yields and municipal bonds; thus high yield bonds would seem to provide a significant diversification benefit to a more traditional, conservative bond allocation, along with a higher return potential.3

Again, history has shown us that high yield bonds have a similar return profile as equities with much lower risk, providing a risk adjust return outperformance.  This, along with the diversification benefit, leads us to believe that high yield bonds should be considered as an attractive alternative for a portion of an investor’s equity allocation, especially for investors who currently feel equity prices have gotten ahead of themselves.

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.
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). Bloomberg Barclays Municipal Bond Index covers the long-term, tax-exempt bond market (source Barclays Capital). S&P 500 index data sourced from Bloomberg, using a total return including dividend reinvestment. Correlations calculated based on monthly returns for the various Bloomberg Barclays indices and S&P 500 and using the monthly percentage change in yield for the 5-yr and 10-yr US Treasury bonds.
3  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). Bloomberg Barclays Municipal Bond Index covers the long-term, tax-exempt bond market (source Barclays Capital). Bloomberg Barclays US Treasury Intermediate is the Intermediate sub-index of the US Treasury Index with includes public obligations of the US Treasury with a remaining maturity of one year or more (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 calculations are based on monthly returns.
Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This commentary is for informational purposes only. Any recommendation made may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and loans and other fixed income, equity, and fund securities involves various risks and uncertainties, as well as the potential for loss.
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Is Retail the Next Energy?

With weak same store sales and countless store closures announced over the first quarter, retail has been in the spotlight as an area of mounting weakness.  So far this year we have seen bankruptcies from Payless Shoes, H.H.Gregg, Eastern Outfitters, BCBG Max Azria and Wet Seal, while Sears had “going concern” language in their year-end 10K filing.  Should some of the tax initiatives like the border tax actually see the light of day, that will do further damage to retailers.

Certainly retail isn’t as prominent in the high yield indexes as energy was going into its downturn (thus we would not expect to see the broader high yield bond and loan market pressure/negative contagion that we have seen with oil), but it is still an important industry group and investors should be cautious as to what they hold in many of the passive products.  Retail is approximately 4% of the high yield bond index and 6.5% of the floating rate loan index.1  Retail is undoubtedly under pressure and we would expect see further bankruptcies in this industry, just as we saw a spike in energy-related bankruptcies last year (though we do continue to expect total default rates for the broader high yield bond and loan market to remain well below historical long-term averages).  For instance, the retail sector has the highest yield to maturity and yield to worst of all the industries in high yield bond index, by a wide margin, and the spread for the retail industry is nearly 400bps above the average spread for the entire high yield bond index of 457bps,2 indicating to us the stress we are already seeing in this industry.

We have talked time and again about the value of active management in terms of what you don’t own.  As active managers, we are not forced to own something just because it is part of an index or the broader higher yield market.  Not ever retailer is destined for a significant security price decline or bankruptcy, but there are certainly many that we believe should be avoided.  With our active strategy, we can look at the fundamentals of a credit and determine our view of its prospects and whether we want to own the name or not.  We aren’t a lender that is forced to make a loan to every company that wants one, rather we are able to be selective and choose to whom and what we want to lend.

1 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “Credit Strategy Weekly Update,” J.P. Morgan North American Credit Research, March 31, 2017, p. 59-60.
2  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “Credit Strategy Weekly Update,” J.P. Morgan North American Credit Research, March 31, 2017, p. 59.
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A Look at Valuations: Corporate Bonds and Equities

We often look at valuations in the high yield market by analyzing the spread over a risk free rate, which is generally a comparable maturity Treasury bond.  Here’s a look at where we have been historically versus where we are today:1

Over the past 20-years, the average spread has been 575bps, however that includes the massive widening of 2008 when spreads shot up as high as 2,147bps; thus we feel looking at the median 20-year value of 517bps is more appropriate.  Today we sit about 100 bps inside that 20-yr median, with our current spread level of 412bps, so we are currently below the median but still well above historic lows hit of sub-250bps both in mid-to-late 1997 and mid-2007.

Similarly, if we look at spreads in investment grade corporate bonds over the same period, we see that we are at a spread level currently of 123bps versus a historical average of 158bps and median of 145bps.2

So again, here we are below the historical averages and medians, but above the lows of 55bps in mid-1997.  However, the high yield market currently has a nearly 300bps spread advantage versus investment grade bonds, which is a notable advantage in the currently low yield environment.

Turing to equities, we see elevated valuations.  Here, the history extends back decades, so let’s look at the last 50 years.3  Over this period, we have seen only one time that Shiller PE Ratios have surpassed current levels, and that was back in the Internet bubble of the late 90s.

While the chart above looks at the price earnings ratio based on average inflation adjusted earnings from the previous 10 years, even if we look at forward 12 month PE ratio for the S&P 5004 we come to the same conclusion that current equity valuations are well above levels we have seen over the last decade.

So while none of these asset classes appear “cheap” by these historical average and median levels, it does appear to use that that there is still some value in the high yield market relative to these other asset classes.  Equities are getting back to valuations we last saw during a bubble and the highest valuations in over a decade.  While time will tell if and when these valuations normalize, we do struggle to see catalysts to send them higher.  If anything, we believe equities have gotten ahead of themselves and priced in the benefits from the Trump-administration policy changes, tax declines, infrastructure spending, and strong economic growth.  However, so far we are seeing an administration that is stalled in following through on these measures, so we feel there is more downside should some of these initiatives appear to not come to fruition.

On the investment grade corporate bond side, this asset class does carry a high duration (a measure of interest rate sensitivity), so should we see much of a move in rates, we would expect this asset class to be more susceptible, not to mention the low yield this asset class currently offers investors.

High yield spreads are below historical averages, but that largely makes senses given the outlook for the biggest risk we see—defaults—is also below average (see our piece, “Spreads, Oil, and Finding Value in the High Yield Market”).  While the high yield bond market certainly isn’t as “cheap” as it was a year ago, there is still what we see as attractive spread and yield in selective credits and we are working to capitalize on that value for investors.

1  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. Spread referenced is the spread-to-worst (government OAS), for the period 12/31/1996 to 3/27/2017.
2  The Bank of America Merrill Lynch US Corporate Index tracks performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market.  Spread referenced is the spread-to-worst (government OAS), for the period 12/31/1996 to 3/27/2017.
3  The Shilller PE for the S&P 500 is the price earnings ratio based on average inflation adjusted earnings from the previous 10 years, known as the Cyclical Adjusted PE Ratio, Shiller PE, or PE 10.  Data from http://www.multpl.com/shiller-pe/, based on monthly data from 1/1/67 to 3/31/17.
4  Butters, John, “Earnings Insight,” Factset, March 31, 2017, p. 20.
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Spreads, Oil, and Finding Value in the High Yield Bond Market

We have seen a huge rally in high yield over the last year.  As the high yield market was positioned a year ago, oil was just bouncing of its lows in the $20s, contagion from the energy sector (given energy was by far the largest industry group in the high yield market) had translated into weakness in pricing across the broader high yield market, and a surge in defaults was expected to happen.  As we sit today, spreads have compressed significantly, which gets to the question, is there still some valued to be squeezed from this market?  And further, given the recent volatility we have seen in energy prices this month, what will keep us from getting back to the early 2016 scenario?

First and foremost, yes we have seen some recent volatility, but we don’t expect oil prices to fall back into the $30s, much  less the $20s.  There were very significant production increases going into the announced cuts by OPEC and others.  This coupled with the calendar (this is a very slow demand time of the year) have led to continued stubborn inventory issues.  However, these inventory issues primarily relate to the US, not global inventories, as inventories in other OECD countries are coming down and will continue to come down.  OPEC is sticking to their output cuts and is expected to extend their cut agreement.  Seasonal demand is going to be picking up in Q2 as refiners crank up for the heavy gasoline season (summer driving season), which will cause inventory draws.  Domestically, outside of the Permian, none of the other zones (Bakken/Eagle Ford) are making money in the $40s and this will continue to be the case as producers experience cost inflation from servicers.  So if we get to a point that US producers aren’t making money, they will cut back on their production.  Furthermore, some of the recent downward pressure has been technically driven from the unwinding of net speculative long positions, which are believed to have peaked in February.  In short, global supply/demand balances will remain in a deficit through 2017, which will provide longer term support for prices despite the short-term volatility.

It should also be noted that we did see a spike in defaults last year, as the weakest of energy companies were weeded out and/or have now restructured, putting them in better position going forward.  However, defaults are already trending down significantly and as we look into the years ahead, defaults are expected to remain below average.1

This gets to the second question, given the spread compression over the last year, is there still value to be had in the high yield market?  While spreads are below historical averages, they are well above historical lows2 and the below average spreads make sense given the below average default outlook.

But given the spread compression, we do have to be cognizant of the environment we are in, as we have seen spreads in a number of securities compress to levels where the security’s yield is not compensating investors for the security’s risk in our opinion.  Risk premiums are our major concern and as we look at individual securities, we ask ourselves, what is an attractive and appropriate yield for this degree of risk?  Despite many overvalued names, we are still finding undervalued securities where we see attractive yield relative to risk.  We have also worked to position ourselves to be more defensive, increasing our new issue allocation, moving to more senior bonds in some cases, and not stretching for yield.

As an active manager, we work to manage yield per unit of risk as we focus on credits that we see as offering value.  We expect to have a tracking error versus the index, which we see as a positive because it means we are differentiating ourselves.  Investors need yield, and in this low yield environment, we believe that an active/selective portfolio of high yield bonds can provide an attractive yield for investors.

1 Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leveraged Loan Morning Intelligence,” J.P. Morgan North American Credit Research, March 3, 2017.
2 Bloomberg Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital).  Spread is the spread-to-worst for the period of 11/30/1998 to 3/24/2017.
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