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.
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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

Yield Still to be had in Today’s High Yield Market

The high yield bond market has seen a decent start to the first half of the year, with the Bloomberg Barclays High Yield Index up 4.93% through June.1  However, as we near almost a decade in this low interest rate environment, many investors are becoming concerned about the yields and rate of return available in today’s high yield market.  While high yield bonds are not routinely carrying high single digit to double digit coupons like they did years ago, the comparable 10-year Treasury yield is also not above 5% as it was back then.

Looking back at the historical data for the high yield market, high yield spreads are below historical averages and medians, but this makes sense given the below average default outlook, as we have noted in recent writings (see our commentary, “Mid-Year High Yield Bond Market Default Review and Outlook”).  And while spreads are below these average and median levels, they are well off historical lows.  Additionally, the premium to the 10-year Treasury is currently above the historical averages and medians, offering a 193% premium to the 10-year versus a historical average of 172% and median 148%.2

We have seen the high yield market mature over the past decade.  Arguably outside of certain energy deals, we are seeing more of the aggressive financing being done in places like middle market lending rather than via high yield debt.  So while the current coupon levels, and likely corresponding near-term return expectations, are not as high as they have historically been, we still see value in today’s high yield market, especially in the context of the broader financial environment.

We don’t expect that interest rates are going to take off.  Demand is a driver of growth and we don’t see demand for much of anything.  The global population is aging and labor rates will undoubtedly be impacted by this as well as technology, innovation and other social and behavioral changes we are in the midst of, be it electronic vehicles, the decline of brick and motor retail outlets, and the shared economy.  With little to drive growth, we don’t see a demand for money or inflation to move rates significantly higher.   The 5-year and 10-year Treasury yields are indicating that there isn’t much in the way of pressure on rates and or a strong demand for money.  Additionally, with all of the post financial crisis regulation, we do not see any systemic issues on the horizon.  Considering both of these factors, it makes sense that risk premiums are generally where they are.

Yes, we do see some securities within the high yield market that offer too low of a yield relative to the risk—be it aggressive leverage levels relative to the yield offered, or a security trading at a premium offering a very low yield to worst to investors, as many names are in the 3-5% yield range—but as active managers, we don’t have to invest in these securities.  Within today’s high yield bond and loan market we believe our active strategy makes sense and offers investors value from both a yield and duration perspective versus the indexes and many index-based products.

Bloomberg Barclays US High Yield Index covers the universe of fixed rate, non-investment grade debt, data from Barclays Capital for 12/31/16-6/30/17.

2  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 5/16/17 and 6/30/17, https://markets.jpmorgan.com.

Posted in Peritus

Passive versus Active in High Yield

There is so much talk about active versus passive, with many seeming to feel the world of investing was moving to largely passive over the last couple years, only to see active management once again gain some ground in 2017.

Passive investing, or index-based investing, is premised on the belief that markets are efficient, and prices quickly and thoroughly reflect information, thus consistently outperforming the market is difficult.  Investors don’t focus on the current earnings or outlook for a company, or generally even what a company does for that matter.  A passive or index-based product or vehicle will seek by replicate its underlying index by holding the same securities or a representative sample of the same securities and through that replication seek to achieve returns in line with the index.  So, the argument is to just by the cheaper passive product for whatever market sector you are interested in.  And this has worked over the last couple years as markets have been steadily, and seemingly indiscriminately, moving up.

But it begs the question, can decades of active investment management and numerous successful managers over this history just be an aberration or has something changed today?  Our answer to both questions is no.  Yes, markets have certainly gotten more efficient in their ability to disseminate and process information, which is even down to microsecond now with algorithms dictating buy and sell decisions.  But if markets were completely efficient, you wouldn’t see big moves in security prices on earnings results or other news items, and in many cases the first move isn’t always the lasting one.  For instance, on a weak earnings announcement or outlook, you may see a stock initially take a big move down only to recover much of that as analysts have time to process the information and the company offers further explanation via a conference call or other media appearance.  Or there may have been some investors who had a thorough understanding of the business and industry and foresaw the earnings decline and sold ahead of time.  Markets are two sided, you can turn on any financial news program and find two people arguing for different valuations and outlooks for a security—buyers and sellers are what create opportunities for investors and by no means do we see this as dead or a way of the past.

Additionally, many tout some market research that shows passive management as outperforming active management due to the cost of active management (generally higher fees as you are paying someone to actually do the investment work and analysis), but some of this research includes closet indexers masquerading as “active” managers, who still hold a large amount of securities like an index and only slightly deviate from an index but charge a higher fee.  True active management is focused on a specific strategy or investment philosophy, has a more focused portfolio, and generally relies on analytical and/or fundamental research.  Also many of the most successful active managers focus on the longer term, so there will be periods of underperformance but the goal is that the active manager will perform better over the longer term.

In the high yield bond and loan market, we especially view active management as important.  The passive argument will work fine until it doesn’t, and the selling hits.  We believe that what you do and, equally important, what you don’t own matters. Why blindly buy everything in an index (or virtually everything for the index products that hold a representative same), when the index does nothing to address risk other bank on the concept of diversification by holding a lot of securities.  The passive products can’t avoid or sell a security in which they see outsized risks, or even where yields being generated are exceeding low for the credit profile.  Active products are flexible in how they allocate money and can change their allocations given the market outlook, while the passive products can’t get defensive if the market environment warrants doing so.  Passive products don’t focus on value, whereby active managers can look to buy the right securities and at the right prices.

Another deficiency that we see with many of the passive products in the high yield market is that often they have as the underlying index a sub-index of the broader high yield market index, and that sub-index eliminates a large portion of the individual high yield issues.  Our own experience has been that it is often in these eliminated securities that we have historically found value.  Active managers have the ability and flexibility to access an entire market, even the securities that may not be included in an index or sub-index.

With the historically high valuations that we are currently seeing in a variety of financial markets, we believe investors are turning to passive management at the wrong time, at a time when we believe active investing becomes the most important.  In today’s high yield bond market we are seeing many securities trading a very low yields, in many cases around 3% and 4%, bringing down the total average yield on the index and the products that track them.  Yet with an active strategy, we are able to avoid these securities or sell an existing holding if the yield gets too low.  And while default rates remain low, we do see certain securities and market sectors as vulnerable, and as an active manager we have the ability to execute discretion in not investing in these securities.  We believe the ability to actively position your portfolio for a certain market and economic environment is important for investors, as is looking for value, especially in a market like we are seeing today where that value is harder to find.

Posted in Peritus

The High Yield Market: Market Size, Ownership, Funds, and Opportunities

The entire U.S. fixed income market (municipals, Treasuries, mortgages, corporates, federal agency bonds, money market, and asset back securities) totals over $40 trillion.1 

Breakdown of U.S. Fixed Income Asset Class (as of December 31, 2016)

Corporate credit (high grade corporate bonds, high yield corporate bonds, and floating rate loans) is about $8.9 trillion of this pie. The high yield bond market is a large and growing market, now totaling $1.5 trillion in the U.S. and $2.0 trillion of U.S. dollar denominated high yield debt globally.2

If you add in high yield floating rate loans, that includes another nearly $0.9 trillion and together high yield bonds and loans account for nearly 30% of corporate debt.  One thing is clear, that the high yield debt market is a growing market, and we believe one that cannot be ignored for fixed income investors.

As we look at just who owns high yield bonds, the three largest categories of owners are pension funds, insurance companies, and retail mutual funds, all of which have relatively similar size of ownership at just over a quarter of the market each.3

With this we see both institutional and retail customers as active in the space. At $42.1 billion, high yield exchange traded funds (ETFs) account for about 14.2% of the total $296 billion “retail” high yield fund base4, which includes the much larger mutual fund counterpart.  High yield ETFs account for about 2.8% of the broader U.S. high yield market and have been around that level for the last five years, and loan ETFs are just over 1% of the total US loan market.5

While a very small portion of the total market, the place of high yield ETFs within the broader high yield bond market has been a discussion point over the last couple years, with some critics speculating that some widespread sell pressure in high yield ETFs could cause a collapse in high yield markets due to “liquidity” issues. We have previously explained how regulations post the financial crisis have led to less market making and lower dealer inventory of bonds, and the impact that has had on markets (see our piece “Understanding Market Liquidity”, “The Pricing Issue in High Yield“).

Flows in and out of these “retail” mutual and exchange traded funds (though we know that various institutions are buyers of mutual funds and ETFs as well) can be volatile week over week, but again, these flows pale in comparison to size of the total market.  For instance looking back over the last year and a half of weekly retail exchange traded and mutual fund flows (chart below)6, the second largest reported weekly retail outflow on record occurred in March 2017 and totaled around $5.68 billion.7  This amount compared to a $1.5 trillion U.S. high yield bond market means it is about 0.4% of the total market, so seemingly minuscule.

Over this period, the largest ETF-specific weekly outflow (and the largest ETF outflow on record) was $3.45bil8, so only about 0.2% of the total U.S. high yield market size.  Last week we saw the third largest ETF-related daily outflow on record and with that, the high yield market was down only 0.25%9, which certainly indicates that the market was able to handle the large ETF outflows without any significant disruption.

Not only do we see ETFs benefiting from their in-kind redemption mechanisms, in this environment of lower dealer inventory and heightened price volatility, we believe that high yield ETFs provide an advantage over mutual funds during more volatile times because ETFs trade/price intra-day, so we would argue provide a more accurate and true pricing mechanism for going in and out of the high yield market than mutual funds that only trade at the end of the day.

We see the high yield bond and loan market as an important piece of the fixed income asset class, especially in this global low yield and high domestic equity valuation environment.  We believe that high yield ETFs provide investors great accessibility to the asset class. And while the post financial crisis regulations may add an element of volatility to the market, we would view this volatility as an opportunity for active managers like Peritus who have the ability to capitalize on discounts and can be intentional about the credits they invest in.  While we have seen a strong year plus for the high yield market, we believe that there are still attractive opportunities within the high yield space for active managers who are able to search for value.

1 From the publication “Outstanding U.S. Bond Market Debt” release by SIFMA, data as of 12/31/16. Loan market size as of 12/31/16 from Acciavatti, Peter D., Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li..  “Credit Strategy Weekly Update,” J.P. Morgan, North American High Yield and Leveraged Loan Research, January 6, 2017, p.51.  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/?#research.na.high_yield.
2 Acciavatti, Peter D., Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li..  “Credit Strategy Weekly Update,” J.P. Morgan, North American High Yield and Leveraged Loan Research, January 6, 2017, p.51, https://markets.jpmorgan.com/?#research.na.high_yield.
3 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2016 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 30, 2016, p. 296, https://markets.jpmorgan.com.
4 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2016 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 30, 2016, p. 117-118, https://markets.jpmorgan.com.
5 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2016 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 30, 2016, p. 117-118, https://markets.jpmorgan.com.
6 Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 6/23/17, 4/20/17, 2/3/17, 11/23/16, 10/26/16.  https://markets.jpmorgan.com. Leverage Commentary and Data, www.lcdcomps.com.  Based on weekly reported fund flow information, including Jon Hemingway, “HY funds see $899M of inflows in latest week,” 8/18/16; Matt Fuller, “US HY fund flows turn negative with ETF-heavy outflow,” 5/26/16; Matt Fuller, “Investors dump record $5B of retail cash into US HY funds,” 3/3/16.
7 Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 3/17/17, https://markets.jpmorgan.com/?#research.na.high_yield.
8 Leverage Commentary and Data, www.lcdcomps.com.  John Hemingway, “HY funds endure whopping $4.12B outflow,” 11/3/16.
9 Morning Intelligence, 6/22/17.  Daily return based on the one day return for the JP Morgan US High Yield Index.
Posted in Peritus

Mid-Year High Yield Bond Market Default Review and Outlook

Coming off of a spike in total high yield bond default rates in 2016 due to a large number of energy, metals and mining, and other commodity related defaults, the expectation was for defaults to significantly ease heading into 2017.1

As we sat six months ago, the expectation was for defaults to be 2.5% in 2017 and 3.0% in 2018, versus a 2016 level of 3.6% (see our piece, “High Yield Default Rate: 2016 Review and 2017 Outlook”).  As we hit the midpoint for 2017, the LTM default rate has fallen to 1.3% as monthly default volume continues to trend downward.2

While some seem to be concerned about the impact of potentially higher interest rates on the high yield market, investors need to be aware that the biggest driver of spreads historically is not interest rates (interest rate risk) but rather the default rate and outlook (default risk).  As we look forward, the default rate expectations for full year 2017 and 2018 have fallen to 2.0% or lower versus an expectation of 2.5% for 2017 and 3.0% for 2018 six months ago.3

This puts the default rate and expectations well below the historical average of 3.3%.4

Credit/default risk remains at the core of spread movement and, as we look over the next 18 months, we believe that the benign default outlook bodes well for the high yield market. Even with the spread tightening we have seen so far this year, according to J.P. Morgan’s research, the implied default rate based on current spreads in the high yield bond market is 1.7% versus an actual default rate of 1.3%, or 1.77% if you include distressed exchanges, and an outlook of 2.0% or lower for the next couple years.5 So while some may argue that the high yield market is expensive based on the current spread level, in looking at them relative to default rates and expectations, it seems reasonably valued.  Additionally, we believe that adding an effective active management overlay on top of this can help to further stem default exposure and potentially improve spread/yield value.

1  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 6/1/17, https://markets.jpmorgan.com/?#research.na.high_yield.
2  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 6/1/17, https://markets.jpmorgan.com/?#research.na.high_yield.
3  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “Credit Strategy Weekly Update,” High Yield and Leveraged Loan Research, J.P. Morgan North American Credit Research, 6/16/17, p. 5-6, https://markets.jpmorgan.com/?#research.na.high_yield.
4  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 6/1/17, https://markets.jpmorgan.com/?#research.na.high_yield.  Based on monthly LTM default rates from December 1998 through May 2017.
5  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “Credit Strategy Weekly Update,” High Yield and Leveraged Loan Research, J.P. Morgan North American Credit Research, 6/1/17, https://markets.jpmorgan.com/?#research.na.high_yield.
Posted in Peritus

Rates and Gridlock

In the seven months since the election we have seen the 10-year Treasury yield move up to 2.6% in December, hit that level again in March, and we have since seen a steady decline to where we are today with the 10-year yield getting close the same yield level we saw the day after the election.1

As we wrote about at the beginning of the year (see our piece “Pricing Risk and Playing Defense”), our expectation was that we would see gridlock and delays in Trump getting anything passed—just as we are now seeing.  We also expected then, and continue to expect, that we won’t see much of a move in interest rates.  The lack of global demand and demographic trends are real and will have a lasting impact.  Inflation remains low and risks to growth persist in Europe, causing the ECB to continue with their quantitative easing when they met this past week.  In the US, Q1 GDP was the slowest in three years.  The population is aging and that will continue for decades to come, again, not favorable for demand growth of much other than maybe certain segments of healthcare.

When the Fed meets this week, we may see another rate increase.  However as we said back at the beginning of the year, if the Fed continues to raise rates, we would expect to see a flattening of the yield curve.

The equation is debt + demographics = no demand. We can talk about infrastructure spending, keeping jobs in America, and a reduction in corporate taxes, but we don’t see that as moving the needle enough to outweigh the continued drags from the debt burden and a demographic shift away from consumption of goods. What this means to us is that should the Fed pursue further rate hikes, we will likely see a flattening of the yield curve. We would expect that medium to long term interest rates will do nothing. (From “Pricing Risk and Playing Defense,” February 2017)

And that is just what we are starting to see, with the 2-year Treasury rate just at about where it was on March 13th, when we saw the recent high of 2.62% on the 10-year Treasury, but the 10-year rate is now down almost 50bps from the March 13th level.

We continue to expect that we won’t see much of a yield move in the longer-term Treasuries (5-Year Treasury rates and longer).  It is the 5-year and 10-year rates that are more relevant for us as high yield bond investors, as that is generally the issuing maturity range for high yield bonds and it is on those yields that spread levels are generally based.  While the Fed may well take a couple more rate increases over the year as they continue their slow move upward, we expect that to hit the shorter end of the curve more than the longer end.

As we close in on the half-way point for 2017, with our outlook for contained longer-term rates and unrelenting political gridlock, we continue to see selective opportunities in the high yield bond and loan space for active managers.  Investors need yield and a while we believe the broad high yield indexes and many index-based products tracking them are expensive at this point (just as many equity indexes and other asset classes are from our view), we do see specific opportunities for individual securities and, as an active manager, remain focused on capitalizing on these opportunities while still working to remain more defensive should volatility once again pick up as the political uncertainty and tempered economic growth continues.

1  Data sourced from US Department of Treasury, for the period 11/9/16 to 6/9/17.  https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield.
2  Data sourced from US Department of Treasury, based on the yields for 2 year through 30 year bonds for the dates 11/9/16, 3/13/17, and 6/8/17.

 

Posted in Peritus