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

The Decoupling of High Yield and Energy

Much of the story in the high yield market over the last almost three years now has been energy related.  In the summer of 2014, we were seeing oil prices (WTI) surpass the $100 level.  In the fall of 2014, oil prices started to falter continuing the downward slide all through 2015 until hitting a bottom of sub-$30 in early 2016.1

As of the summer of 2014, energy related securities were 18% of the high yield bond market index2, the largest industry concentration in the index by far.  As we saw oil prices slide, we saw the high yield bond market take a step back.  Once we started seeing oil continue to trend below the $50 price in early 2015, we started seeing the daily returns in the high yield market very tied to the daily moves in oil prices.3

Especially from early 2016 to early 2017 we saw that correlation between oil prices to high yield returns, as oil rebounded from the $26 WTI price low in February 2016 to the current level around $50, all the while the high yield market posted strong double-digit returns.

Over the last couple months we have seen returned volatility to oil prices; though while prices are moving up and down, often more than 1% in a single day, it has been within a tight range of about $45 to $50.  But, of note, over this recent period, we have seen a decoupling of the high yield market returns and oil prices.4

We have seen a steady move upward in high yield bonds, even on the days when we are seeing a fall in oil prices.  Factors other than oil prices are driving the high yield market, and to us that makes sense.  Many of the weaker energy related companies have already been weeded out and forced to restructure, with energy-related defaults at 12.4%, or 17.2% including distressed exchanges, during 2016, which accounted for 67% of total high yield market defaults and distressed exchanges for last year.5  Over the past few years, energy companies have been forced to become more efficient.  While energy remains the largest industry concentration within the high yield market at 15%6 and we do still see some vulnerable issuers within the high yield indexes if oil prices stay below $50 for a prolonged period (as the higher cost/highly levered producers will be pressured), given the restructurings we have already seen over the last two years these problem credits are not nearly as widespread as they were going into 2015 and 2016.  Furthermore, we don’t see much in the near to medium term to move oil prices significantly above or below this range—globally we are seeing some demand growth, but we are also seeing some supply come back on, especially here in the US shale regions, as prices hover around $50.

Thus as we look at the high yield landscape today, and the energy sector within it, we believe the “energy-contagion” may well to continue to have less and less of an impact, as investors focus more on the interest rate and economic environment and yield the high yield market has to offer investors.

1  West Texas Intermediate prices from 7/1/14 to 5/31/17, sourced from Bloomberg.
2  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, June  27, 2014, p. 51 https://markets.jpmorgan.com/?#research.na.high_yield.
3  West Texas Intermediate prices price changes (%) and Bank of America Merrill Lynch High Yield Index daily total return from 6/30/15 to 3/31/17, data sourced from Bloomberg.  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.
4  West Texas Intermediate prices price changes (%) and Bank of America Merrill Lynch High Yield Index daily total return from 4/1/17 to 5/31/17, data sourced from Bloomberg.  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.
5 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. 4-5, https://markets.jpmorgan.com/?#research.na.high_yield.
6  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, June  27, 2014, p. 48, https://markets.jpmorgan.com/?#research.na.high_yield.
Posted in Peritus

The Demographic Impact on the Fixed Income Market

We see demographics as an important factor when considering interest rates and the fixed income market.  We are in the midst of a significant global shift in demographics as the baby boom population ages.  As we look out over the next 30 years, it is expected that the oldest age groups will be growing rapidly, both in the US and globally.1

U.S. Demographic Trends

Global Demographic Trends

This demographic shift has far reaching implications on a variety of fronts.  For us in the fixed income market, we believe that it will create a shift from equities into fixed income, and we are already starting to see the beginning stages of this shift.

For instance, pensions are increasingly focusing on portfolio immunization and liability driven investing.  Portfolio immunization involves matching the duration of plan assets with the duration of liabilities, while liability driven investing focuses on matching the future cash flow needs from the liabilities with the income from the assets.  Liability driven investing is often utilized by both insurance companies and pensions and requires consistent yield generation to provide the necessary income.  On the pension side, we are currently seeing growing allocations to bonds within defined benefit plans, while equity allocations have remained relatively steady.2

Looking at how that “bond” exposure in the graph above breaks down, we have seen the growth come from the Treasury security and corporate and foreign bond allocations.

We believe these global demographics matter not only for pension investing, but also for retail investing.  Be it in 401Ks, IRAs, or other individual retirement plans, as people near or enter retirement, they tend to focus more on income generation and capital preservation and less on growth—they want income they can live off of for years to come.

As we look forward, we expect the demand for Treasuries, corporate bonds, and other fixed income securities to accelerate as demographics take hold.  In turn, we would anticipate that this higher demand for assets like Treasuries and overall lower global demand of hard goods and services (consumption) caused by an aging population (who tend to consume more of healthcare but less consumption of many other hard goods and services) to further help constrain interest rates in the years to come (see our piece, “Pricing Risk and Playing Defense” for further detail).

It is also important to keep in mind this demographic shift as you consider the current state of the high yield market.  Pensions, insurance companies and retail mutual funds each own about one quarter of the high yield market, with the final quarter comprised of various other funds (hedge, equity, investment grade).3

Again, liability driven investing used by pensions and insurance companies requires consistent yield generation, and the high yield market can work to provide that yield, especially relative to the yield offered by other fixed income alternatives.  Considering these demographic trends, we believe this may serve to create a steady and lasting source of demand for high yield bonds as well.  As we look at the current high yield market, with spreads below historical average and median levels, we see this demand as another reason that spreads very well could continue to tighten further.  People are looking for yield, be it pensions, insurance companies, institutional investors or retail investors, and relative to many other fixed income options, the high yield market still offers what we see as reasonable yield for investors.

1  “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  Federal Reserve Statistical Release, Financial Accounts of the United States, L.118.b Private Pension Funds Defined Benefit Plans, release date March 10, 2016, https://www.federalreserve.gov/releases/z1/20160310/accessible/l118b.htm.
3 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2016 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2016, p. A154, https://markets.jpmorgan.com/?#research.na.high_yield.  Data for 2016.

 

 

Posted in Peritus

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.
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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.
Posted in Peritus

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.
Posted in Peritus

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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