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

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.
Posted in Peritus

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