A Look at Valuations: Corporate Bonds and Equities

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

As we wrote earlier this year in our piece “Pricing Risk and Playing Defense,” we are not believers in a significantly higher interest rate environment.  The global economy is simply too weak to tolerate higher rates.  The Fed will raise rates in 2017, as they started to do last week, however we believe the increase will be moderate and gradual.  As we began 2017, the bond market was already anticipating and pricing in at least two, 25 basis point increases in the Federal Funds rate and with any action they do take, we don’t expect the medium and long end of the curve to do much.

While the financial market enthusiasm over the last four months has been in anticipation of a domestic demand improvement, we have still not seen that materialize, as evident by the Fed’s comments last week.  Leading up to last week’s Fed meeting, in the days prior we saw the 10-year Treasury yield hit the December 2016 high on an expectation that the Fed may be more aggressive in its action, only to quickly decline back to around 2.5% once the Fed released their comments on Wednesday.  The Committee clearly remains “data dependent” and does not share the market’s optimism.

Given that we have yet to see any substantial pro-growth policies come to fruition, and it looks like Congressional approval on items such as tax cuts and infrastructure spending may take a while to actually happen, if they can get there at all, we do believe the equity markets have gotten ahead of themselves.  However, we continue to see demand for one important investment characteristic—yield.  We believe that a tight and thoughtful portfolio within the high yield bond and loan markets can provide that yield for investors.  With both the potential change in policy and interest rate backdrop, we view our asset classes much more favorably than other fixed income areas.  We believe that high yield debt is positioned to outperform the longer duration and lower yielding fixed income cousins such as investment grade corporates, munis, and mortgages in 2017.

While 2016 seemed to be dubbed the year of indexing by financial commentators, we believe 2017 will prove to be the year of active management.  We believe volatility will return to markets and what you don’t own will be as important as what you do.  As we look at our own strategy, we are working to manage technical and liquidity risk very deliberately by using our strategic new issue allocation, by which we purchase newly issued bonds.  This allocation is focused on market technicals and includes tight sell parameters and a shorter term holding period.  Regardless of interest rate views, floating rate loans serve to reduce portfolio duration (interest rate sensitivity) and can allow investors to participate in a more senior part of the company’s capital structure.  We will continue include an allocation to loans within our strategy.  The focus of our strategy will remain on our core, value-based bond holdings, and as industry themes or asset class opportunities present themselves, we will use proceeds from the new issue allocation to redeploy into such alpha-generating investments.  These core, fundamentally-driven holdings are complemented by our new issue allocation, allowing us to take advantage of the opportunities we see from both a fundamental and technical side of the market.  Our end goal is to compile a portfolio with greater stability, while working to generate alpha for investors.

We believe it is time to play a good defense and we will work to do just that while also capitalizing on the select value-based opportunities within today’s high yield market.  To read more on our take on interest rates, the global outlook, and our investment strategy in this environment, see our recent writing “Pricing Risk and Playing Defense.”

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High Yield in a Rising Rate Environment

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Pricing Risk: The Three U’s

Every investment opportunity set (asset classes and individual securities) has risk.  The key is to identify the risk and “price” it correctly.  For us, assessing and pricing risk involves analyzing credit spreads in light of their expected default rates.  This can be done for the high yield bond and loan asset classes as a whole and for individual securities.  For the indexes today, those spreads have narrowed significantly and currently sit at 437bps, relative to historical medians of 524bps and historical averages of 577bps.1

As we look forward, spreads are pricing in a very low default rate, which is expected to be 2.5% this year, versus historical averages of 4%.2

While we do not disagree that default rates will be subdued for the next couple of years, there is no arguing that spreads for the indexes seem to be pricing in near perfection.  Given that spreads are below median/average levels as we begin 2017, we do not want to be tightly correlated to the indexes.  Rather, we will be opportunistic in our approach to buying securities and expect that 2017 will reward bond pickers not asset allocators.

Thus, we believe active management will be key as we move through the year.  As always, credit is a negative art.  This means what you don’t own is just as important as what you do own.  As we begin 2017, we see that securities of many cyclical industries have rebounded to a level where investors are not being compensated for the volatility of revenues and we will steer clear in our portfolio.  But in terms of what we do own, as active managers, we continue to look for credits where the three “U’s” are firmly in place:  undervalued, unloved and most importantly—UNDER-OWNED.  It is hard to argue that any asset classes today fits that bill but we can certainly make a very good argument that individual securities can.

As active credit investors, we are contrarians by nature.  We are not contrarians for the sake of being different, but rather for trying to generate real alpha.  Within our core holdings, we want to purchase securities that have low expectations, not securities that are priced to perfection.  Thought of another way, there are very few bad bonds but lots of bad prices and it is our job to figure out if securities are priced where they are for the right or wrong reasons.  Sometimes this mis-pricing (under-valued situation) is created through company specific news and sometimes it is industry contagion.

One industry where we believe opportunities may evolve is in healthcare with the “repeal” of Obamacare.  Nobody really knows what “repeal and replace” actually means but the volatility created by President Trump’s rhetoric is likely to produce some interesting opportunities as the year develops.  It is highly unlikely that currently insured patients will be simply dropped from coverage.  Specialty pharma is another area that we continue to like, as the inevitable bashing on drug pricing works its way through Congress.  This is one of the few industries that we have seen substantial organic revenue growth, and while more competitive bidding is likely to pressure some companies, many others not impacted will likely be thrown out in the inevitable contagion trade.

In terms of the “under-owned” credits, that involves looking in areas other aren’t and not setting arbitrary restraints that force us to invest in the same, often largest issues everyone else is.  For instance, the largest high yield index-based ETFs invest according to underlying indexes that have size restrictions of $500mm or $400mm in individual tranche size/$1billion in total debt outstanding.3  So this can serve to eliminate approximately half of individual bond issues4, and historically it has often been in these eliminated medium-sized, niche companies where we have found the most value.

There are always attractive opportunities within the high yield market but 2017 is a time to focus on value and price in risk as you strategically compile a portfolio.  One thing we are highly confident of in 2017 is that volatility will increase significantly.  European elections (along with Brexit) are sure to add some fuel to the protectionist fire.  This could have the effect of increasing risk premiums and credit spreads.  Since we have a sanguine view on default risk, we think the biggest challenge for 2017 will be volatility and manic risk premiums, as we can envision a credit market that suffers bouts of neurosis as President Trump’s threats ebb and flow.

With our active strategy we will take advantage of the opportunities that present themselves in this environment while working to stay more defensive and avoiding the credits that we see as over-valued and “priced to perfection.”  To read more on our take on interest rates, the global outlook, and our investment strategy in this environment, see our recent writing “Pricing Risk and Playing Defense.”

1 Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leveraged Loan Morning Intelligence,” J.P. Morgan North American Credit Research, January 18, 2017, January 3, 2017, and December 21, 2016.  Peter Acciavatti, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “High Yield Market Monitor,” J.P. Morgan North American Credit Research, March 1 and February 2, 2017.  Data January 31, 1994 to February 28, 2017 based on month-ending spread levels, with median and averages based on the median and average of month-end spread levels over that period.
2 Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leveraged Loan Morning Intelligence,” J.P. Morgan North American Credit Research, January 5, 2017.
3 Fund restrictions sourced from the ETF prospectus and summary prospectus at https://www.spdrs.com/product/fund.seam?ticker=JNK and http://us.ishares.com/product_info/fund/overview/HYG.htm.  Size limitation based on the underlying indexes for each fund.  The fund may use a representative sample of the underlying index, which means it is not required to purchase all securities in the underlying index.  Both funds may invest up to 20% of the portfolio in assets not in the underlying index.
4 See our piece “Tranche Size Constraints in High Yield ETFs,” http://www.peritusasset.com/2016/02/tranche-size-constraints-in-high-yield-etfs/, February 16, 2016.  Statement based on assessing the amount of individual tranches under $500mm in the Bank of America Merrill Lynch US High Yield Index as of 2/11/16, data sourced from Bloomberg.  Similar analysis with similar results was done as of 1/12/17.  The Bank of America Merrill Lynch High Yield Index monitors the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.
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Debt + Demographics = No Demand

The consensus is that rates will be going up, but the consensus has been wrong about rates time and again over the past several years—none of us know the future.  What we do know is that the two monsters of debt and demographics remain in the room and nobody is going to change their impacts.  And they have a far bigger impact than much of the optical engineering we are now witnessing with Trump-O-Nomics.

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.”  That population shift is graphically pictured below.1

US Demographic Trends

Global Demographic Trends

We expect these demographic trends to have a continued and lasting impact on economic growth and final demand.

Demand and inflation are both considerations as one looks at a potential increase in rates.  A focus on bringing manufacturing back onshore can certainly be viewed as a possible source of inflation given that costs to produce the same goods inside the US may be higher.  But as prices rise, demand can fall.  This is known as the price elasticity of demand.  In a no growth world, this elasticity of demand applies to everything from commodities to interest rates.  Even ignoring the threatened tariffs, higher interest rates are likely to temper demand from their recent record highs in areas like auto.  Think of real estate today.   Will higher interest rates help or hurt this industry?  We are already seeing the impacts of higher interest rates on mortgage origination.  If higher rates are due to a growing and robust economy, demand is more inelastic because everyone is making more money.  While the government statisticians continue to tell us we are at full employment and everything is rosy, the real world tells a different story.  So in our view we have both price and demand ceilings on most everything.

Oil prices provide an excellent example.  As we discussed last year, oil prices in the $20s and $30s were unsustainable as this price did not cover the cost of even the best wells outside of the Middle East.  While we are not surprised to see prices above $50, we believe that there is a ceiling on oil prices for a couple of reasons.  First, the majority of demand for oil still involves gasoline.  While miles driven in the US surprised to the upside in 2016, this was due to the aforementioned price elasticity of demand.  As prices collapsed, demand increased.  This demand “chip” has been spent.  Additionally, excess Chinese demand for storage kicked in during 2016.  However, this demand is highly sensitive to pricing.  We have seen recent storage demand estimates of around 400,000 bpd, but this demand can simply disappear as prices grind higher.  So while gasoline is one of the most “inelastic” commodities it is not perfectly inelastic.  We are all inundated with analyst data on supply and the ability of OPEC to bring supply in balance, but for us it is all about demand.  We see very little focus on understanding the demand drivers—and ultimately we see these demand drivers as putting a cap on just how much higher oil prices can rally from here.

We also see ceilings on interest rates.  The Fed and numerous analysts talk about “normalizing” interest rates.  What does that mean?  The amount of government, corporate and consumer debt in the world is probably uncountable.  So as rates rise, more of everyone’s cash flows go to servicing that debt, stealing buying power away from other areas.  Should rates rise too high, this would create defaults in mortgages, corporate bonds and loans and even government bonds.  How high is too high?  Nobody knows that answer.  But what we do know is that we have had effectively zero percent interest rates for eight years now, yet what has that done to stimulate the real economy globally?  Not much.  So how would higher rates stimulate growth?  They won’t.  Rather we can be in a situation where higher rates thwarts higher rates because of the demand impact.

So you can see the paradox we are now involved with.  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 as high yield bond investors is that should the Fed pursue further rate hikes, we would expect to see a flattening of the yield curve, with medium to long term interest rates not doing much.  Because high yield bonds generally have maturities of 5-10 years, it is these 5-yr and 10-yr US Treasuries that are more relevant to our market, these are the securities off which we price “spreads.”  We would expect little in the way of rate pressure to materialize for high yield bonds.  To read more on our take on interest rates, the global outlook, and our investment strategy in this environment, see our recent writing “Pricing Risk and Playing Defense.”

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/.

 

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Demand and Rates

With Trump’s election, it is now seems to be “consensus” that the Federal Reserve is going to raise rates another three times in 2017.  We 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%.1

Global growth has not changed since Trump was elected.  The Euro Zone remains a complete mess and Brexit is not going to help.  Waiting in the wings are key elections (France in particular) and these elections are likely to be won by those hostile to immigration and global trade and are firmly in the protectionist camp.  Similar to the Trump rhetoric, these politicians are playing on voter’s nostalgic and blurry memories.

Frighteningly, there appears to be some congressional support behind the notion of a “border tax.”  At first, it appeared the targets were specifically China and Mexico, but this is spreading rapidly with Trump’s recent comments in the German newspaper Bild where he targeted and threatened BMW and other German automakers with a 35% import tariff.  Ironically, BMW is one of the (if not the largest) exporters of autos from the United States.  Auto supply chains are incredibly global and complex so this type of rhetoric is not positive.  The real question remains whether this is negotiating bluster or something more tangible.  Do not forget that trade is one area where the President has real and independent authority.  Stated another way, many of these potential trade policy decisions do not require congressional approval.  If tariffs/border taxes are enacted, most will be challenged in various courts and tribunals.  But this takes time and the damage can be instant and long lasting.  So as Trump looks to make his mark early, there is little mystery as to why trade is front and center.  While this type of strong arming plays very well to a Midwest manufacturing/industrial audience, does anyone believe that protectionist policies are good for broad economic growth?  For that matter, are higher interest rates and higher energy prices stimulative or regressive for consumer spending?

Regardless of the outcomes of these issues, we do have considerable certainty on one key variable—demand.  Our portfolios are broad and eclectic.  As such, this gives us a very granular look at pricing and volumes for most major industries.  Every quarter over the past couple of years has felt like “Groundhog Day.”  Revenues down a few percent (often blamed on a strong dollar or the weather, which is our favorite because you can use good weather—people are doing other things versus shopping like going to the beach—or bad weather—they stay inside and don’t go to the mall), while EBITDA is up slightly helped by factors such as cost reductions.  While putting smart, successful business people (i.e., Wilbur Ross, Steven Mnuchin, Rex Tillerson) in charge of key government positions is a great idea, how does this change final demand for goods?  In our view it doesn’t.

The lack of demand will be a hindrance to the Fed’s ability to raise rates; we are not believers in a significantly higher interest rate environment.  The global economy is simply too weak to tolerate higher rates.  The Fed will raise rates in 2017, however, we believe any increase will be moderate and gradual.  The bond market has already anticipated and priced in at least two, 25 basis point increases in the Federal Funds rate and with any action they do take, we don’t expect the medium and long end of the curve to do anything.  To read more on our take on interest rates, the global outlook, and our investment strategy in this environment, see our recent writing “Pricing Risk and Playing Defense.”

1  10-year US Treasury yield for the period 11/8/16 to 2/17/17, source U.S. Department of Treasury.
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Investment Options in Corporate Debt

Fixed income is an important component of a balanced portfolio.  The problem many investors and advisors face today is where do you find yield in this environment and what happens to your fixed income exposures should rates rise?  Where can you go in the fixed income sector?

A traditional balanced portfolio often includes some sort of corporate bond component, and often the focus is on investment grade bonds.  However, we believe that investors should additionally consider high yield corporate debt as part of their corporate fixed income component.  Even accounting for the traditionally higher default risk, high yield bonds have outperformed investment grade bonds over the past twenty five years.1

25-yr HY, IG return2

While defaults are a consideration when evaluating the corporate bond space, the forward default outlook for the next several years shows projected defaults to be well below average, indicating a more benign default environment for high yield bonds as we look forward.2

JPM Default Forecast 2-3-17

We would see a generally positive fundamental environment for corporate credit on this front.

On the interest rate front, investment grade bonds carry a much longer maturity and lower yield, in turn making their duration (a measure of interest rate sensitivity) much longer, at about 4 years for high yield bonds versus 7.3 years for investment grade.3

HY, IG stats 1-31-17

The vast majority of high yield bonds are issued with maturities ranging from 5-10 years, while investment grade bonds often have maturities well beyond that range.  This puts the average maturity of the high yield index at just over 6 years while the average maturity on the investment grade index is 4.5 years longer, closer to 11 years.

Additionally, investment grade returns historically have been very negatively correlated with changes in Treasury yields, while high yield bonds have been positively correlated.4

Correlation chart 1-31-17

This means that if your concern is rates will rise, which in turn will cause the yield on government bonds (5- and 10-year Treasuries) to increase, then historically, returns on investment grade bonds have decreased, thus the negative correlation.  On the flip side, the positive correlation between high yield and Treasuries would indicate that as yields increase in Treasuries, we have historically seen positive returns in high yield bonds.  The historical data shows that high yield bonds have actually performed well in periods of rising rates (see our writings “Strategies for Investing in a Rising Rate Environment” and “The Election Impact on the High Yield Market: Rates and Regulation”).

As we look at the fixed income sector, we believe that high yield bonds are a viable investment choice in today’s market relative to investment grade bonds.  Investment grade debt carries a much longer maturity and a much higher duration, meaning more interest rate risk should we see rates rise.  In addition, the coupon income and yield is much higher for high yield bonds, as indicted by the charts above.   Those looking for some yield generation for their fixed income debt allocation and less interest rate exposure should take a look a high yield corporate debt.

1  Bloomberg Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). Bloomberg Barclays US Corporate Investment Grade Index consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements (source Barclays Capital).  Returns cover the period of 1/31/1992 to 1/31/2017.
2  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leveraged Loan Morning Intelligence,” J.P. Morgan North American Credit Research, February 3, 2017.
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.  Data as of 1/31/17. 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, using modified adjusted duration.
4  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).  Returns cover the period of 1/31/1992 to 1/31/2017.  5-yr and 10-yr US Treasury percentage change in yield is for the period 1/31/1992 to 1/31/2017, with data sourced from Bloomberg.  Correlation performed based on monthly returns for HY and IG index and monthly yield changes for the US Treasuries.
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Pricing Risk and Playing Defense

Since the election, we have watched equity markets soar, bond yields rise dramatically and animal spirits returning to life.  Is this the beginning of new trends or the beginning of the end of the rallies that began in 2009?  The reality is that none of us know the future.  What we do know is that the two monsters of debt and demographics remain in the room and nobody is going to change their impacts.  And they have a far bigger impact than much of the optical engineering we are now witnessing with Trump-O-Nomics.  The equation we are dealing with is debt + demographics = no demand.

As we look toward 2017, we believe volatility will return to markets and what you don’t own will be as important as what you do.  It is time to play good defense and we will do just that while also capitalizing on the select value-based opportunities within today’s high yield market.  Click here to read our most recent market commentary, “Pricing Risk and Playing Defense,” in which we discuss our market outlook and corresponding investment strategy.

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Managing Volatility

As we have talked with advisors and investors over the past couple years, we often hear the topics of yield and volatility mentioned.  Investors are looking for yield and income generation, especially in the persistently low yield environment we’ve seen for years now, but they also don’t want to go out on a limb in terms of volatility, as they want to protect their or their clients’ money.  Caution seems to be the investment mindset of choice these days.

We have heard these calls for lower volatility and over the past year have worked to dampen the volatility within our own strategy.  Below are some of the actions that we have taken along this effort:

  • Increasing the number of positions: While we certainly don’t want to take the “one-of-everything” strategy that seems to be employed by many index-based and other large funds that hold hundreds and even over a thousand securities, we have expanded our number of holdings.  The law of diminishing returns comes into play as you get to a certain number of holdings; thus we don’t see holding hundreds of securities as to your advantage.  Rather we want to hold the right securities; enough diversification to work to lower security specific risk and volatility while still staying true to our active strategy.
  • Monitoring Position Sizes: Holding a broad number of individual securities alone isn’t enough.  We also continually monitor our position sizes.  For instance, with the big run up in certain of our holdings in 2016, we saw some of these securities become overweights within our portfolio.  Thus, as we see fit, we have and will continue to work to trim back position sizes to levels we see as appropriate.
  • New Issue Allocation: As we have spoken about on numerous occasions, we have implemented a strategy enhancement of allocating a certain portion of our portfolio to newly issued bonds.  Our experience has been that these bonds tend to be well vetted prior to issuance, which can help minimize the unfavorable surprises in the weeks and months following issuance—meaning less potential downside volatility.  Additionally, our experience has been, and market research indicates, that bonds tend to be more liquid immediately following issuance, which may also serve to help managed liquidity.
  • New Issue Sell Disciple: Part of the new issue strategy involves continually rolling out of prior new issue holdings into more recently issued bonds.  By and large our experience over the last year has been that we are selling these holdings at premiums to issuance price, allowing for potential capital gains.  However, we have implemented a tight sell discipline on downward price movements, which we believe will allow us to better protect on any potential downside, further enhancing the volatility focus of this portion of the portfolio.

As we look toward 2017, we believe that active management and the ability to manage downside volatility will be all the more important for investors across the broad spectrum of asset classes, including high yield: we expect that in 2017 what you own and, importantly, what you don’t own will matter.  We have decades of experience in actively managing high yield portfolios.  Our end goal has been and will continue to be to generate alpha for our investors.  We believe the skill set we have acquired over these years in managing high yield debt allows us to continue with that goal of alpha generation all the while working to manage downside volatility with recent actions taken.

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 report is for informational purposes only. Any recommendation made in this report 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. High yield bonds are lower rated bonds and involve a greater degree of risk versus investment grade bonds in return for the higher yield potential. As such, securities rated below investment grade generally entail greater credit, market, issuer, and liquidity risk than investment grade securities. Interest rate risk may also occur when interest rates rise. Past performance is not an indication or guarantee of future results. Actual results may vary depending on market conditions, among other factors. The index returns and other statistics are provided for purposes of comparison and information, however an investment cannot be made in an index.
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