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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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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