It has been a tumultuous couple months in the high yield market. Since the first of June, we’ve seen spreads in the high yield market widen 75bps, putting them now solidly above historical median levels.1
We are also now sitting near the highest spread levels that we’ve seen over the last few years.2
Let’s take a look at a few of the factors impacting this market:
Interest Rates
The interest rate chatter started to reemerge in May and has since continued. We have been very vocal in our belief that much of this concern is unfounded, not only because the high yield market has historically performed well during periods of rising interest rates (see our piece “Strategies for Investing in a Rising Rate Environment”), but also because we don’t believe that we’ll see a rapid spike in rates.
Yes, the Fed will likely take some action over the next several months to get the ball rolling, but we don’t see that their own “data dependent” targets being met to justify aggressive and sustained rate hikes. Their inflation targets of 2% seem to be getting further away as we see energy and commodity prices fall. Yes, the unemployment rate is improving, but the labor participation rates are certainly not (nor are wages), which can make some of the employment face value improvements a bit deceptive. Additionally, earnings have been lack luster so far this season, which doesn’t seem to indicate that we are the in midst of strong economic growth. We’d expect any interest rate move to be moderate and believe the high yield market will weather it well, as it has historically done.
Liquidity
Much has been made recently of the “lack of liquidity” in the corporate bond market. While the Volker Rule officially went into effect on July 21st, banks have been preparing for years and trimming back their trading activities. Under this rule, banks are not able to engage in “proprietary trading” which means they are limited in their ability to trade for their own books, thereby reducing dealer inventories and subsequently market liquidity. Yes, this likely has led to heightened volatility within the high yield market.
However, history has shown us that pre or post Dodd Frank and the Volker rule, markets are generally volatile and choppy when we see the tides turn and the “risk off” trade emerge, just as we have seen over the past few weeks. When investor sentiment quickly turns and money outflows escalate, we have historically often seen outsized price moves in bonds, so it is certainly something that players in the space have experience in dealing with. It makes for good headlines for the financial media, but for long terms investors like us, we actually see periods of heightening volatility as an opportunity to buy assets on the cheap and wait for the rebound in the securities for which there is no fundamental reason for the price hit.
Energy, Commodities, and China
We have once again seen the energy markets take a hit, with oil prices touching below $50 again
and down nearly 20% since the beginning of the month. News of the collapse in the Chinese stock market and the implications for the broader economy there, as well as supply increases domestically and potentially from Iran down the road have all contributed to the recent decline. The troubles out of China and whether we will see a decreased demand from this commodity-intensive economy has also carried over into various commodity markets worldwide, including high yield issuers in this industry.
As we have pointed out on numerous occasions, the energy industry is the largest industry within the high yield space, accounting for about 14-17%3 of the market, depending on the index referenced. So certainly the decline in energy prices will hit a portion of the high yield market, but that doesn’t necessitate abandoning the entire market. Investors need to understand what they own and avoid the companies that are seen as most vulnerable. For instance, we have mentioned on numerous occasions that we see many of the domestic shale producers as especially vulnerable in this environment, given the capital intensity of their business models and high decline rates, as well as the companies that service them.
General Contagion….The Opportunity
While certain energy credits are justifiably getting hit, these various concerns are bleeding over to other areas of the high yield space in which there are no changes in fundamentals and/or prices are unjustifiably gapping down as the market overreacts. The most basic premise in investing in buy low and sell high. We see this general market contagion as an exceedingly attractive opportunity to acquired quality bonds and loans at lower prices.
Active, long-term value investors have the flexibility to avoid the names where fundamental concerns are warranted, as well as sell securities where prices may still be elevated and/or yields low and redeploy proceeds into names where we have seen spread widening and/or price declines that are not justified and wait for the rebound. Part of managing risk is not just buying the right names but buying at the right prices—we’d see today’s market as much more attractive and ironically even a lower risk proposition than when market conditions are in rally mode and everyone is trying to acquire overpriced securities. We believe that today’s high yield market is offering investors attractive value for active, long-term investors.
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