We have seen extreme volatility over the past week, with a precipitous fall and rebound for equities. It is often said that the bond markets lead the way, and over the last month or so, we have seen spreads widen in the high yield market and Treasury yields decline, and now it appears that the equity markets, triggered by China, are catching up. But with all of this volatility, just what has changed in the last couple weeks in terms of the underlying security fundamentals, specifically in the high yield market?

Energy/Commodity Markets

Fears that with China showing signs of weakness, this could lead to lower demand for certain commodities, including oil. Many of these concerns are warranted and investors should be aware of what they own. As we have noted before, energy is the largest industry concentration within the high yield market, at about 15% depending on the index¹, and investors, especially in index-based and passive high yield vehicles, should make sure they understand their exposure to the sector and analyze the fundamentals and prospects of their investments in the space at the current oil price levels. However, there may also be opportunities within the commodity sector due to these current events. For instance, gold has moved off of its lows and has actually rallied over the past three weeks. With the yuan devaluation, many foreign countries may turn to gold as a safe haven parking spot for their foreign reserves.

Given the risks in this space, investors need to be actively managing their allocations. There are likely some opportunities, but the recent global issues will have an impact on the fundamentals of many companies, leading to credits that should be avoided. Investors need to do the fundamental work to discern the opportunity from the falling knife.

Interest Rates

It is becoming increasing more expected that an immediate (September) move in interest rates is unlikely. Maybe some of the domestic data will continue to show some gains, but as we have noted in the past, this Fed has proven to not only be “data dependent” but also market dependent, meaning we wouldn’t expect them to do anything at the risk of sending markets down. So now that most market participants seem to be convinced any rate move will be delayed until later 2015 or early 2016 that may well become a self-fulfilling prophecy.

For all those concerned about a rate rise, that pressure appears to be easing as the first hike is likely pushed out and we would continue to expect any move will be very moderate in the nearer-term. As we have noted in the past, historically the high yield market is less sensitive to interest rates and has historically performed well in rising rate environments, yet given the market perception, right or wrong, that all fixed income securities will be hit if rates were to rise, we would view the easing interest rate fears as an incremental positive from a market psychology perspective.

Asset Valuations

We have seen a global repricing of risk, which we would view as a healthy reaction given that economies around the world are under pressure. While equity markets have faced havoc over the last week, we have actually seen spreads in the high yield market widening since the beginning of the summer.²

We are now at spread levels not seen since the summer of 2012, with the spread on the high yield index sitting at 646bps, well above the nearly thirty-year median level of 521bps and average level of 582bps.³

We view the recent spread widening as a great opportunity for selective investments in the high yield space. While caution should be had in investing in certain bonds within the energy and commodity sectors, generally speaking we continue to see attractive fundamentals in the broader high yield market, despite the recent market volatility and global concerns. Importantly, much of the high yield market is domestic focused, and in many cases niche companies, so would not face the same sort of pressures from currency or weakening global demand faced by many of the larger, multinationals in investment grade corporates or lager cap equities. Additionally, we would see the currently lower prices/higher yields on high yield bonds as presenting us with a better entry point and with that, a lower risk proposition. Finally, we would expect that the currently moderate domestic economy and low inflation on the back of the commodity weakness will constrain rates, which should further help the high yield market from a market psychology perspective.

Whether or not we are at the market “bottom” is anyone’s guess, but we believe investors should capitalize on what we see as currently attractive spread/yield levels relative to risk in much of the high yield market and take advantage of the tangible yield and income this asset class produces.

1 As of 7/31/15, Energy was 15.3% of the Credit Suisse High Yield Index and 16.35% of the J.P. Morgan US High Yield Index. JPM source, Acciavatti, Peter Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, July 31, 2015, p. 51.

2 Data sourced from Credit Suisse, for the period of 7/1/15 to 8/25/15.  The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. “Spread” referenced is the spread-to-worst.

3 Data sourced from Credit Suisse, as of 8/25/15.  Historical spread data covers the period from 1/31/1986 to 8/25/2015.  The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. “Spread” referenced is the spread-to-worst.