There is no denying Friday was a brutal day in the high yield bond market, as investors seemed to be spooked by the freezing in redemptions and liquidation of the Third Avenue Focused Credit Fund, which by all accounts is a fund focused on distressed debt and had a large portion of their portfolio in non-rated bonds, so not truly representative of the broader high yield market. But fear and indiscriminate selling ensued and the high yield bond market was the topic of the day.
By all indications, 2015 will go down as a losing one for high yield bonds, one of the few negative years in the nearly 30 years of tracking (see our piece “Compelling Value in Today’s High Yield Market” for more on how the high yield market has performed following those negative years). The object of investing, what advisors preach to their clients, is buying low and selling high. However, in times such as this, investors are usually caught in an emotional tug of war where they know they should buy at the lows but fear down markets and the risk of losing principal that they worked years to build.
Yet as we sit today, we are seeing what we believe is considerable value for those managers and investors that are willing to look forward and can actively navigate through today’s high yield market. Unlike equities where we are seeing valuations well above historical averages1, in the high yield bond market spreads have backed up to levels that we haven’t seen in four years2, creating what we believe to be an attractive entry point/opportunity to add to your positions.
For those investors that are facing the tug of war between value and fear, as contrary as it seems, we believe that buying during down markets can actually lower your risk in many cases. An important part of investing is buying at the right price and down markets present the opportunity for investors to buy undervalued, mispriced securities. During up markets, people tend to chase the same names, bidding them up well over their true value. Yet, in down markets, fear can lead to indiscriminant selling, and may create attractive opportunities for value in many cases. This is what is happening now; people are running for the exits and causing many bond and loan prices to plummet despite the bond/loan issuers remaining fundamentally solid. We believe that what needs to be done is similar to what should have been done in the early-2000s and 2008 downturns, whereby investors that purchased/held/added to their positions collect their interest payments and saw a swift rebound in the security prices.
The Peritus team has experience going back two decades in the high yield market and has navigated through these cycles before. We believe that just as we have seen in past cycles, this asset class is set to rebound as the smoke clears. Today is eerily similar to what we saw back in the early 2000’s, when the high yield bond market was contending with a few problem industries: telecom, media, and technology. We saw those industries completely melt down, similar to what we are seeing today with the commodity and energy space. At the time, we stuck to our investment philosophy, focusing on the fundamentals, and were able to position the portfolio for the environment and our portfolio benefited, outperforming as the cycle turned. 2008 presented a similar opportunity as the entire market melted down. Again, focusing on fundamentals, we stuck with and added to the positions we believe would survive and reaped the rewards in 2009 and beyond.
We are seeing big gaps down in the pricing of bonds, but can’t help ask the question, where is the crisis? What is fundamentally driving this massive sell off in high yield? The well-publicized liquidity concerns are certainly a piece of the decline, but in all past cycle downturns there has been a fundamental catalyst. In 2001/2002, the tech boom was blowing up and the economy was going into a recession, acerbated by the September 11th attacks. As mentioned above the telecom, media, and technology industries (TMT) were in free fall, but together these industries were 40-50% of the high yield market.2 Many of these companies didn’t even have real businesses, so default rates saw a big spike. In 2008, the world was seeming to be ending. Financial markets were imploding, leverage was unwinding, and we were seeing big bank failures. Defaults again spiked as we headed into the “Great Recession.” (See our piece, “Why This is Not 2002 or 2009” for more detail on these time periods that encompassed the prior major default cycles.)
As we sit today, yes energy is a problem industry and the largest industry component of the high yield market, and if you combine that with commodities together they are about 20% of the high yield market, so less than half of what we saw back during the TMT collapse. And while energy prices are down significantly, these companies largely do have real businesses and products, but may just not be able to survive this bout of weak pricing. Thus by all accounts, we do expect defaults to accelerate in the energy and commodity sectors, but we see the rest of the high yield market as largely fundamentally solid. We don’t believe we are heading into a recession. There is no massive delevering that needs to take place. Default rates are expected to increase as energy and commodity defaults heat up, but are expected to remain tame for the rest of the high yield market, putting total market default rates still below historical averages going back nearly thirty years (see our piece, “The Defaults Ahead” for further details). There will be names to avoid, but also what we see as plenty of attractive opportunities.
Investors need to decide what is a realistic expected return over the next few years. When investing in the high yield bond and loan market, we believe there are four important metrics to pay attention to: distribution yield, yield to maturity, average maturity, and duration. Distribution yield is important as you want consistent income that more than justifies the fee and ideally generates more than the index. Yield to maturity is important because that is your ultimate catalyst—bonds have a set maturity date at which it is required to be paid back at par, though bonds are generally taken out earlier, often at call or tender prices above the par price. Bonds and loans will fluctuate in value over their life, but at the end of the day, we generally see these bonds approach their preset call or maturity prices as those dates approach. The offset to this would be defaults, but as noted above default rates are currently and are estimated to remain below historical norms. The portfolio’s average maturity shows the average life in years that pertains to the yield to maturity, giving you an indication of how long it will take for the yield to maturity to play out. Duration is important as that is an indicator of your portfolio’s interest rate sensitivity, generally the lower the duration the less sensitive a portfolio will be to interest rates.
We are seeing double digit yield to maturities offered by numerous securities that we view as fundamentally sound, as well as bonds offered at notable price discounts to par in many cases. We believe this leg down in the high yield market is presenting active managers with attractive opportunity for capturing yield and income distribution, as well as the price discounts can present investors with capital gains and the potential to increase the net asset value of their portfolio over time. Just as we have seen in past downturns, we believe experience and active management remains essential as you navigate through these markets, thus we don’t believe indexing/passive management is appropriate—as noted above, there are problem sectors such as certain areas in the energy industry that need to be avoided. Yet we believe there is value to be had for investors focused on fundamentals and strategically building a portfolio for the long term. We have seen the high yield bond market decline this year due to volatility but there is no economic crisis that we must contend with as we have seen in past cycles; today there is fear causing gaps down in bond pricing. We believe this is when you want to put money to work, buy low and sell high and position yourself for a rebound in the market that we ultimately do expect.
1 Based on S&P 500 PE Ratio as of 12/11/15, see http://www.multpl.com/.
2 Data sourced from Credit Suisse, as of 12/110/15. Historical spread data covers the period from 1/31/1986 to 12/11/2015. 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.
2 Acciavatti, Peter, Tony Linares, Nadia Nelson, and Moliehi Pefole. “2002 High Yield-Annual Review,” J.P. Morgan, January 2003, p. 58.
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