We have had a ton of economic statistics out over the last week from the month of September.  What has all of this data told us?  Nothing new.  Unemployment is still above 9% and even though some said it was better than expected, they are wrong; it was what was expected as 45,000 Verizon workers parked their picket signs at the door and went back to work.  Retail sales were good, but not blowout.  Costco did not meet projections, so can you take anything away from this?   Probably not because they have missed earnings from time to time over the 20 years I have been shopping there.  It’s always a circus at that place.  Trust me with seven family members we know it all too well.

Mortgage rates are at all-time lows but this means little.  Refinancing an existing mortgage is difficult enough given income and equity requirements.   If you don’t have a house, you are most likely a career renter or have lost your job and house and will not get one again for a few years.  Bank lending needs to be loosened up again for that industry to begin to grow, but isn’t that what got us in trouble in the first place?  I heard a speech by a manager than manages a real estate fund for a local pension fund and he stated that if we didn’t build another house, we have enough empty houses on the market to last 26 years at the current uptake. Not sure about the math, but the point being home ownership rates just got too far ahead of reality.

What is going to cause this new normal to drive demand from the consumer?  Where will this come from?  If Washington would give some clarity on taxes, debt or regulation you might see some more spending, but it’s not likely to happen until after the 2012 election.  Europe is trying to figure their mess out and it will eventually happen because it has to.  They may have a few banks follow Lehman and Bear Stearns, but it will not end the world.

What needs to happen is people need to forget the tech and housing bubbles that created a lot of fictional wealth for people that normally would not have it, as their jobs don’t afford that possibility.  Those assets have been spent, lost and given back.  We are not in a new normal, but an old normal where you work for a paycheck, spend what you earn and save for college tuitions, weddings and retirement. If you are really driven and hungry the American dream is still alive; you can become anything and own anything, as America is still a free enterprise country. Well, kind of.

With that said we all still have issues to figure out and financial goals to achieve.  The question is what is that goal or hurdle you need to get over or what is that liability that has to be met every month?  Where do I put my assets so they meet those things I just laid out? You have choices, and with those choices you have to decide at what time do I start this process because making $0 from my assets will not get me there.  The clock stops for no one.  I look at it this way, we work an hour and make X amount of money or we work X amount of time and close a deal and make X amount and then on to the next deal, if there is one.  Investing is no different.  You have a choice to have cash in your hand every day or you can wait to be paid down the road in the hope that it will be higher.  Math has taught us that a dollar today is worth more than a dollar down the road and history has taught us that yield generation matters.  If your employer wanted to pay you cash every day, would you take it?  I can bet you’d much rather have that than be paid once a year.

In the investing world you risk your cash to make a return as you need to meet a goal or a liability.  Why would you not take your cash return daily (weekly, monthly, or semi-annually) if math and history tells you it is a better option?  Humans by nature think they can time the market and get in and out at the right times.  How many of the wealthiest people in the world have done this?  None I can think of.  Bill Gates collected cash every day by selling something as did Warren Buffet with the businesses he owned and pocketed the cash.  The Middle Eastern countries became wealthy because they collected cash every day buy selling liquid gold (oil).

Peritus manages client assets in the high yield fixed income market.  If you bought one bond that yields 10% and one stock that has no yield, and over the next year the bond drops by 10%, as does the stock, where would you be with each investment?  You would be breakeven with the bond, as you were paid 10% in cash and still own the bond with a maturity date coming up in a few years where the company is obligated to pay you your principal back, whereas with the stock you are down 10% and left wondering when and if you are getting your money back. Simplistic, but the math is the math.

We gave some statistics last week in our post about how the high yield bond market has historically performed very well when spreads reach 900bps (The Quarter in Review).  According to J.P.  Morgan, their High Yield Index peaked on Tuesday at 896bps and many of the other high  yield indexes surpassed the 900bp level on that day.  Again, as we noted last week, after spreads have reached 900bps in the past, they have historically posted average annual returns on a one, two, and three year basis of 17.9%, 16.8%, and 15.7%, respectively.  And J.P. Morgan added, “Notably, if you had invested in high-yield bonds in September 2008 when spreads reached 900bps, you would have endured spreads widening to a record high 1900bp during the next 6 months and still managed to record a 1 year return of +20.4%.”¹ So while there may be some volatility, which is unavoidable given the factors the generally send spreads spiking, this historical data seems to indicate that in the medium and long-term, the returns are ample—well above historical averages.

There is value to be had in this market of what we see as bargain pricing given the credit quality of the issuers.  Capital gain opportunities are once again prevalent and we are taking full advantage of them.   So at current spread levels we feel that we are poised well for the long-term as we take advantage of a rare spread opportunity in the high yield space.

¹ Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Alisa Meyers, and Rahul Sharma.  “Credit Strategy Weekly Update:  High Yield and Leveraged Loan Research.”  J.P. Morgan North American High Yield and Leveraged Loan Research, October 7, 2011, p.1.

While we saw a decidedly positive tone in the equity markets over the past week on the hope we are moving towards some sort of solution in Europe, it was definitely a mixed week for high yield corporate bonds.  The high yield market started the week out significantly to the downside as we faced pricing pressure from some large funds rumored to be liquidating and outflows in the ETF and mutual fund space.  However, in the final days of the week we saw the buying interest increase due to what some view as bargain pricing in the space.  Spreads for the Bank of America Master High Yield Index peaked on Tuesday at 910bps before ending the week at 855bps, which was still wider by 14bps from the end of last week.  The yield peaked at 10.13% on Tuesday, but ended the week wider by only 24bps at 9.78%.  The week saw a return of -0.80%, putting us at -2.48% YTD.¹

After last week’s pick up in new issue activity, we saw only one high yield bond deal price this week for $500mm.  We’ve seen the new issue market price $6.8bil in September versus only $1.2bil in August, which at least shows some recovery.  In terms of fund flows, we saw the outflows resume in the high yield ETFs and mutual funds, after five weeks of inflows.  Lipper reported an outflow of $363mm for the week ending on Thursday.²

As we have said in several of our recent writings, we feel that current levels in the high yield market offer investors an exceedingly attractive opportunity for yield in what we see as money good credits offering long-term value.

¹ Yield, spread and return data sourced from Bloomberg.

² Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Alisa Meyers, and Rahul Sharma.  “Credit Strategy Weekly Update:  High Yield and Leveraged Loan Research.”  J.P. Morgan North American High Yield and Leveraged Loan Research, October 7, 2011.

Given the market’s weakness and the volatility over the last quarter, we think it’s worth taking a look at where we have been and where we think we are going.

Where We Have Been:

Unless you were invested in Treasuries or short the markets, the third quarter didn’t look good for anyone.  We have seen a swift and massive repricing of financial asset classes throughout the world.  We begin Q4 just as we began Q3, with all eyes on Europe and how they will address the sovereign debt crisis and, more specifically, the solvency of Greece.  In the U.S., we have seen weakening economic data and consumer confidence over the past three months.  The equity markets have taken a massive hit, as the markets seem to be waking up to the fact there is little to drive growth.  The thought now seems that at best the L-shaped “recovery” continues or at worst, we enter a double dip recession.

As the “risk-off” trade has been in full swing, the high yield bond market has also felt an impact.  To put some returns in perspective, take a look at the following:

While the high yield market has taking a hit, we have definitely fared better than the equity markets.

Looking Forward:

As we sit here today at the beginning of the fourth quarter, we are looking at spread levels in the high yield market that have not been seen since October 2009.³

Current spread levels do seem to price in a recession.  Looking back at the trends in the chart above, we see spreads spike to over 800bps just as we are entering recessionary periods.  For instance, we saw a spike in late 1990, as we entered the 1991 recession; a number of spikes over the 2000-2002 period as we faced the tech bubble bursting and the recession at that point; and then most recently a massive spike in 2008, as the financial crisis emerged (though we would argue the 2008 spike in spreads to almost twice that of the historical peaks was an anomaly that we would not expect to see again).

So if we are currently sitting at spread levels not seen since October 2009 and spread levels that are pricing in a recession, what do we see as the outlook for the high yield bond market?  Well, first let’s address the issue of a double dip recession.  The reality is that defining a “double dip” is more of a technical issue.  For instance, what is the difference between +0.5% growth or a -0.5% retraction?  For all intents and purposes, from our perspective, there is really no difference.  Maybe we avoid a double dip, maybe we don’t, but the reality is that there is anemic, if any, growth and companies will have to continue to deal with this.  While many of the leading economists have upped their probability of another recession, the majority of those probabilities are still under 50%.

And a further comment on the point of a potential recession.  Even if there is a double dip, we would not expect a massive decline in GDP, such as we saw in 2008.  First and foremost, there is no massive domestic liquidity crisis or bubble that we are coming off of this time around.  Second, the decline in 2008/2009 was compounded by the fact that orders just stopped as companies worked through existing inventories. This lead to a severe contraction in orders and economic output.  However, as we sit today, companies have still not ramped inventories post the 2009 decline and are running relatively lean, meaning that there is not a huge inventory balance that can be worked through.  This means we would see a softening in orders as demand softens, but we would not see the vaporization we saw during the last cycle.

Finally, as we think about spreads now at levels not seen since late 2009, we have to consider fundamentally, how do we compare to that time?  We would argue that we have seen improvement on many fronts.  While the unemployment needle has not moved much, and we would not expect a rapid recovery in unemployment given the caution with which companies are being managed, we have seen recovery in other areas.  For instance, the banking sector in the U.S. has been forced to execute disciple and recapitalize.  Corporate balance sheets have made massive progress in delevering and increasing liquidity, with Corporate America now sitting on record amounts of cash.  As we have explained before, the crisis of 2008/2009 and the complete lock-up of liquidity has resulted in a significant mind-set change for corporate management, as they have spent the past three years cutting costs, improving profit margins, paying down debt, extending debt maturities, and increasing cash and liquidity balances.  And while the markets may have bought off on the “V” or “U” shaped recoveries, the management teams we see in the high yield names that we cover largely had no such expectation, nor are they in the full expansion mode that we saw prior to the last recession.  Rather, that have been taking a cautious approach, as evidenced by the fact no significant re-hiring has taken place.

Another benefit of recently going through a recession and having seen little in the way of demand pick up since then is that the most financially vulnerable of companies have already been weeded out, defaulted and restructured.  This fact, along with the massive refinancing done in the debt markets over the past couple years, providing for that additional liquidity and extended maturities, means that the default outlook over the next few years for is for default rates well below historical averages, and significantly below what one would expect given the current spread levels.⁴

In their recent analysis, J.P. Morgan stated that the “implied default rates based on today’s (spread) levels are 8.5%.”⁵ So even if there is a surprise pick up in the default rates, the market does already seem to be pricing that in.  To put an 8.5% default rate in context, as the chart above notes the average for bonds is 4.3% and we have only seen levels higher than 8% during recessions.  Right now the default rates are sub-2% and are expected to remain around that level for the next couple years.

As we look at where we are today and the potential outcomes going forward, we see the high yield bond market as positioned well from not only a fundamental perspective, as discussed above, but also from a technical perspective.  Taking current spread levels of just over 900pbs⁶ in the context of historical data, 900bps has shown to be an attractive entry point.  In looking at the prior six times when high yield bond spreads crossed the 900bps threshold, J.P. Morgan determined that the return performance over the subsequent periods was as follows:⁷

While history is not always perfectly correlated to the future, this would indicate that historically over the long-term, a blow out in high yield spreads has provided an attractive and profitable entry point.

As we look forward, we fully recognize that the current issues faced throughout the world are real and significant.  If there is a sovereign collapse in Europe, the ramifications could be widespread.  However, we do not see that as a certainty, nor do we see conditions getting as dire as they were in 2008/2009.  At the same time, corporate balance sheets seem to be positioned well for the uncertainty ahead, management teams (at least in most of the names we cover) seem to be managing to reasonable and conservative expectations, and the uncertainty ahead seems to be priced in to current high yield bond levels.  We view the high yield bond market as an attractive opportunity for tangible yield and potential capital gains in this environment.

¹ Data sourced from Barclays Capital.  The Barclays U.S. High Yield Index is an unmanaged index considered representative of the universe of U.S. fixed rate, non-investment grade debt. One cannot invest directly in an index.

² Data sourced from Bloomberg.

³ Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Alisa Meyers, and Rahul Sharma.  “Credit Strategy Weekly Update.” J.P. Morgan North American High Yield and Leveraged Loan Research.  August 5, 2011, p. 10.

⁴ Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Alisa Meyers, and Rahul Sharma.  “Credit Strategy Weekly Update.” J.P. Morgan North American High Yield and Leveraged Loan Research.  September 30, 2011, p. 28.

⁵ Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Alisa Meyers, and Rahul Sharma.  “Credit Strategy Weekly Update.” J.P. Morgan North American High Yield and Leveraged Loan Research.  September 30, 2011, p. 11.

⁶ Yield on the Barclays U.S. High Yield Index as of 10/4/11 was 914.7bps.

⁷ Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Alisa Meyers, and Rahul Sharma.  “Credit Strategy Weekly Update.” J.P. Morgan North American High Yield and Leveraged Loan Research.  September 30, 2011, p. 11.

Despite a better tone for equities for most of the week on some hope about a European resolution and slightly better U.S. economic data, high yield bonds continue to trade with a very heavy tone, underperforming equities on the week. The yield and spread on the Bank of America Master High Yield Index (BAML) widened 51bps and 40bps, respectively, to 9.54% and 841bps, the highest levels for both YTD. The return for the BAML Master High Yield Index for the week was -1.74%. On a two week, monthly, and YTD basis, high yield bonds still outperform by a wide margin over the equities.¹

2 week        MTD            YTD

BAML HY Index                 -3.29%        -3.60%        -1.69%

DJI Average                        -5.18%        -6.03%        -5.74%

S&P 500 Index                   -6.91%        -7.03%        -8.69%

This week high yield bond mutual funds and ETF’s, according to Lipper, reported inflows of $327mm, the fourth straight weekly inflow into the asset class for a total of $1.627 billion. High yield primary volume increased again, as six deals in total priced this week for $3.0 billion in proceeds.

Secondary trading volume remains light and focused on the higher rated area of the market, as fear over weakening market conditions has investors cautious to add risk. While we do not dismiss economic, market and European contagion risk, we continue to believe that these levels represent an excellent entry point in to the high yield asset class for those with a medium to longer term time horizon.

¹ Source: Bloomberg

Our sales and marketing efforts and conference attendance often lead us to discussions with the boards of many of the large pension funds in America.  As has been well publicized by the media, for the most part, these funds are massively underfunded as a result of the financial crisis and a decade of lackluster, to say the least, equity returns.  Those return bogies of 7.5-8% are getting harder and harder to meet in today’s environment.

I found a recent article very telling of how these large pension funds have just experienced another hit—in this case the “rock bottom” interest rate policies, such as that we have seen from the Federal Reserve.  Interestingly enough, the article cited a study that said the funding shortfall today for these pensions is even larger than it was during the 2008-2009 financial crisis.

As the options for yield for pension funds become more and more limited, where do they turn to generate the necessary income?  Well, naturally our answer is the high yield market.  While it may be a self-serving answer, since that is the market in which we operate, we do believe in the real and tangible benefits of high yield bonds.  The coupon income attached to these bonds accrues daily and pays out quarterly or semi-annually.  And, this added coupon benefit helps to soften the losses during times of market declines.  Plus, bonds have finite outcomes (assuming a default is avoided), via a maturity or call date, so you aren’t left waiting around for economies to improve and growth to ensue to drive up equity pricing or waiting around for the Federal Reserve to raise interest rates (which could be a long wait at this point given they have targeted low rates through June 2013).

We have written several times about our competitors, the index based mutual funds and ETFs of the world, and the kind of securities that are held in those funds.  These funds will always hold securities that are highly levered and subject to potential default because they are required to hold anything in the index above a certain dollar issuance level.  These vehicles will give people access to the asset class at a lesser fee than actively managed accounts, but with that you are exposed to these sorts of risks.

This is from a publication today:¹

Harrah’s Still a Losing Hand

Elsewhere, a trader said that even though he thought the junk bond market was “up slightly, at least the indexes [...] the names that have a seemed to lot of volume, were down slightly.” Chief among these, he said, was Caesars Entertainment’s recently hard-hit 10% notes due 2018. He saw $30 million of the bonds issued by the Las Vegas-based gaming giant, the former Harrah’s Entertainment, down “another” 1½ points, last trading at 63.  A second trader, who also saw the Caesars bonds continuing to come in, pegged them down “another 2 or 3 points,” in the 62-63 area.

I have been all over the country this year speaking at conferences, meeting with investment advisors and doing interviews about the high yield asset class and Peritus’ expertise in this space.  What amazes me is that advisors still keep their client assets in these index based funds, despite this seeming risks, just because there is more trading volume.

¹ Deckelman, Paul and Paul Harris, “Prospect News High Yield Daily,” Tuesday September 27, 2011, p. 5.

Continued fear about the European banking situation, more equity volatility and an increasingly grim outlook for an economic recovery weighed heavily on markets this week. The yield on the Bank of America High Yield Master Index increased 42bps to 9.03%, while the spread was wider by 55bps to 801bps over Treasuries over the course of the week. The high yield bond index’s performance continues to outpace equities on a one week, MTD and YTD basis:¹

1 week        MTD            YTD

BAML HY Index           -1.58%        -1.89%        .04%

DJI Average                   -6.41%        -7.25%        -6.96%

S&P 500 Index              -6.54%        -6.65%        -8.30%

These numbers make sense given that high yield bonds are higher in the capital structure than equities, and should not be as affected when there is market volatility and the economy is slowing.

J.P. Morgan this week lowered their forecast for Euro area GDP for the coming year to mild recession levels beginning next quarter, -0.5% for 3Q11, -1% for 1Q12 and -1.5% for 2Q12. The continued slowdown in the European economy and the stress on the European banking system will likely continue to weigh heavily on all financial markets for some time, as there does not appear to be a quick fix for these issues.

CCC bonds continue to underperform the rest of the high yield market, returning -2.28% on the week, while the spread on the CCC index blew out 80bps. MTD the CCC index is down 4.02% and the spread is 142bps wider to 1361bps and is now yielding 14.39%.

This week high yield bonds funds reported inflows of $517mm, according to the Lipper data, the third straight weekly inflow for the asset class, for a total of $1.3 billion during that time. Interestingly, money is flowing in to the high yield asset class with all the global volatility. This would seem to point to investors viewing the high yield spreads as attractive, even against the continued slowing economic pace. Aided by the cash inflow, primary market activity picked up this week, pricing five new issues for total proceeds of $2.6 billion. This marked the largest weekly new issue volume in eight weeks and more than the last seven weeks combined.

Given the strength of corporate balance sheets, low interest rates, and slow to no growth environment, we continue to view these levels as an attractive entry point for investors. While economic activity will likely continue to slow and European issues will persist for the foreseeable future, we believe the back-up in the yield and spread of the Bank of America High Yield Master Index since 4/31/11 of 216bps to 9.03% and 330bps to 80bps, respectively, are overdone. We believe high yield credit spreads and yields will tighten by the end of the year.

¹ Source: Bloomberg

Today, the Fed just couldn’t help itself from intervening.  While not a full Q3, the Federal Reserve is undertaking steps they hope will help boost the economy. They announced today that they will buy $400mm of longer-term Treasuries and sell shorter-term Treasuries by June 2012.  They will also reinvest proceeds from maturing agency debt and mortgage back securities into other mortgage debt.  The media has termed this “Operation Twist,” with the goal of lowering long term rates and flattening the yield curve.

In their press release, the Fed noted that there are “significant downside risks to the economic outlook, including strains in global financial markets.” ¹ The markets seemed to pick up on the word “significant” and trade down in response.  Given the events of the last couple months, the weak economic data we continue to see posted and the daily issues faced in Europe as they deal with potential nations defaulting, did we need the Fed to tell us that there are significant downside risks to the economic outlook?  How is that a surprise to anyone?  Maybe it is just that reality hurts and they reminded us of reality.

At the end of the day, what does the Fed’s move accomplish?  The goal is to ultimately lower mortgage rates so more people can refinance (in turn lowering their monthly expense obligations) and for businesses to lower their cost of borrowing.  However, the problem is that the loans are just not to be had.  On the mortgage side, yes, this may help a small constituency of the population.  Maybe those potential homebuyers sitting on the sidelines, now it is just cheap enough for them to enter the housing market…but I can’t imagine that is a huge chunk of the population.  And for existing homeowners, rates have been low for a while, so those that could refinance, I would have expect have largely already done so.  The bigger problem is that all of the people who refinanced already over the last ten years and did things like take out home equity lines of credit, or those who were part of the massive buying in the middle of the last decade, just don’t have the equity in their homes needed to refinance.  With the collapse in the housing market, having the 20% equity needed to refinance is extremely difficult for this large portion of the population.  So while the potential lower monthly payments would be welcomed, these people just do not have enough cash to make the big payments that would be required to get to that 20% equity level.

For corporations and businesses, yes lower rates do have a benefit of lower borrowing costs, but again, that requires that the business be in a strong enough position that they can get a loan in the first place. The three years of tough economic times have taken a toll on businesses, especially the small businesses that are the cornerstone of our economy.  These businesses that need the loans the most and would benefit the most from low borrowing costs are struggling to get them, so lower rates really won’t help them out.

I’m not sure what today’s moves accomplish; rather it still seems that we have long-term problems that will take a long time to work through.  Whether it be the Fed, or some stimulus package from Congress, it just seems that these efforts will do little to change the ultimate situation.  There are significant downside risks and issues that we must work through with discipline and recognition that there is no quick fix.  And we invest with that long-term perspective in the forefronts of our mind.

¹ Board of Governors of the Federal Reserve, Press Release, September 21, 2011.  www.federalreserve.gov

Last week I was out of my suit and into my boots and camouflage.  No, I was not doing a stint in the military; I was on my annual archery elk hunting trip in my hometown, Clark Fork, Idaho.  Clark Fork has grown by 25% over the last 30 years to 530 people.

When I travel, I like to take the pulse of America to see how things are going for them.  One of my favorite restaurants on the planet is located in my hometown and it is called the Squeeze Inn.  Janet, the owner, cook, waitress, purchaser and dishwasher  is a gem of a human.  She has traveled the world, lived on the streets with the homeless, reaching a hand to help many of the street people, runs businesses, counsels and helps struggling youth in Clark Fork, and last but not least writes grants for various purposes in her community and for the local school.

Janet likes to talk, and is second to none, so when I started asking questions about the local economy she opened up about her business, it’s cost, her clientele, both local and tourists, and what she has done to try to make a living.  Janet stated her number one problem in the restaurant business is food costs.  She has to drive 100 miles to buy her ingredients for the gourmet menu she offers.  She does so because it is not cost effective to have deliveries or buy retail.  Food delivery companies are trying to pass their higher costs through to these restaurants.  Some restaurants can pass these costs onto their customers via higher menu pricing, but the Squeeze Inn simply can’t.  She has not raised her prices in three years.  She has tried to do some tricks to increase profitability, but those have been unsuccessful.

Let’s talk about the patrons that like the Squeeze Inn like I do.  I ate there every night (five nights) except for two because those were her two days she is closed.  She has a combination of locals and tourists that come to her establishment.  Clark Fork is located in the northern panhandle of Idaho, tucked in where the Clark Fork River meets Lake Pend Oreille.  There are many campgrounds/RV Parks and highway 200 is a major artery to Montana, where you go right into Flathead Lake basin and Glacier National Park.  The tourists were half of normal level and the locals were nonexistent in their patronage this summer.

What does this tell us about the state of the economy and how main stream America is making it?  It’s not good.  I went onto the website About.com and found that 50% of Americans pay 97.1% of the U.S. Income taxes and the other 50% pay 2.9%.  This tells me that higher cost of living, which includes food and energy, is having a major impact on this bottom 50% of Americans as their discretionary income is evaporating.  The other 50% is under attack by our President as he thinks they should pay their “fair share.” Would that be more than the 97.1% they already pay?

As a fixed income investment company that looks to make loans to public companies on behalf of our clients around the world, we take this kind of information and apply it to the companies we are looking to lend to.  Corporate America, just like small-business America, has cut where they can and now must weather the storm of low demand and higher costs.  While our Government has not had a large enough dose of reality, their turn is coming as they will have to start leaning on the free lunches.  The result of all of this is that unemployment will most likely not go down as there is no demand out there, as witnessed at the Squeeze Inn, nor can our Government continue to keep this kind of payroll.