As we process all of this data, we evaluate whether any change in the investment thesis is warranted.  While in most cases there is no change, our earnings evaluation can result in a sell or an increase in position sizes.  For instance, if the company is underperforming and we see further downside exposure relative to the security’s price, we may choose to sell.  On the flip side, if we see the security as significantly undervalued, with a disconnect between the credit fundamentals and the credit’s yield/price, we may choose to add to an existing position.

Furthermore, earnings season can create a variety of opportunities for new investments.  Often we see a security’s price taken down/yield widen on the company missing expectations or giving an unfavorable outlook, yet we may believe the market is overreacting to the news or the issue causing the weakness is just temporary.  This can create an undervalued situation and what we see as an attractive buy-in price—these are the sort of opportunities we look for as a value-focused manager.  Or we may have a security that we are watching but as an extra layer of caution want to see how the company is recently performing before we pull the trigger to make an investment, and the earnings announcement allows us to do just that.

This is just part of the merit and worth we see in active management.  We are intentional about what we hold and why we hold it.  In the high yield market, earnings surprises often have an impact on security prices, so we don’t believe blinding holding something no matter the valuation or outlook is the answer.  Per our strategy, we target about 70-100 credits within a portfolio, which we believe does allow us enough diversification to moderate our security specific risk and keeps position sizes relatively low, but also gives us a limited enough number of securities that we are able to evaluate what we hold.  In times like this, we believe it is very important to have an active manager monitoring what securities are held and how a portfolio is constructed.

We are sitting at record price levels in the S&P 500, DOW, and Nasdaq, with many questioning investor complacency and valuations.

While these concerns have spread across a variety of financial sectors beyond just these equity indexes, we view the high yield market a bit differently.  Yes, there are credits that are overvalued within this market, but there are still some bonds and loans that we see as fairly and even undervalued.  Yes, yields are low relative to historic levels, but this is in a context of persistently low rates around the world.  Spread levels are still well above historical lows.

Looking at recent history, we don’t believe we can say that high yield investors are complacent.  It hasn’t been a straight upward move over this market “cycle” as we have seen with equities.  In fact, if you look at the chart of spreads within the high yield market, we have seen this market go through its own cycle of sorts.²

Almost a year and a half ago we saw spreads widen to over 900bps, hitting 919 bps on February 11, 2016.³  While this is nowhere near the spread widening we saw in 2008/2009, which is certainly the outlier as reflected in the chart above, the spread highs that we saw in early 2016 were near the spread highs that we saw during the prior spread peak during the Telecom, Media, and Technology (TMT) collapse of 2001/2002, when spreads topped out right around 1,000bps.  There is even high yield data going back to the early 1990’s, when the country was in the midst of the recession, and we saw spreads peak then again right around that 1,000bps level.⁴

It is important to understand some of the factors that were present going into the declines at the turn of the century, 2008, and even 2015/2016 as we evaluate where we are today.  As we closed out the 1990s, we were in the midst of the internet/technology bubble.  Telecom, media, and technology were going to revolutionize the world and financial markets were wide open to these companies seeking money to establish their businesses, with investors hoping to grab a piece of the pie.  Just as we were seeing companies with little the way of actual revenues, much less profits, able to generate equity proceeds via IPOs, we were seeing similarly relaxed issuance standards during this time in the high yield market.  Media and Telecom (Broadcasting, Cable/Wireless, and Wireline and Wireless telecommunications) accounted for 45% of all high yield bond new issuance in 1999 and 57% in 2000.⁵  Telecom alone was 20% of the high yield market by August 2000⁶, and add media and technology and these three high flying areas were a significant piece of the high yield market.

As the internet bubble burst, and the events of September 11^th hit in the midst of this, we started seeing default rates accelerate.  Total default rates moved up from about 4-5% in the years prior to 9-10% in 2001 to mid-2002.⁷  Media and telecom defaults accounted for 44% of all defaults in 2001 and 65% in 2002.⁸

The issues that preceded the decline early 2008, before the full scope of the financial crisis hit, were also related to relaxed issuance standards.  But here it wasn’t a specific industry that caused the problem; but rather three letters—LBO.  Leveraged buyouts have always been part of the high yield market and in many cases have created value for investors along the way.  LBOs in and of themselves weren’t the problem; rather, it was a massive wave of LBOs that hit during 2005-2007 and were being done at high multiples with very thin equity allocations committed to the deal.  This meant these new structures were left to be heavily financed with debt.  Acquisition financing in the high yield bond market grew from 13% of total new issuance volumes in 2003 to 51% in 2007.⁹  Higher leverage multiples were widely accepted as leverage on the index grew from an average of 4.5x in 2003 to 5.4x at the end of 2007.¹⁰

High multiples and heavy debt loads proved to be a toxic mix as the financial crisis hit in the latter part of 2008.  The premise of the elevated multiples and large debt financing was that these companies would grow into their capital structures.  But as the “Great Recession” hit, those hopes for growth evaporated in many cases.  Default rates across the high yield market spiked in late 2008 and early 2009, and these highly levered LBOs weighted on the market and default rates for years to come.

Moving to the more recent history, the market disruption in 2015-early 2016 was similar to what we saw in 2001/2012, where specific industries were of issue.  This time it was energy and commodities (metals and mining), which by mid-2014 were about 23% of the high yield index.¹¹  We saw the “contagion” spread to the broader high yield market as investors became concerned about high yield in general given the energy concentration, which lead to selling and pricing pressure and spread widening across the high yield market.  Default rates did accelerate, but it was contained to the problem industries of energy and commodities.  In 2016, these two industries accounted for a staggering 81% of all default volume.¹²

But this cycle it was much shorter lived as those problem industries were a smaller portion of the high yield market than the telecom, media and technologies companies were back in 2000.  Additionally, we saw commodity and energy prices move up from the bottom and largely stabilize, easing much of the market overhang and uncertainty.

So as we circle back to today, where does that leave us?  Defaults are the major risk for high yield investors and on that front, we have seen the weaker energy and commodity players largely already dealt with and restructured (cleaned up their balance sheets and eliminated debt), and given we haven’t seen a rapid rise in energy prices (oil is still half of where is was in the summer of 2014), we don’t see another collapse brewing.  We also aren’t seeing aggressive issuance in the energy space, with energy at 14.7% of YTD issuance, exactly in line with the sector’s weight within the high yield index.¹³  But just because the energy concerns have moderated, are there any other problem industries on the horizon?  We’d certainly argue that retail has clearly become a challenged space, but this sector only accounts for under 4% of the high yield bond index.¹⁴  Of note, other than energy, no other industry comprises more than 10% of the high yield index.  Default rate expectations remain below historical levels for the foreseeable future.¹⁵

Looking at the broader high yield market fundamentals, aggressive issuance has gotten this market in trouble before, but YTD issuance has been well disciplined.  While issuance proceeds are up 8% versus last year, non-refinancing volume is at its lightest pace since 2011, with refinancing dominating the primary market at 64% of total YTD issuance, with merger and acquisition issuance at just 17%.¹⁶  Investors certainly don’t seem to be complacently just waiving in the deals.  Leverage statistics within the market are reasonable and still well below what we saw in 2007, currently at 4.4x, and interest coverage is strong at 4.1x¹⁷ indicating to us that management teams are continuing to exert caution as they look at empire building and growth opportunities (or lack thereof) going forward.

So again, while some may argue investor complacency in other markets, we don’t feel the same holds true for high yield.  Investors haven’t fallen asleep at the wheel over this cycle, as evidenced by the spread widening we saw just a year and a half ago.  Market technicals remain disciplined, as we see issuance dominated by refinancing and two way fund flows within the market.  Credit fundamentals remain reasonable, as evidenced by the leverage and coverage stats.  Moody’s recently reported their measure of liquidity stress was at a record low, as corporate liquidity has improved.  Defaults are tame and expected to remain so for the next couple years.

As we look at today’s high yield market caution is warranted, yes, but we certainly don’t believe it is time to run for the exits as investors may well miss out on valuable yield by doing so.  There are overvalued and very low yielding securities within the high yield market, or certain cases where we believe investors are overlooking key risks for specific credits. For instance, over 30% of the high yield index trades at a YTW of 4% and under¹⁸, which certainly doesn’t indicate value to us.  We believe investors should exercise caution by actively not passively participating in the high yield market—putting together an active portfolio versus buying a passive, index-based product—rather than avoiding the high yield market altogether.  Relative to the other fixed income options or equity valuations, we believe there is still attractive yield to be had by in investing in high yield bonds, but that value has certainly become less pervasive over the last year requiring investors to avoid aggressively stretching into credits we would classify as overly risky or to accept the very low yields offered by a notable portion of the market, which can create risks of their own via pricing risk if the security is trading above call prices or higher interest rate risk.  There is value but we believe investors should actively search for that value on a credit by credit basis.

¹  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.  Data sourced from Bloomberg for the period 1/1/2007 to 7/17/17.

²  The J.P. Morgan Domestic High Yield Index is designed to mirror the investable universe of the US dollar domestic high-yield corporate debt market, including issues of US and Canadian domiciled issuers.  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 5/17/17, 6/30/17, and 7/28/17, https://markets.jpmorgan.com/?#research.na.high_yield.  Spread is the month-end average spread to worst for the period 1/31/1994 through 7/27/17.

³  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High Yield Market Monitor,” J.P. Morgan North American High Yield Research, March 1, 2016, p. 1.

⁴  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 5/17/17, 6/30/17, and 7/28/17.  Spread is the month-end average spread to worst for the period referenced.

⁵  Acciavatti, Peter, Tony Linares, Nadia Nelson, and Moliehi Pefole, “2002 High-Yield Annual Review,” J.P. Morgan Global High Yield Research, January 2003, p. 63.

⁶  Acciavatti, Peter, Tony Linares, Nadia Nelson, and Moliehi Pefole, “2002 High-Yield Annual Review,” J.P. Morgan Global High Yield Research, January 2003, p. 12.

⁷  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 6/1/17.

⁸  Acciavatti, Peter, Tony Linares, Nadia Nelson, and Moliehi Pefole, “2002 High-Yield Annual Review,” J.P. Morgan Global High Yield Research, January 2003, p. 12.

⁹  Acciavatti, Peter, Tony Linares, and Nelson Jantzen, “2008 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 2008, p. 55.

¹⁰  Acciavatti, Peter, Tony Linares, and Nelson Jantzen, “2008 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 2008, p. 56.

¹¹  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High Yield Market Monitor,” J.P. Morgan North American High Yield Research, July 1, 2014, p. 20.  Data based on the percentage of the JP Morgan US High Yield Index, with Energy 18% and Metals and Mining 5%.

¹²  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Default Monitor,” J.P. Morgan North American High Yield Research, January 3, 2017, p. 4.

¹³  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High Yield Market Monitor,” J.P. Morgan North American High Yield Research, p. 15, 20.

¹⁴  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High Yield Market Monitor,” J.P. Morgan North American High Yield Research, p. 20.

¹⁵  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 6/1/17, 6/19/17.

¹⁶  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High Yield Market Monitor,” J.P. Morgan North American High Yield Research, August, 1, 2017, p. 8.

¹⁷  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 7/17/17.  Acciavatti, Peter, Tony Linares, and Nelson Jantzen, “2008 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 2008, p. 56.

¹⁸  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, constituents as of August 1, 2017.

Bloomberg Barclays US High Yield Index covers the universe of fixed rate, non-investment grade debt.  Index data sourced from Bloomberg.

Looking back at the historical data for the high yield market, high yield spreads are below historical averages and medians, but this makes sense given the below average default outlook, as we have noted in recent writings (see our commentary, “Mid-Year High Yield Bond Market Default Review and Outlook”).  And while spreads are below these average and median levels, they are well off historical lows.  Additionally, the premium to the 10-year Treasury is currently above the historical averages and medians, offering a 193% premium to the 10-year versus a historical average of 172% and median 148%.²

We have seen the high yield market mature over the past decade.  Arguably outside of certain energy deals, we are seeing more of the aggressive financing being done in places like middle market lending rather than via high yield debt.  So while the current coupon levels, and likely corresponding near-term return expectations, are not as high as they have historically been, we still see value in today’s high yield market, especially in the context of the broader financial environment.

We don’t expect that interest rates are going to take off.  Demand is a driver of growth and we don’t see demand for much of anything.  The global population is aging and labor rates will undoubtedly be impacted by this as well as technology, innovation and other social and behavioral changes we are in the midst of, be it electronic vehicles, the decline of brick and motor retail outlets, and the shared economy.  With little to drive growth, we don’t see a demand for money or inflation to move rates significantly higher.   The 5-year and 10-year Treasury yields are indicating that there isn’t much in the way of pressure on rates and or a strong demand for money.  Additionally, with all of the post financial crisis regulation, we do not see any systemic issues on the horizon.  Considering both of these factors, it makes sense that risk premiums are generally where they are.

Yes, we do see some securities within the high yield market that offer too low of a yield relative to the risk—be it aggressive leverage levels relative to the yield offered, or a security trading at a premium offering a very low yield to worst to investors, as many names are in the 3-5% yield range—but as active managers, we don’t have to invest in these securities.  Within today’s high yield bond and loan market we believe our active strategy makes sense and offers investors value from both a yield and duration perspective versus the indexes and many index-based products.

¹  Bloomberg Barclays US High Yield Index covers the universe of fixed rate, non-investment grade debt, data from Barclays Capital for 12/31/16-6/30/17.

²  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 5/16/17 and 6/30/17, https://markets.jpmorgan.com.

Passive investing, or index-based investing, is premised on the belief that markets are efficient, and prices quickly and thoroughly reflect information, thus consistently outperforming the market is difficult.  Investors don’t focus on the current earnings or outlook for a company, or generally even what a company does for that matter.  A passive or index-based product or vehicle will seek by replicate its underlying index by holding the same securities or a representative sample of the same securities and through that replication seek to achieve returns in line with the index.  So, the argument is to just by the cheaper passive product for whatever market sector you are interested in.  And this has worked over the last couple years as markets have been steadily, and seemingly indiscriminately, moving up.

But it begs the question, can decades of active investment management and numerous successful managers over this history just be an aberration or has something changed today?  Our answer to both questions is no.  Yes, markets have certainly gotten more efficient in their ability to disseminate and process information, which is even down to microsecond now with algorithms dictating buy and sell decisions.  But if markets were completely efficient, you wouldn’t see big moves in security prices on earnings results or other news items, and in many cases the first move isn’t always the lasting one.  For instance, on a weak earnings announcement or outlook, you may see a stock initially take a big move down only to recover much of that as analysts have time to process the information and the company offers further explanation via a conference call or other media appearance.  Or there may have been some investors who had a thorough understanding of the business and industry and foresaw the earnings decline and sold ahead of time.  Markets are two sided, you can turn on any financial news program and find two people arguing for different valuations and outlooks for a security—buyers and sellers are what create opportunities for investors and by no means do we see this as dead or a way of the past.

Additionally, many tout some market research that shows passive management as outperforming active management due to the cost of active management (generally higher fees as you are paying someone to actually do the investment work and analysis), but some of this research includes closet indexers masquerading as “active” managers, who still hold a large amount of securities like an index and only slightly deviate from an index but charge a higher fee.  True active management is focused on a specific strategy or investment philosophy, has a more focused portfolio, and generally relies on analytical and/or fundamental research.  Also many of the most successful active managers focus on the longer term, so there will be periods of underperformance but the goal is that the active manager will perform better over the longer term.

In the high yield bond and loan market, we especially view active management as important.  The passive argument will work fine until it doesn’t, and the selling hits.  We believe that what you do and, equally important, what you don’t own matters. Why blindly buy everything in an index (or virtually everything for the index products that hold a representative same), when the index does nothing to address risk other bank on the concept of diversification by holding a lot of securities.  The passive products can’t avoid or sell a security in which they see outsized risks, or even where yields being generated are exceeding low for the credit profile.  Active products are flexible in how they allocate money and can change their allocations given the market outlook, while the passive products can’t get defensive if the market environment warrants doing so.  Passive products don’t focus on value, whereby active managers can look to buy the right securities and at the right prices.

Another deficiency that we see with many of the passive products in the high yield market is that often they have as the underlying index a sub-index of the broader high yield market index, and that sub-index eliminates a large portion of the individual high yield issues.  Our own experience has been that it is often in these eliminated securities that we have historically found value.  Active managers have the ability and flexibility to access an entire market, even the securities that may not be included in an index or sub-index.

With the historically high valuations that we are currently seeing in a variety of financial markets, we believe investors are turning to passive management at the wrong time, at a time when we believe active investing becomes the most important.  In today’s high yield bond market we are seeing many securities trading a very low yields, in many cases around 3% and 4%, bringing down the total average yield on the index and the products that track them.  Yet with an active strategy, we are able to avoid these securities or sell an existing holding if the yield gets too low.  And while default rates remain low, we do see certain securities and market sectors as vulnerable, and as an active manager we have the ability to execute discretion in not investing in these securities.  We believe the ability to actively position your portfolio for a certain market and economic environment is important for investors, as is looking for value, especially in a market like we are seeing today where that value is harder to find.

Breakdown of U.S. Fixed Income Asset Class (as of December 31, 2016)

Corporate credit (high grade corporate bonds, high yield corporate bonds, and floating rate loans) is about $8.9 trillion of this pie. The high yield bond market is a large and growing market, now totaling $1.5 trillion in the U.S. and $2.0 trillion of U.S. dollar denominated high yield debt globally.²

If you add in high yield floating rate loans, that includes another nearly $0.9 trillion and together high yield bonds and loans account for nearly 30% of corporate debt.  One thing is clear, that the high yield debt market is a growing market, and we believe one that cannot be ignored for fixed income investors.

As we look at just who owns high yield bonds, the three largest categories of owners are pension funds, insurance companies, and retail mutual funds, all of which have relatively similar size of ownership at just over a quarter of the market each.³

With this we see both institutional and retail customers as active in the space. At $42.1 billion, high yield exchange traded funds (ETFs) account for about 14.2% of the total $296 billion “retail” high yield fund base⁴, which includes the much larger mutual fund counterpart.  High yield ETFs account for about 2.8% of the broader U.S. high yield market and have been around that level for the last five years, and loan ETFs are just over 1% of the total US loan market.⁵

While a very small portion of the total market, the place of high yield ETFs within the broader high yield bond market has been a discussion point over the last couple years, with some critics speculating that some widespread sell pressure in high yield ETFs could cause a collapse in high yield markets due to “liquidity” issues. We have previously explained how regulations post the financial crisis have led to less market making and lower dealer inventory of bonds, and the impact that has had on markets (see our piece “Understanding Market Liquidity”, “The Pricing Issue in High Yield“).

Flows in and out of these “retail” mutual and exchange traded funds (though we know that various institutions are buyers of mutual funds and ETFs as well) can be volatile week over week, but again, these flows pale in comparison to size of the total market.  For instance looking back over the last year and a half of weekly retail exchange traded and mutual fund flows (chart below)⁶, the second largest reported weekly retail outflow on record occurred in March 2017 and totaled around $5.68 billion.⁷  This amount compared to a $1.5 trillion U.S. high yield bond market means it is about 0.4% of the total market, so seemingly minuscule.

Over this period, the largest ETF-specific weekly outflow (and the largest ETF outflow on record) was $3.45bil⁸, so only about 0.2% of the total U.S. high yield market size.  Last week we saw the third largest ETF-related daily outflow on record and with that, the high yield market was down only 0.25%⁹, which certainly indicates that the market was able to handle the large ETF outflows without any significant disruption.

Not only do we see ETFs benefiting from their in-kind redemption mechanisms, in this environment of lower dealer inventory and heightened price volatility, we believe that high yield ETFs provide an advantage over mutual funds during more volatile times because ETFs trade/price intra-day, so we would argue provide a more accurate and true pricing mechanism for going in and out of the high yield market than mutual funds that only trade at the end of the day.

We see the high yield bond and loan market as an important piece of the fixed income asset class, especially in this global low yield and high domestic equity valuation environment.  We believe that high yield ETFs provide investors great accessibility to the asset class. And while the post financial crisis regulations may add an element of volatility to the market, we would view this volatility as an opportunity for active managers like Peritus who have the ability to capitalize on discounts and can be intentional about the credits they invest in.  While we have seen a strong year plus for the high yield market, we believe that there are still attractive opportunities within the high yield space for active managers who are able to search for value.

¹ From the publication “Outstanding U.S. Bond Market Debt” release by SIFMA, data as of 12/31/16. Loan market size as of 12/31/16 from Acciavatti, Peter D., Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li..  “Credit Strategy Weekly Update,” J.P. Morgan, North American High Yield and Leveraged Loan Research, January 6, 2017, p.51.  US High Yield Market size as of 11/30/16 from Acciavatti, Peter D., Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “2016 High-Yield Annual Review,” J.P. Morgan, North American High Yield and Leveraged Loan Research, December 30, 2016, p. 279, https://markets.jpmorgan.com/?#research.na.high_yield.

² Acciavatti, Peter D., Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li..  “Credit Strategy Weekly Update,” J.P. Morgan, North American High Yield and Leveraged Loan Research, January 6, 2017, p.51, https://markets.jpmorgan.com/?#research.na.high_yield.

³ Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2016 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 30, 2016, p. 296, https://markets.jpmorgan.com.

⁴ Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2016 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 30, 2016, p. 117-118, https://markets.jpmorgan.com.

⁵ Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2016 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 30, 2016, p. 117-118, https://markets.jpmorgan.com.

⁶ Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 6/23/17, 4/20/17, 2/3/17, 11/23/16, 10/26/16.  https://markets.jpmorgan.com. Leverage Commentary and Data, www.lcdcomps.com.  Based on weekly reported fund flow information, including Jon Hemingway, “HY funds see $899M of inflows in latest week,” 8/18/16; Matt Fuller, “US HY fund flows turn negative with ETF-heavy outflow,” 5/26/16; Matt Fuller, “Investors dump record $5B of retail cash into US HY funds,” 3/3/16.

⁷ Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 3/17/17, https://markets.jpmorgan.com/?#research.na.high_yield.

⁸ Leverage Commentary and Data, www.lcdcomps.com.  John Hemingway, “HY funds endure whopping $4.12B outflow,” 11/3/16.

⁹ Morning Intelligence, 6/22/17.  Daily return based on the one day return for the JP Morgan US High Yield Index.

As we sat six months ago, the expectation was for defaults to be 2.5% in 2017 and 3.0% in 2018, versus a 2016 level of 3.6% (see our piece, “High Yield Default Rate: 2016 Review and 2017 Outlook”).  As we hit the midpoint for 2017, the LTM default rate has fallen to 1.3% as monthly default volume continues to trend downward.²

While some seem to be concerned about the impact of potentially higher interest rates on the high yield market, investors need to be aware that the biggest driver of spreads historically is not interest rates (interest rate risk) but rather the default rate and outlook (default risk).  As we look forward, the default rate expectations for full year 2017 and 2018 have fallen to 2.0% or lower versus an expectation of 2.5% for 2017 and 3.0% for 2018 six months ago.³

This puts the default rate and expectations well below the historical average of 3.3%.⁴

Credit/default risk remains at the core of spread movement and, as we look over the next 18 months, we believe that the benign default outlook bodes well for the high yield market. Even with the spread tightening we have seen so far this year, according to J.P. Morgan’s research, the implied default rate based on current spreads in the high yield bond market is 1.7% versus an actual default rate of 1.3%, or 1.77% if you include distressed exchanges, and an outlook of 2.0% or lower for the next couple years.⁵ So while some may argue that the high yield market is expensive based on the current spread level, in looking at them relative to default rates and expectations, it seems reasonably valued.  Additionally, we believe that adding an effective active management overlay on top of this can help to further stem default exposure and potentially improve spread/yield value.

¹  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 6/1/17, https://markets.jpmorgan.com/?#research.na.high_yield.

²  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 6/1/17, https://markets.jpmorgan.com/?#research.na.high_yield.

³  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “Credit Strategy Weekly Update,” High Yield and Leveraged Loan Research, J.P. Morgan North American Credit Research, 6/16/17, p. 5-6, https://markets.jpmorgan.com/?#research.na.high_yield.

⁴  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 6/1/17, https://markets.jpmorgan.com/?#research.na.high_yield.  Based on monthly LTM default rates from December 1998 through May 2017.

⁵  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “Credit Strategy Weekly Update,” High Yield and Leveraged Loan Research, J.P. Morgan North American Credit Research, 6/1/17, https://markets.jpmorgan.com/?#research.na.high_yield.

As we wrote about at the beginning of the year (see our piece “Pricing Risk and Playing Defense”), our expectation was that we would see gridlock and delays in Trump getting anything passed—just as we are now seeing.  We also expected then, and continue to expect, that we won’t see much of a move in interest rates.  The lack of global demand and demographic trends are real and will have a lasting impact.  Inflation remains low and risks to growth persist in Europe, causing the ECB to continue with their quantitative easing when they met this past week.  In the US, Q1 GDP was the slowest in three years.  The population is aging and that will continue for decades to come, again, not favorable for demand growth of much other than maybe certain segments of healthcare.

When the Fed meets this week, we may see another rate increase.  However as we said back at the beginning of the year, if the Fed continues to raise rates, we would expect to see a flattening of the yield curve.

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 is that should the Fed pursue further rate hikes, we will likely see a flattening of the yield curve. We would expect that medium to long term interest rates will do nothing. (From “Pricing Risk and Playing Defense,” February 2017)

And that is just what we are starting to see, with the 2-year Treasury rate just at about where it was on March 13^th, when we saw the recent high of 2.62% on the 10-year Treasury, but the 10-year rate is now down almost 50bps from the March 13^th level.² 

We continue to expect that we won’t see much of a yield move in the longer-term Treasuries (5-Year Treasury rates and longer).  It is the 5-year and 10-year rates that are more relevant for us as high yield bond investors, as that is generally the issuing maturity range for high yield bonds and it is on those yields that spread levels are generally based.  While the Fed may well take a couple more rate increases over the year as they continue their slow move upward, we expect that to hit the shorter end of the curve more than the longer end.

As we close in on the half-way point for 2017, with our outlook for contained longer-term rates and unrelenting political gridlock, we continue to see selective opportunities in the high yield bond and loan space for active managers.  Investors need yield and a while we believe the broad high yield indexes and many index-based products tracking them are expensive at this point (just as many equity indexes and other asset classes are from our view), we do see specific opportunities for individual securities and, as an active manager, remain focused on capitalizing on these opportunities while still working to remain more defensive should volatility once again pick up as the political uncertainty and tempered economic growth continues.

¹  Data sourced from US Department of Treasury, for the period 11/9/16 to 6/9/17.  https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield.

²  Data sourced from US Department of Treasury, based on the yields for 2 year through 30 year bonds for the dates 11/9/16, 3/13/17, and 6/8/17.

As of the summer of 2014, energy related securities were 18% of the high yield bond market index², the largest industry concentration in the index by far.  As we saw oil prices slide, we saw the high yield bond market take a step back.  Once we started seeing oil continue to trend below the $50 price in early 2015, we started seeing the daily returns in the high yield market very tied to the daily moves in oil prices.³

Especially from early 2016 to early 2017 we saw that correlation between oil prices to high yield returns, as oil rebounded from the $26 WTI price low in February 2016 to the current level around $50, all the while the high yield market posted strong double-digit returns.

Over the last couple months we have seen returned volatility to oil prices; though while prices are moving up and down, often more than 1% in a single day, it has been within a tight range of about $45 to $50.  But, of note, over this recent period, we have seen a decoupling of the high yield market returns and oil prices.⁴

We have seen a steady move upward in high yield bonds, even on the days when we are seeing a fall in oil prices.  Factors other than oil prices are driving the high yield market, and to us that makes sense.  Many of the weaker energy related companies have already been weeded out and forced to restructure, with energy-related defaults at 12.4%, or 17.2% including distressed exchanges, during 2016, which accounted for 67% of total high yield market defaults and distressed exchanges for last year.⁵  Over the past few years, energy companies have been forced to become more efficient.  While energy remains the largest industry concentration within the high yield market at 15%⁶ and we do still see some vulnerable issuers within the high yield indexes if oil prices stay below $50 for a prolonged period (as the higher cost/highly levered producers will be pressured), given the restructurings we have already seen over the last two years these problem credits are not nearly as widespread as they were going into 2015 and 2016.  Furthermore, we don’t see much in the near to medium term to move oil prices significantly above or below this range—globally we are seeing some demand growth, but we are also seeing some supply come back on, especially here in the US shale regions, as prices hover around $50.

Thus as we look at the high yield landscape today, and the energy sector within it, we believe the “energy-contagion” may well to continue to have less and less of an impact, as investors focus more on the interest rate and economic environment and yield the high yield market has to offer investors.

¹  West Texas Intermediate prices from 7/1/14 to 5/31/17, sourced from Bloomberg.

²  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, June  27, 2014, p. 51 https://markets.jpmorgan.com/?#research.na.high_yield.

³  West Texas Intermediate prices price changes (%) and Bank of America Merrill Lynch High Yield Index daily total return from 6/30/15 to 3/31/17, data sourced from Bloomberg.  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.

⁴  West Texas Intermediate prices price changes (%) and Bank of America Merrill Lynch High Yield Index daily total return from 4/1/17 to 5/31/17, data sourced from Bloomberg.  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.

⁵ Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Default Monitor,” J.P. Morgan North American High Yield Research, January  3, 2017, p. 4-5, https://markets.jpmorgan.com/?#research.na.high_yield.

⁶  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, June  27, 2014, p. 48, https://markets.jpmorgan.com/?#research.na.high_yield.

U.S. Demographic Trends

Global Demographic Trends

This demographic shift has far reaching implications on a variety of fronts.  For us in the fixed income market, we believe that it will create a shift from equities into fixed income, and we are already starting to see the beginning stages of this shift.

For instance, pensions are increasingly focusing on portfolio immunization and liability driven investing.  Portfolio immunization involves matching the duration of plan assets with the duration of liabilities, while liability driven investing focuses on matching the future cash flow needs from the liabilities with the income from the assets.  Liability driven investing is often utilized by both insurance companies and pensions and requires consistent yield generation to provide the necessary income.  On the pension side, we are currently seeing growing allocations to bonds within defined benefit plans, while equity allocations have remained relatively steady.²

Looking at how that “bond” exposure in the graph above breaks down, we have seen the growth come from the Treasury security and corporate and foreign bond allocations.

We believe these global demographics matter not only for pension investing, but also for retail investing.  Be it in 401Ks, IRAs, or other individual retirement plans, as people near or enter retirement, they tend to focus more on income generation and capital preservation and less on growth—they want income they can live off of for years to come.

As we look forward, we expect the demand for Treasuries, corporate bonds, and other fixed income securities to accelerate as demographics take hold.  In turn, we would anticipate that this higher demand for assets like Treasuries and overall lower global demand of hard goods and services (consumption) caused by an aging population (who tend to consume more of healthcare but less consumption of many other hard goods and services) to further help constrain interest rates in the years to come (see our piece, “Pricing Risk and Playing Defense” for further detail).

It is also important to keep in mind this demographic shift as you consider the current state of the high yield market.  Pensions, insurance companies and retail mutual funds each own about one quarter of the high yield market, with the final quarter comprised of various other funds (hedge, equity, investment grade).³

Again, liability driven investing used by pensions and insurance companies requires consistent yield generation, and the high yield market can work to provide that yield, especially relative to the yield offered by other fixed income alternatives.  Considering these demographic trends, we believe this may serve to create a steady and lasting source of demand for high yield bonds as well.  As we look at the current high yield market, with spreads below historical average and median levels, we see this demand as another reason that spreads very well could continue to tighten further.  People are looking for yield, be it pensions, insurance companies, institutional investors or retail investors, and relative to many other fixed income options, the high yield market still offers what we see as reasonable yield for investors.

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/.

²  Federal Reserve Statistical Release, Financial Accounts of the United States, L.118.b Private Pension Funds Defined Benefit Plans, release date March 10, 2016, https://www.federalreserve.gov/releases/z1/20160310/accessible/l118b.htm.

³ Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2016 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2016, p. A154, https://markets.jpmorgan.com/?#research.na.high_yield.  Data for 2016.