It seems the best way to sum up on the markets of late is with the word “volatile.”  We’ve seen surprise moves on the currency and interest rate front from the likes of Switzerland and Canada and the launch of quantitative easing in Europe.  Russian hostilities are once again heating up and talk of a Greek euro exit.  Oil continued to hit new multi-year lows during the month.  There have been many major earnings disappointments, as factors such as a strong dollar and weakening demand weigh on multinational corporations.  Q4 GDP came in weaker than expected.  Thus, in January, we saw the Dow Jones Industrial Average move more than 100bps on the majority of the trading days in the month and both the Dow and S&P 500 fall over 3% on the month.  We’ve seen the 10-year Treasury yield fall from 2.17% to 1.68% and the 30-year Treasury yield fall from 2.75% to 2.25%, a decline of a whopping 49bps and 50bps, respectively.

While volatility is generally viewed as a negative thing in investing—in fact, risk is often measured in terms of volatility of returns—it isn’t always necessarily negative.  In reality, we believe that volatility can create some compelling opportunities for investors, especially for those that are actively managing portfolios.  But its nature, volatility often leads to issues in specific securities or industries causing contagion to other areas of the market.  This in effect can create securities that have been hit purely by that contagion, and for no other fundamental reason.

We believe this is exactly what we are seeing right now in much of the high yield market.  Some of this contagion from weakness in the energy sector and in equities has bled over into the high yield space, creating what we believe to be compelling opportunities in many non-energy related names for which we have seen no change in the fundamentals of the businesses.  Many of the high yield issuers tend to be relatively small, niche, largely domestic focused companies.  Thus we would expect many of them to be much less impacted by currency factors hurting large multinationals that are pervasive in investment grade corporates and the large equity indexes.  While the US economy has had some hiccups, we certainly don’t expect to see a massive economic decline here.

As we look at today’s high yield investment landscape, we are excited about the current opportunities we see.  Since last June, yields for high yield bonds have increased 1.79% and spreads for the high yield market versus Treasuries have increased 188bps to nearly 600bps.¹  Some of this is rightfully so in the energy names (see our recent writings on our concerns for US shale issues), but there is also much of the market that has been hit for what we see as no fundamental reason.  When we see prices decline and yields increase for what we view as no fundamental reason, we would view that as an attractive entry point.

To give the opportunity we currently see a little more tangibility, consider the statistics below:²

So since last June, the month during which we saw the recent lows in spread levels, we have seen the percentage of the index at a discount to par move from a mere 11.5% to over 37% and the percentage of the index at a yield-to-worst level of 7.5% or higher move from about 11% to just under 30%. This means that today, there are over 830 individual bond issues that are priced sub $100 and nearly 700 individual issues that trade at a YTW of 7.5% or higher within the Barclays High Yield Index. So as we look at the landscape, there are plenty of names to evaluate and opportunities offering what we see as attractive yield and capital gains potentials. Furthermore, we see this opportunity as even more attractive given the expectations for a benign default environment to continue, excluding certain sectors of the energy space.³

 While 2014 was characterized largely by the lack of volatility for most the year, and active management suffered as a result, we see those tables turning in 2015 as we expect this volatility to continue.  As we sit today, we see an attractive entry point into the high yield market for active managers who can parse through the space to determine where there is value to be had, and where there are value-traps.

1 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 26, 2014, p. 33 and January 29, 2014, p. 33, as represented by the JPMorgan High Yield Bond Index, which consists of fixed income securities with a maximum credit rating of BB+ or Ba1. Referenced spread is “spread to worst” and referenced yield is “yield to worst.” The yield to worst is the lowest potential yield that can be received on a bond, without the issuer actually defaulting, and includes the various prepayment options such as call or sinking fund.  The spread is the spread to worst based on the yield to worst less the yield on Treasuries.

2 Based on our analysis of the Barclays Capital High Yield index constituents as of the indicated dates. Barclays Capital US High Yield Index. Formerly the Lehman Brothers US High Yield Index, this is an unmanaged index considered representative of the universe of US fixed rate, non-investment grade debt.

3 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. 14. See data in our piece “The Year Ahead: High Yield, Energy, and Interest Rates.”

The Bank of Canada surprised markets today by cutting rates.  With a Federal election approaching, an argument could certainly be made for some political angling.  Regardless, the reaction of the Canadian dollar was swift and immediate, plunging almost 1.5 cents against the greenback.  The Eastern provinces focused on manufacturing benefit from a very weak C$, as it boosts competitiveness in the export markets.  Importantly, the oil industry also benefits as they are receiving primarily US dollars for selling oil, against Canadian dollar expenses, helping to improve profit margins.  This, along with tight differentials for heavy oil (referring to the price of WCS, Western Canadian Select, a heavier grade of crude oil, versus WTI, or West Texas Intermediate), provide some powerful offsets to crude’s pricing implosion and we expect will benefit many Canadian oil producers, an area of the market in which we have been strategically positioned.  At some point, we believe that oil prices will stabilize and these fundamentals will be recognized and rewarded.

Investors are often led down the path that they must invest in equities in order to generate a decent return, and that the high yield market is too risky and speculative.  However, reality and the data points suggest otherwise.  Looking over the past couple decades and various periods in between, you can see that high yield has outperformed the equity market (as measured by the S&P 500 Index) on a risk adjusted basis (return/risk) over the past 5, 10, 15 and 25 years, and performed equivalently over the last 3 years.¹

Here, risk is defined as standard deviation, or volatility of returns.  Even taking into account the enormous technology and internet rallies of the late 1990’s, high yield bonds have performed only slightly lower than equities over the past 25 years, but with nearly half of the risk (standard deviation), for a significant risk adjusted outperformance.³

Looking at that “riskiness” of the high yield asset class in another way, investors need to remember that in a company’s capital structure, equities fall below bonds, no matter the bond rating (investment grade or high yield).  This means that in any sort of difficult situation, the bonds get paid back first.  Further, as the data above shows, high yield bonds have much lower risk as measured by volatility (annualized standard deviation), giving high yield bonds what we see as a significant return/risk advantage.

The data speaks for itself: it seems to be time for investors to reconsider their sizable allocations to the equity market and instead, consider an increased allocation to the high yield bond market.  We believe that the compelling historical long-term returns profile and lower risk (volatility) relative to equities warrants investors paying more attention to the high yield asset class and that it supports the argument that high yield should be a core part of an investment portfolio, especially in today’s low-yielding environment. And with the advent of high yield exchange traded funds, accessing the high yield market is now available to retail and institutional investors alike.

¹Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 29, 2014, p. A144. “High Yield Bonds” as represented by the JPMorgan High Yield Bond Index, which consists of fixed income securities with a maximum credit rating of BB+ or Ba1.

² Sharpe ratio consists of annualized returns divided by the annualized standard deviation of return.

³ Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. 123.

2014 will go down as a year that was a “statistical champion” as both stocks (as measured by the S&P 500 and the Dow Industrials) and bonds (the more interest rate sensitive asset classes) had very good years. It was a year of duration over credit. What we mean is that interest rate sensitive sectors (Treasuries, mortgages and investment grade) dominated, while credit (high yield bonds and loans) were beaten down. At the beginning of 2014, we were one of the few firms calling for flat to lower rates, but even we did not see an 80 basis point move down in the 10-year Treasury.

So where does that leave us as we head into 2015? Stocks look extended. They are not cheap by any measure but the party continues until it doesn’t. How about bonds? Wholesale selling of the high yield asset class due to its large exposure to the energy industry has created what we see as attractive entry points into numerous names that have nothing to do with the energy markets. We did not see these types of discounts going into 2014. While we don’t expect interest rates to rise much in 2015, they are unlikely to fall and become a tailwind for longer duration asset classes, such as investment grade bonds. Read more of our piece, “The Year Ahead: High Yield, Energy, and Interest Rates,” click here.

As we have discussed in our recent writings, we have been strategically allocated to the energy sector in our portfolios and, as such, have been hit by the decline in energy prices, as well as general high yield market contagion, with the meltdown in energy exploration and production (E&P) credits spreading to the overall high yield and loan markets.  We believe that in today’s broader high yield market we are now seeing a disconnect between fundamentals and pricing and that disconnect has created what we see as an attractive entry point into the high yield asset class.

We have been and continue to be strategically positioned in the oil and gas industry, and that positioning has and continues to be very intentional.  While oil prices have fallen below $60 per barrel for the time being, we believe prices below $80 are unsustainable and have provided chapter and verse as to why (see our piece, “Rome Is Burning”).  Simply put, costs of unconventional oil (where the production growth actually is) are high and returns must be there for production to continue.  This includes certain tight oil plays (i.e., US shale producers), along with deepwater and oilsands.  There is limited growth in production globally outside of these areas.  The Saudis know this and will keep the heat on.

We believe that the law of unintended consequences may ultimately lead to a collapse in production not only from the US, but Venezuela, Libya and Nigeria as well.  For instance, just last week, Libya announced that infighting within the country causing the closure of two of the largest ports has led to a significant decline in production.  The world is not as well supplied as many believe.  Thus we would foresee that as production/supply takes a hit, this could lead to a dramatic rebound in oil prices on a supply/demand imbalance, as we continue to see growing global oil demand needs.

Turning to the US, domestic shale producers who are levered are experiencing bond price declines in some cases of up to 30-50% over the past couple months.  We are not invested in these US shale producers, as we believe that defaults will be real and recoveries may be minimal for many investors.  Many of these “businesses” have huge decline rates, we’ve seen reports that in some cases they can even be upwards of 70% per year; thus we would view them more akin to “projects” than real, sustainable businesses.  Even prior to the oil price decline, it was our opinion that these basins will be drilled out and start declining in the next few years, and with current price points we would expect decline that may well accelerate.

These huge decline rates in shale matter because it means that large capital spending, and equity and debt financing to fund that spending, is required to keep production steady at best in many cases.  While other players in the space, such as the oilsands producers up in Canada, have the ability to meaningfully cut back on capital expenditures and conserve cash during these periods of low oil prices, without taking a massive hit on the product front, we don’t see this same ability with many shale producers, which can quickly lead to a downward spiral for both the bonds and equities in these companies.

We have very specific energy themes, such as focusing on Canadian producers, service providers, and midstream companies, and have been very intentional as to what we hold and why we hold it.  Looking at the general high yield space, at over 16% of the high yield index, energy is the single biggest industry by a factor of two (healthcare is just over 8% of the high yield index)¹ and must be dealt with by income-focused investors whether that is through high yield markets or MLPs (master limited partnerships), which also tend to have large exposure to energy.  Investors need to understand what is underneath the energy exposure they do have.

¹ Based on the J.P. Morgan US High Yield Index.  Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update.”  J.P. Morgan, North American High Yield and Leveraged Loan Research, December 12, 2014, p. 42.