Volatility has seemed to be the trend in markets over the past couple months.  It was just a few weeks ago that we saw equity markets getting crushed, only to roar back and actually finish up for the month of October and back near all-time highs.  It makes no sense to us that investors have no problem dealing with volatility in stocks, “investing for the long run,” as the stock market has historically gone up, but with the high yield asset class, we often see the “risk on” or “risk off” mentality, meaning investors think they should either be fully invested or out of the market altogether.

In reality, over the long-run high yield bonds have actually performed relatively equivalent to equities (as measured by the S&P 500 index), with nearly half of the volatility, or “risk,” as measured by the standard deviation.  This has led to risk adjusted out performance (return/risk) over the history of the high yield market:¹

People seem to often view the high yield market as an all or nothing trade, with its attractiveness merely based on short-term measures.  Yet we believe its true attractiveness is the steady income it provides, in both up and down markets, and potential for price appreciation/capital gains.  As we look at the high yield market today, the recent re-pricing of the market over the past few months has created what we see as exceedingly attractive opportunities for yield, as well as discounts (pricing below par and call prices) that we have not seen in some time in many names, allowing for more potential opportunities to realize capital gains.

What many investors don’t grasp is that you can actively position businesses and industries in a fixed income portfolio the same way you can equities.   The difference is that we get paid every day as our securities accrue interest and we have finite outcomes via stated maturities², which helps us remain patient.  So why not collect the regular income generated (coupon payments) and enjoy a market that has historically had nearly half the volatility as as the stock market?

1 Credit Suisse High Yield Index data from Credit Suisse. S&P 500 numbers based on total returns. Calculations based on monthly returns and standard deviation is calculated by annualizing monthly returns. Return/risk is based on annualized total return/annualized standard deviation.  The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. Use the links below to download index data and constituents. The S&P 500® is a market-value weighted index of 500 selected common stocks, most of which are listed on the New York Stock Exchange. It is widely recognized as representative of the equity market in general. Values based on monthly compounding.

2 Bonds and loans have stated maturity dates as the ultimately outcome, barring a security default. However, there may be reasons that a bond or loan is taken out earlier, such as due to early calls or tenders at premium prices. Actual results may differ materially from the stated maturity.

The concurrent storms in energy and the secondary bond/loan markets have tested our mettle. However, we believe that both of these will pass as quickly as they came, but provide fantastic entry points for thoughtful investors as there is a hard cold reality every investor is facing: interest rates (yields) remain paltry and we expect will continue to for the foreseeable future. We ultimately expect the underlying fundamentals in certain segments of the energy sector will be realized and now are seeing yields and discounts (to par) in the broader high yield market that we have not seen for some time. This compares to an equity market where we expect valuations to struggle to move higher in a world of slowing growth. For more on our thoughts about financial markets and outlook, click here to see our latest piece, “Rome is Burning.”

The tally is in and it was a very bad evening for the Democratic party.  Senate races in Iowa, North Carolina, Georgia and a host of other States went red.  Alaska is still to be determined (likely Republican) and Louisiana is slated for a run off.  All told, it looks likely the Republicans have garnered a solid majority in the Senate (up to 53-54 seats) and the biggest majority in the House (over 246 seats and counting) since Truman 60 years ago.  This certainly seems to have surpassed the nightmare scenario envisioned by the Dems.  While the markets may enjoy a honeymoon rally, it always fades.  Gridlock is still assured as bills submitted to President Obama can be vetoed.

But we see some potential positives for our strategic investments in the oil sector.  Two things jump out at me.  First, the Keystone XL seems likely to be approved.  While a veto is possible, the hit suffered by the Democrats may have been severe enough to push this through.  It could get tied to some additional legislation, but I’d say the odds are good for approval.  Ironically, the oil industry has found many ways around this through rail and barge and pipeline reversals, but the Gulf Coast refining complex is desperately in need of heavy sour crude (not the light crude provided by the “shale” guys).  Venezuela and Mexico have been the biggest suppliers of this product and neither of them look sustainable.  Was it any wonder that Warren Buffett went long Suncor (the largest Canadian oilsands producer) some time ago?  So we would expect the Canadian heavy oil producers could get a nice boost.  As we have noted in our prior writings, we are favorable to the Canadian exploration and production companies and have made strategic investments in the space.

Also likely is the elimination or easing of the ban prohibiting the exporting of crude oil.  The delusion that is being suffered by both parties is that of “energy independence.”  At the risk of repeating myself for the 700^th time, we are producing around 9 million barrels of oil per day.  This includes a large percentage of super light oil (condensate), which much of the US refining complex, built around processing heavy crudes, has no need for.  Hence the concept of exporting it.  But we consume around 19.5 million barrels of oil per day.  How is that “independent”?  While we are all enjoying the lower gasoline prices, I don’t believe they will be around very long.  Perhaps just long enough for consumers to load up on trucks and SUVs and crush any notion of an electric car industry.

My take remains the same.  US growth in production has been impressive and a nice salve to control world oil prices.  I expect that in the next 2-3 years that production peaks and then fades.  Perhaps it dies a different death as investors begin to focus on the decline curves of these wells and the lack of a sustainable business model in many cases.   Outside of the US, production growth looks non-existent.  It seems that Libya, Nigeria, Venezuela, Iraq and a host of other producers are all unsustainable and the world’s spare capacity is not what it is stated to be.

We view last night’s election results as an incremental positive for the oil industry and continue to expect higher oil prices in the long-run.

Peritus was mentioned in the article, “This ETF is drilling for high yield,” by MarketWatch, October 30, 2014.

It was hard to ignore the call in the fixed income space for “short duration” investing over the last couple years. Duration is a measure of interest rate sensitivity (the percentage change in the price of a bond for a 100 basis point move in rates), so the lower the duration the theoretically less sensitive those bonds are to interest rate movements. Lower duration bonds would not eliminate the interest rate impact, just lessen it. We see this as a good strategy broadly speaking if you are talking the high yield asset class versus the investment grade asset class, with the high yield market naturally having a much lower duration due to its higher starting yields and generally shorter maturities. However, we believe this strategy is lacking when it is used to parse out the high yield space itself, investing in only the lower duration names within the high yield category, irrespective of other considerations.

This gets back to the concept of yield. In a box, this sounds like a good strategy, but you need to factor in the starting yield on the portfolio to mathematically assess if practically speaking this is the right strategy. If you were to invest according to a “short duration” strategy in the high yield debt market, let’s hypothetically say you could achieve a portfolio with a duration of 2.0 years, so a 100 bps change in rates over 6mos would mean that the price of your portfolio would theoretically decline by 2.0%. If your starting current yield on the portfolio was 6.5%, meaning you theoretically generate 3.25% of income over that 6mos, then you are looking at a theoretical net gain of 1.25% (3.25% – 2.0%) over the period of rising rates. However, if you can build a portfolio in the high yield bond and loan market investing according to both maximizing yield and considering duration, let’s say you can build a portfolio with a duration of 2.5 years and a current yield of around 9%. In this case, your theoretical sensitivity to a 100bps movement over 6mos would be a price change of 2.5%, but you would be theoretically generating 4.5% of income over the 6mos, so your net theoretical gain would be 2.0%. If that 100bps interest rate movement is over a year instead of 6 months, that yield benefit gets even larger, putting you at a theoretical net gain of 4.5% for the hypothetical short duration portfolio versus a theoretical gain of 6.5% for the higher yielding portfolio.¹

But you also most consider what if rates don’t rise, then what? It seemed the short duration investing was the big trend heading into 2013 as virtually everyone thought rates were going to rise, and the trend hasn’t abated as the year has progressed. However, that rate increase hasn’t played out, as rates on the 10-year Treasury ended 2013 at 3.04%, and now sit around 2.2% today. As noted above, duration is a measure of price change based on a change in interest rates, and that price move works in both directions: a theoretical price decline if rates rise as we have profiled above, but also a theoretical price increase if rates decline. So in an environment such as we have seen so far this year, with rates declining, then the higher yielding portfolio would not only benefit from the higher starting yield but a theoretical positive price movement per the duration calculation.¹

So we see this as compelling evidence that investing purely according to a short duration strategy and not factoring in yield is not necessarily the wisest way to approach this market and the seemingly ever present interest rate concerns. At the end of the day, yield matters. A higher yield can go a long way in making up for relatively small differences in duration. Furthermore, even if rates do rise, it very well can take longer than many expect (many were certainly wrong on how 2013 would play out!), making the argument for the higher yielding portfolio versus the purely short duration portfolio even stronger.

For more on the high yield market’s historical performance during periods of rising rates and the current strategies in place, and their deficiencies, to address the rising rate environment, see our piece “Strategies for Investing in a Rising Rate Environment.”

1 The duration and price movement relationships are approximates and calculations are provided for illustration only. These calculations assume that credit spreads remain constant and do not factor in any fees or expenses or changes in price movements for other reasons, including security fundamentals, etc. Actual results may be materially different.

Peritus was mentioned in the article “One Country EM Bond ETF Investors Need to Watch” by Todd Shriber of ETF Trends, October 21, 2014.