High yield bonds performed well again this week, driven by continued strong technicals and a good start to the Q1 earnings season, and despite a late-week sell-off in the equity markets. For the week, the spread on the Bank of America High Yield Index (BAML) tightened 8bps to 594bps over Treasuries, while the yield on the index tightened 9bps to 6.98%. It’s important to note that we’ve traded through 7% and 600bps on the index, and so far this year we have failed to hold these levels for very long after trading through them. For returns, the BAML HY index was better by 0.70% on the week, bringing the YTD total to 6.78%. The total return for the BAML HY Index for April was 1.35%.*

This week’s inflows in to the high yield market were the largest since mid-February, with $1.2 billion in fresh capital flowing into the asset class via ETFs and mutual funds. The new issue market continues to function, but the pace has slowed significantly from the beginning of the year, causing high yield investors to focus on the secondary market to put new money to work, in turn driving prices up as demand through inflows overwhelms supply.  Against the backdrop of strong corporate earnings, a prolonged low interest rate environment and a flat- to slow-growth economy, we believe the yield offered by owning the high asset class is still very attractive and demand for high yield bonds should remain robust for the foreseeable future.

* Data sourced from Bloomberg.

The high yield market traded better again this week, as cash continued to flow back into the market after the large outflow of a couple weeks ago, and despite some disappointing U.S. economic data and the ever present European market fear. For the week the spread on the Bank of America High Yield Index (BAML) tightened 12 bps to 602bps over Treasuries, while the yield on the index was 16bps tighter to end the week at 7.07%. So far this year the high yield market has not been able to hold levels inside of 7% and/or 600bps. For performance, the BAML HY index returned 0.67% bringing the month to date total to 0.85% and 6.05% year to date.*

After the big outflow from the high yield market a couple weeks ago (-$1.3 billion), demand has turned sharply positive with inflows last week of $644mm and again this week totaling $637mm. We’ve now had inflows in 20 of the last 21 weeks, with over $26 billion entering the space over that period. With the overall tone of the market continuing to improve this week, high yield primary market activity picked up with 17 deals pricing for proceeds of $6.5 billion, brining YTD activity to over $128 billion.  With YTD returns of over 6%, a market that is still yielding over 7% (a nice premium to Treasuries up and down the curve), and the reality that investors have few options to pick up incremental yield away from the high yield market, we expect that money should keep flowing in to the high yield asset class. At these levels we continued to find this market very attractive.

* Data sourced from Bloomberg.

I find it very interesting that the misnomer remains that investing in the high yield asset class is an all or none trade.  First of all, we agree with some of the recent market commentary that the passive and index-based ETFs and mutual funds should be avoided because they are thoughtless trades in an asset class that requires thought.  But bonds are not stocks.  They do not require markets to go up and expectations to get beat.  They require the lender to pay the interest rate and refinance at maturity or call date(s).  There is an exit strategy built in.

Additionally, we have written chapter and verse about the A to E (amend to extend) issues in the very large LBO’s from the 2006-08 vintage.  These loans will be coming due in the coming years and these companies will have to deal with these capital structures that in our opinion are unsustainable.  This means that the bonds in these issuers will default.

This does not mean that high yield bonds are bad as a general asset class; rather, it means that you need discipline to avoid the silliness that comes with money flows and good times.  Use of proceeds is one flag.  Refinancing debt, general working capital and/or acquisitions have to be analyzed, but generally pass the first smell test as legitimate needs.  When you see large dividends taken out by equity sponsors, it’s a red flag.  Even if the dividend does not destroy the credit metrics (i.e., significantly increase leverage), you may be creating a problem down the road.  Private equity sponsors tend to be good partners because when companies run into problems, they generally put more equity in to keep them alive and provide their own investors a hope certificate, continuing to confuse their investors about their rates of return (i.e., they don’t mark their holdings down as they calculate returns inside of the private equity vehicle).  However, if the private equity guys have already extracted some or all of their initial investment via a dividend, what incentive do they have?

The bottom line is that the high yield asset class needs to be viewed as a permanent asset class in a portfolio, not a “trading vehicle.”  High yield bonds and leveraged loans are a $2.5 trillion asset class combined.  After 30+ years of data, high yield bonds provide better or equal returns to equities, provide immediate and tangible returns through cash flow, and have less than half the risk of equities.*  Why do they continue to be viewed as a trading vehicle?  Actively managed high yield provides investors what they want:  tangible cash flows with manageable and largely knowable downside.

* See our piece, “The New Case for High Yield” for source details and further data.

I just don’t get it.  Over and over again, we hear commentary that the market is moving up or down driven by the prospects of further Federal Reserve intervention.  When hopes dim that the Fed can or will do further quantative easing or raise rates earlier than 2014, the market turns down.  Yet, on days like today, when those at the Fed, here Bernanke himself, hint at the ability and willingness of the Fed do more to help the economy should it be warranted, the markets embrace the news and head higher.  Shouldn’t it be the opposite?  Shouldn’t we be cheering that the Fed won’t be stepping in with further intervention or will be raising rates sooner than expected?  Rationally speaking, that would seem a positive signal as that would mean that we are heading in the right direction and the economy is showing steady signs of recovery.  The only reason for further quantative easing or leaving rates low for an “extended period”  is if the economic recovery stalls.  In this bailout nation, have we become so dependent upon government intervention to drive the market up?  I am afraid so.

As an investor, I care a lot more about reality; I am certainly not going to rely on the government to pick up any slack in the economy to drive my returns in any way.  Here at Peritus, we focus on the company’s fundamentals, ability to generate cash and service their debt structure, and what sort of margin of safety there is should there be a stall in any economic recovery or a further demand hit.  We aren’t betting on the economy to improve dramatically and the jobless rate to decline, nor are we betting on further Fed easing/intervention or for rates to stay low for an “extended” period.  We face the reality of the environment we are in:  we see little to drive growth, unemployment to remain high for the foreseeable future, and a muted and prolonged recovery at best, and as big boys and girls, we’ll deal with it as we invest rather than hoping someone will come in and manipulate things in our favor.

The high yield market traded with a much better tone this week, bouncing back from last week’s negative return, on a good start to the Q2 earnings season and despite widening sovereign yields in Europe. For the week, the spread on the Bank of America High Yield index (BAML) tightened 12bps to 614bps over Treasuries, while the yield was 14bps tighter to 7.23%. For performance the BAML index returned 0.38% on the week, bringing the year-to-date total to 5.34%.

High yield bond mutual funds and ETFs reported inflows of $637mm this week after last week’s big outflow of $1.29 billion, which had brought an end to the 18 week inflow streak. Still we’ve had 19 inflows in the last 20 weeks with over $25 billion moving into the asset class over that period. For the week, nine new high yield deals priced for $3.1 billion in total issuance bringing the year-to-date total to $122 billion, outpacing last year’s total of $107 billion over the same time period.

Is this a surprise?  When you live deep in the sea of corporate financials, you have a good take on what is going on in the world.  Unlike many investment advisors across the U.S., Peritus actually builds financial spreadsheets and profiles on each and every company we are looking to own or do own in our client portfolios, whether it be our ETF (ticker HYLD), our separate accounts, or our CBLO’s.

In doing this nitty gritty work you discover how the economy is really plugging along and what is impacting it either to the positive or negative.  You can also decipher the extent of demand for the product or service.  Our index-based/passive brethren and large mutual funds do not do this kind of work.  They put hundreds and hundreds of securities in a fund and then sell you sunshine through an economist and say the water is fine, come on in.  These economists are glorified sales people, as I have heard very few of them talk negatively about the economy.  Why?  They only make a bonus if assets are going up, not if you are selling their fund.

If you look at the data points from the Empire Manufacturing, to jobless claims, to consumer comfort, to Philadelphia Fed, to home sales, you will see that all of these disappointed versus expectations.  This is proof that people are still maintaining their lifestyles, but not spending beyond their means, so there is nothing to drive demand up.

Where do you make money in this environment?  The stock market is up over 30% since the most recent fall on blah economic statistics.  If the economy is growing at 2%, why is the stock market up 30% in 6 months and has doubled in value since the 2008 crisis?  Some of this rebound is expected as prices of stocks and bonds did as they always do: trade to the extreme.  But we see little to justify a further move in equities.  In the corporate bond-land, you only need for your companies/investments to maintain their existing business status to get paid.  If you can lock in a double digit current yield with a duration under four years, why would you not put a big allocation there?  We are seeing these sorts of credits available in the high yield market.

Your job is to find a manager that has a lot of experience in this asset class, and a track record of delivering returns.   You need to have the manager that does due diligence on every company in the portfolio and is not just buying one of everything and saying you are diversified.  You need to have an investment instrument that can deliver this product to you with transparency and liquidity.  Peritus is a manager with these attributes.  Visit www.advisorshares.com/fund/hyld to find additional details.

Happy investing, as we have years more of this economic state.

The second quarter is off to a shaky start:  following the pace of the equity markets, the softness in the high yield market continued yet again this week.  While the equity markets were down 1-2%, the Bank of America Master High Yield Index (BAML) was down only 0.35% on the week.  The market have been roiled by continued concerns in Europe, now focused more on Spain and Italy, and some weaker economic data here at home.  Looking at the various indexes, we see the following:*

This week we saw new issuance of $5.6billion over nine deals, now putting year-to-date issuance at $109.5 billion over 220 tranches issued.  Despite the continued strong new issuance market demand, we saw demand in high yield mutual funds and ETFs wane, with an outflow of $1.293 billion for the week, according to Lipper-AMG.  After the very sizable inflows through the first quarter, this is a significant turn; however, it is still too early to tell if the trend will continue and impact the market from a technical perspective.

As we look at our portfolio and potential investments, we continue to see solid companies with attractive yields and well above average spreads.  We feel that our attention to fundamentals and security selection process will serve us well in this environment.

*Data sourced from Bloomberg, 4/13/12.

High yield is an asset class where active management is essential to performance.  There is a certain degree of volatility to the high yield market and inherent risks that must be monitored and managed.  There are also continual opportunities—and opportunity cost trades—that should be capitalized upon as the manager looks to maximize return and/or lower risk.  With an actively managed portfolio, we are able to invest in what we see as the best risk/reward opportunities in the high yield bond market.

The biggest risk in managing high yield bonds is default: while there may be some noise in pricing over the holding period, what an investor really cares about is whether or not they get their money back by maturity, and get all of the interest payments expected.  As an active manager, managing that risk is our primary job—and just looking at a credit’s rating is an extremely inefficient way to manage that risk.  Peritus has a saying: “Credit is either AAA or D.”  If the credit is paying, it is effectively AAA; if not, it is in default.  Corporate credit ratings by their nature are favorably biased towards the company’s size and longevity and are reactive rather than proactive.  Sometimes history can be incredibly misleading, so an astute investor needs to look both at the past as well as their outlook for the future.  At Peritus, we look to the fundamentals and valuation of the company rather than the ratings and can capitalize on the fact the rating agencies often get it wrong.  We prefer to lend to companies that have high market shares and generate free cash flow, and that we believe will continue to possess these characteristics in the future regardless of their history or their rating.

In considering default, or credit, risk there is a significant misunderstanding in the high yield space about default and recovery rates.  The Altman data goes back through the history of the asset class (1977 to present) and according to this, the average default rate is approximately 3% with the average loss rate (factoring in the recovery on the holdings) of just over 2%¹—so not vastly different than what has been experienced by the loan market (and this doesn’t take into account the higher yield generated over the holding period in bonds versus loans).  However, this high yield default data is skewed by a couple of cycles.  First, the buyout bust of 1990-1991.  Leverage metrics became silly and the default and recovery cycle was quite predictable and avoidable if you were a conscientious bond investor.  Yet, the largest skew to the data comes from 2001-2002 when the TMT cycle (telecom, media and technology) was vaporizing.  ILEC’s, CLEC’s, RLEC’s and a host of other telco business plan financings were done in the very hot high yield market instead of where they belonged….in the venture capital camp.  Once again this market was avoidable for anyone with discipline and a calculator.  The 2001-2002 cycle pushed recovery rates well below average because many of these telco startups provided no recovery for bondholders.  The lesson is that active management is all about saying no and avoiding those defaults: it is what you don’t buy that determines your destiny, not what you do buy.

In today’s market, that same discipline is essential.  There are plenty of names to avoid, and others that offer a better risk/reward profile that must be actively sought out.  While all markets have rallied significantly since the beginning of 2009, high yield bonds continue to possess sizable spreads as measured by the yield advantage over 5-year Treasuries.  Our bond portfolio possesses spreads of some 900 basis2 points over the 5-year Treasury which is well above historical medians of just over 500bps³.  Additionally, corporate credit metrics have seemingly never been this solid in the 28 years I have participated in this market.  Default rates will likely continue to be substantially below historical averages over the coming two or three years, as the massive refinancing wave of the past three years has effectively extended maturities and liquefied balance sheets.  I would also surmise that recovery rates will continue to trend higher.  We see it as a great time to be a high yield investor.

¹ Blau, Jonathan, Daniel Sweeney, and Karen Friendlander. “2011 High Yield and Leveraged Loan Default Review.” Credit Suisse Global Leveraged Finance. January 9, 2012, p. 10.

² The portfolio referenced is the weighted average yield to worst for Peritus’ model high yield bond portfolio (approved list of investments and targeted allocation percentages) as of April 9, 2012. The model portfolio does not represent actual trading. Depending on the timing, market conditions, use of leverage, portfolio size, and other factors, the actual portfolio could be materially different. Prices and other statistics are subject to change.

³ 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. April 5, 2012, p. 14. 20 year median is 523 bps.