There is a lot of talk about how the default rate will pick up and how high yield should be either avoided or the allocation should be lowered.  I don’t necessarily disagree with this take if you are getting exposure to the high yield asset class through the largest ETF’s (HYG and JNK) or the large mutual funds, via the likes of Loomis, Alliance or Putnam.  All of these funds are huge in size and generally own the same securities that are in the high yield index, and as I write this, all in fact own Residential Capital, with the exception of JNK.  JNK may have previously held ResCap too prior to the BK, as many index funds are required to sell as soon as a BK is initiated.

The difference between the index funds/large mutual funds and an actively managed strategy is that the index and large funds have no ability to avoid these types of companies that are potential defaults.  JNK and HYG have to own the whole index, whether it is a solid credit or not.  The mutual funds own many of these same names because they are so big they have to buy all new issues in order to get any allocations and own many of the largest credits because they need liquidity for redemptions.  An actively managed strategy is one where you actually look at the cash flow statement and work your way back to the balance sheet to make sure you have a margin of safety built in.

Will defaults rise going forward?  This could be a real possibility if some of these companies can’t maintain their business in the current economic environment.  This is why you pay an active manager, with many years of experience in analyzing companies and investing client money, to work to avoid these defaults.  Over time, we believe that if you can avoid defaults through an actively managed strategy, you should outperform the other strategies that don’t have this sort of flexibility.

For further details on Peritus’ actively managed strategy, visit www.advisorshares.com/fund/hyld.

So each earnings season, I am interested to see what their take is on the consumer.  One thing that I found interesting in their comments this quarter was that they have seen a pretty sizable move in the end market from branded pet food to private label (read: cheaper) pet food.  Basically people continue to feel pressure to cut their expenses in any way that they can, and moving to cheaper pet food is just one way they are doing that…and according to the American Pet Products Association 62% of Americans own pets, so this is a significant cross section of society.  This is another piece of anecdotal evidence to support our take that there is little to spur the consumer, the main driver of our economy and, as investors, we need to factor this reality into the decisions that we make in allocating money.

Let me give you some recent headlines concerning the world and the U.S. economy.

• The Eurozone is essentially back in a recession, had it not been for Germany, technically it would be.
• The US is hovering at a 2% growth rate.
• China has slowed more than forecast and the talk now is one of stimulus.
• Atlantic City’s April gaming revenues decreased 15%
• Producer Price Index was -0.02 for April
• Consumer Price Index was +0.0 for April
• ADP Employment Change was up only 119K vs. estimates of 170K
• Factory Orders were less than forecast
• Announced Job Cuts were 11% higher over last year
• Average hourly earnings were below last year’s
• Consumer Credit jumped to $21B more than 2X estimates

If you factor all this in, what do you get?  You get an economy that only grew at a meager 2.2% in Q1 and this was apparently fueled by the consumer borrowing money and using credit cards.  The U.S. economy is powered by the consumer—you, me, grannie and all visitors from out of the country.  As you can see from just this small sampling of the data on our economy, there is little demand for goods and workers.  Everyone either owns what they need, has no discretionary money to spend, or both.  I say it is both.  The equity that we built in our homes was either borrowed against and spent, or it has evaporated.  Same can be said of 401K and IRA plans: many have borrowed from them and others are not back to even from the 2008 crisis, but they are four years closer to retirement.

Back to the question of where to put your money in this economy.  When you invest you have a choice between equities, fixed income or cash.  There are many variations to these.  With stocks you can invest in equities of companies trading on an exchange, private equity or venture capital, to name a few options.  In fixed income you have investment grade, high yield bonds/loans, government debt, municipal bonds, or real estate mortgages to name a few.

When investing in stocks or private equity, you need for there to be a catalyst to make the stock go higher.  In fixed income you only need a steady state business or entity to make sure they are able to make their interest payments to you until they can either pay off your debt or refinance it.  Fixed income, barring any defaults, has a built in rate of return that you can take to the bank.  If you want to add in a default rate and recovery rate based on historical levels, you can still have a pretty good estimate of what your return will be going forward.  The challenge in fixed income is whether or not you can analyze the entity you are loaning money to.  Corporations that file audited financials with the government are pretty easy, but municipalities, our government or even the financials, like J.P. Morgan Chase, good luck.

With that said, high yield over the past 30 years has performed relatively equal or better than all the choices I have given you with varying degrees of risk as compared to them.  As per the equity comparison, the risk or volatility in high yields bonds over 30 years has been about half of that of equities with similar returns.*  Do you want to hope there is a catalyst coming to drive equities higher or do you want to loan good companies money, collect your coupons and know when you are getting paid back your money?

Get used to this economic environment as it is here to stay for a while.

*  See our whitepaper, The New Case for High Yield, for specific numbers.  Blau, Jonathan, Daniel Sweeney, and Karen Friedlander. “2012 Leveraged Finance Outlook and 2011 Annual Review.” Credit Suisse Global Leveraged Finance.  January 26, 2012, p.116.

New issue announcements continued to be a major theme in the high yield market with eight deals announced yesterday, and talk of several more already this morning. Most deals are 2-3x oversubscribed, so there doesn’t seem to be any slowing this market down, even with the recent volatility in equities.

High yield bond ETFs and mutual funds reported their fourth consecutive weekly inflow this week of $754mm, bringing the inflow total since early December to over $29 billion. This week saw 14 new high yield bond issues price, despite broader market volatility brought about by equity market uncertainty.  We view this as s positive sign for the overall strength of the high yield market.