The High Yield Market Outlook

As we start the new year, much of the focus has been on interest rates.  We’ve seen the Fed moving up the Fed Funds rate up for the last two years, all the while the 10-year Treasury yield hit the 3% level in early 2014 and has been trending under that ever since.  Is 2018 finally the year we see the 10-year Treasury yield move up and sustain that upward momentum and if so, what will that mean for fixed income?  While we continue to see constraints to a big spike in Treasury yields, including global rates (relative yields on sovereign debt around the world) and global demographics (an aging global population and continued demand for yield), we have clearly seen the upward trend in yields across the Treasury curve so far this year.

High yield bonds have historically performed well in rising rate environment.1  Yet the gut reaction with rising rates seems to be concerned about anything fixed income related.  And for some long duration, low yielding securities (investment grade corporates and municipals as an example), that concern makes sense.  If interest rates rise 1% in a year that will certainly matter a lot more for 10-year security that is yielding 3% versus a 5-year security that is yielding 7%.  Duration is a measure of interest rate sensitivity incorporating maturities/calls and yields, the higher duration the more theoretical interest rate sensitivity.  High yield bonds carry a much lower duration than many other alternatives in the fixed income space.  For instance the duration on the investment grade index is 7.56 years while the duration on the high yield index is 4.0 years, indicating a much higher interest rate risk for investment grade debt.2  Within the high yield debt market, our active strategy focuses on maximizing yield relative to risk, and with that, our strategy tends to carry a higher yield than the high yield bond index and we additionally invest in floating rate loans, both of which allow us to target a duration even lower than that of the high yield index.

Keep in mind that the high yield indexes include securities across the ratings spectrum, from what we would call the “quasi-investment grade” BB names all the way to the C bonds.  Often higher rated securities have smaller coupons (similar to what you would see in the investment grade world).  If this rising rate environment persists, that can change the incentive for companies to refinance or call the low coupon debt early because the interest rates on new debt issuance will have to adjust for higher rates, thus could raise interest costs for these companies.  We believe that the prices on many of these securities trading above their call prices may have to adjust to this fact, so that is something for investors to be aware of as they look at the broader indexes.

But it’s also important to keep in mind the reason that interest rates are currently increasing—a stronger economy.  Historically rates increase in the face of a stronger economy, and stronger economic activity is undoubtedly a positive for corporate credit, as well as a positive for default rates.  Historically, elevated credit and default risk are the biggest negatives for high yield debt.  Default rates are expected to remain historically low and economic activity pick up, which creates a favorable credit backdrop for corporate issuers.

So we don’t feel that a higher interest rate environment and increasing treasury yields is the death nail for high yield.  Nor do we see any systemic issues on the horizon that pose a massive risk to the downside.  Many market prognosticators have been calling for coupon-like returns in high yield for 2018.  We don’t disagree, though we may see some blips of volatility along the way just as we saw in 2017, and in each case of volatility in the high yield market last year that was ultimately met with buying.  On the index level, spreads are relatively tight compared to historical levels.  While there may be some room for further spread compression (price upside) we believe that is much more limited on the index-level, where many bonds are trading at or above their call prices, and as we noted above, if higher rates persist, we may even see some price widening for the very low yielding credits within the index that are trading to call prices.  At the same time, we see an environment of improving corporate fundamentals, generally good liquidity and reasonable leverage at the individual company level, and the default rate to continue to trend well below historical averages, and we believe these fundamentals matter and will provide price support for the market.

If we are looking at coupon like returns for the year, the starting coupon is an important consideration.   With our focus on yield and finding value, our strategy targets producing a yield that is higher than those offered by the high yield index and many of the index-based products.  Additionally, we look for value and with that, our goal is to provide the potential for additional capital gains upside to further support returns.  As we look at the year ahead, we believe that an actively managed, value-oriented high yield debt allocation can offer an attractive place to be positioned for yield seeking investors.

1  For data and further details on the high yield market’s performance during rising rate environments, see our piece “High Yield in a Rising Rate Environment,” http://www.peritusasset.com/2018/01/high-yield-in-a-rising-rate-environment-7/ and “Strategies For Investing in a Rising Rate Environment,” http://www.peritusasset.com/wp-content/uploads/2013/02/Strategies-for-Higher-Rates-Update-June-2016-Final.pdf.
2  Bloomberg Barclays U.S. Corporate High Yield Index covers the universe of fixed rate, non-investment grade deb.  Bloomberg Barclays US Corporate Investment Grade Index consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements.  Macaulay duration to worst is used, based on the yield to worst date.  Source Barclays, data as of 1/31/18.
Posted in Peritus

The Return of Volatility

Today, people are left trying to make sense of yesterday’s wild ride in the equity market in the hour before the market close, followed by the quick move down (even into “correction” territory on the Dow) and subsequent reversal this morning.  There have been a number of “causes” offered by the market commentators, everything from blaming it on the computers/algorithms to inflation concerns to too many leveraged and inverse products (ie., ETFs with two and three times leverage or inverse ETFs).  One of the statements we have heard this morning that has most resounded with us is one commentator saying we have created a “bubble” called “passive investing” over the last several years and that bubble is in the process of bursting.  While this commentator was referring to the equity market, we believe it translates to a variety of asset classes.

Passive investing has certain been widely embraced over the last several years, as money has poured into passive vehicles.  And it has worked for these investors as many asset classes have been trading virtually in a straight line up, with little in the way of volatility.  Investors have seemingly been lulled into complacency and the belief that markets always move up, but this certainly isn’t always the case, as the last several days have demonstrated.

We are not passive investors, rather we are an active manager within the high yield debt market, and are managing our holdings on a daily basis.  We are making buy and sell decision based on our determination of specific credits and how we want to position ourselves.  We don’t see volatility as a reason to panic; rather, we view it as an opportunity to look for credits that may have been hit for the wrong reasons, creating an attractive buy-in.  Nothing has changed fundamentally in the companies in which we invest over the last week.  We own what we own for a reason, rather than owning a security just because we are tracking an underlying index.  Furthermore, credit fundamental remain intact as largely companies have liquidity, corporate leverage isn’t accumulating, and we don’t see a default spike on the horizon.

Interestingly, despite all of the volatility we have seen in equities, the high yield market has been relatively tame over the past several days—we aren’t seeing a big sell-off in credit markets.  While two days of performance by no means makes a trend, it is worth looking at the declines over the past couple days.  From Thursday’s close through Monday’s close, we saw the S&P 500 Index return -6.13%, the Dow Jones Industrial Average -6.98%, and the NASDAQ composite -5.19%, while the Bloomberg Barclays US Corporate Investment Grade Index has returned -0.26% and the Bloomberg Barclays US Corporate High Yield Index -0.52%.1

We don’t see the current market conditions as a reason to panic.  Equity valuations have gotten ahead of themselves and now are adjusting, yet credit markets seem to be holding in as we aren’t seeing big declines in corporate credit.  Volatility in financial markets has returned and we’d view it as an opportunity for active managers.  Investors are waking up to the fact that markets don’t always move up, and re-evaluating if passive is best.  We have maintained that the high yield debt market warrants active management, and believe this active approach is all the more relevant and essential in today’s market.

1  Performance for 2/1/18-2/5/18.  Bloomberg Barclays US Corporate Investment Grade Index consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements (source Barclays Capital).  Bloomberg Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital).  Past returns are no indication of future results.
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High Yield in a Rising Rate Environment

The widely held expectation is that the Fed will raise rates at least three times again this year.  The question becomes what does this mean for fixed income markets?

  • Investors often seem to be under the notion that anything “bond” related is highly interest rate sensitive and will take a hit if rates rise—yet history has proven otherwise for certain fixed income asset classes.
  • Looking at the actual returns for the high yield asset class, in the 15 calendar year periods since 1986 where we saw the 5-year Treasury yield increase (rates rise), high yield bonds posted an average annual return of 12.4% over those periods (or 9.2% if you exclude the massive performance of 2009).1

Higher coupons and yields in the high yield space help cushion the impact of rising interest rates.

  • The higher the starting yield, the less impact we would expect to see from a move in interest rates.

High yield bonds have shorter durations than other asset classes in the fixed income space.

  • Duration is a measure of the price sensitivity of a bond to changes in interest rates, which incorporates the coupon, maturity/call date, and price.
  • High yield bonds are typically issued with five to ten year maturities and are generally callable after the first few years, as well as offer higher coupons, providing the high yield sector with a shorter duration, thus theoretically less interest rate sensitivity versus other asset classes.2

High yield bond returns are slightly positively correlated with changes in Treasury yields.3

  • Certain asset classes, such as investment grade bonds have a negative correlation to changes in Treasury yields.  This means if rates (yields) increase in Treasury bonds, we have historically seen investment grade returns move in the opposite direction (decline).
  • However, high yield bonds are slightly positively correlated to Treasuries, so historically as Treasury rates increase, high yield bond prices and returns have seen little impact to an increase.

The price of high yield bonds have historically been much more linked to credit quality than to interest rates.

  • Historically rates rise during a strengthening economy, and a stronger economy is generally favorable for corporate credit, as profitability and credit fundamentals often improve and default risk declines.

Rather than just assuming all fixed income products will be highly sensitive to interest rate moves, investors need to consider starting yields, durations, and correlations of assets, as well as the broader economic environment, as they assess interest rate risk and build portfolios.  Should a higher interest rate environment persist this year in the face of a stronger economy, we would expect the high yield bond market to be positioned well.

1  Bloomberg Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). Bloomberg Barclays US Corporate Investment Grade Index consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements (source Barclays Capital).  Covers annual, calendar year returns from January 1986 to December 2017. 5-yr Treasury data, 2008-2012 sourced from Bloomberg (US Generic Govt 5 Yr), 2013-2017 data from the Federal Reserve website.
2 U.S. 5 Year Treasury Note is the on-the-run Treasury (source Bloomberg).  Barclays Municipal Bond Index covers the long-term, tax-exempt bond market. Data as of 12/31/17 for the various Barclays indexes, source Barclays Capital, and U.S. 5 Year Treasury Note, source Bloomberg. Yield to Worst is the lowest, or worst, yield of the yield to various call dates or maturity date. Duration is the change of a fixed income security that will result from a 1% change in interest rate. The duration is the Macualay duration to the yield to worst date for the various Barclays indexes and Bloomberg calculated duration to workout for 5-Year Treasury.
3 25-year correlation for the period 12/31/1992-12/31/2017, data sourced from Barclays Capital and Bloomberg.
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The High Yield Bond Market: The Year in Review

We’d characterize 2017 as a steady year for the high yield bond market.  Generally speaking, high yield bonds saw a steady move up with a few small blips down that were short-lived and met with buying.1

In total, the high yield market reported a 7.5% return for the year.2

We would view this as a solid return number, as it is not too far off the 20-year average of 7.8%.3  High yield bonds outperformed many other fixed income sectors, and while returns were less than the equity index returns in 2017, keep in mind high yield did outperform the equity index in 2016.4

In terms of market technicals, we saw a strong new issue market in 2017, with the fourth highest issuance level on record and up over last year.5

We saw a mixed market in terms of fund flows, with both ups and downs, but a total outflow for the year of $14.9bn according to Lipper.6

By no means has this been a “hot” market where money is being blindly thrown at it, which we believe can be a positive in that we don’t see any sort of “bubble” in current market spreads or yields, which in turn we believe makes current levels all the more sustainable.

For all of the worry about rising rates, spread levels, and a market getting ahead of itself after a very strong 2016, high yield bonds posted a solid 2017 and we expect a similar situation in 2018.  We will have more details in our coming writings about our outlook for the year ahead, but in short, we expect coupon-like returns and while there may be some potential for spread compression again this year, we believe that will be more limited on the index level given where spreads currently are.  However, with that in mind, the coupon generated by a portfolio and any potential discounts in a portfolio to call or maturity prices are all the more relevant, which is why we believe active management is all the more attractive if you are able to generate an above index coupon level.  At Peritus, our goal as an active manager is to focus on maximizing yield relative to risk with the objective of providing an above index-level yield/coupon generation and we believe this positions us well as we proceed through 2018.

Footnotes:
1  Based on the Bloomberg Barclays U.S. High Yield Index, which covers the universe of fixed rate, non-investment grade debt.  Cumulative daily total returns for the period 1/1/2017-12/31/2017, data sourced from Barclays Capital.
2  Based on the Bloomberg Barclays U.S. High Yield Index.  Annual total returns for the period 1/1/1987-12/31/2017, data sourced from Barclays Capital.
3  Based on the Bloomberg Barclays U.S. High Yield Index.  20-year average return number based on annual total returns for the period 1/1/1998-12/31/2017, data sourced from Barclays Capital.
4  Equity index referenced is the S&P 500, which had a total return from 12/31/15-12/31/16 of 11.95% versus a Bloomberg Barclays US High Yield Index total return of 17.3% for the same period.
5  Acciavatti, Peter D., Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “2016 High-Yield Market Monitor,” J.P. Morgan, North American High Yield and Leveraged Loan Research, January 2, 2018, p. 9, 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, 1/4/18, 10/25/17, 6/23/17, 4/1/17, and 2/6/17, https://markets.jpmorgan.com.
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Dispersion in the High Yield Market

We saw heightened volatility return to the high yield market in early November, but after a couple weeks it largely dissipated and the market quickly rebounded.  We have seen a few similar bouts so far this year, with the marketing being hit by selling pressure and large outflows for a couple weeks and the media coming out questioning if the high yield market was poised for a big decline, only for it to be very short-lived and buyers return to the market to take advantage of the discounted merchandise.

With that said, we have finally begun to see dispersion in the high yield market.  We are seeing high yield investors reacting to company specific news, taking a bond price down on weak earnings, disappointing news, or industry challenges.  New issues aren’t just being waived in and prices in the secondary market aren’t all increasing irrespective of credit prospects.

Investors are beginning to show some selectivity, which we see not only as healthy but also as providing us a sweet spot as credit pickers.  We believe that the concept that it doesn’t pay to think and just buying the one of everything that has been embraced by passive investors is starting to lose ground.  This has been a popular strategy over the past few years and it has worked as both stocks and high yield bonds have increased.  But changes are happening and we are getting further along in the cycle, so we believe it is all the more important to pay attention to what you own via an active portfolio.

We believe it pays to think and there will be ways to make (and to lose) money.   There are credits that may be misunderstood or don’t meet the minimum tranche size threshold of the larger passive funds, that we see as undervalued and may present an attractive yield and potential capital gains opportunity, and there are credits that we see as expensive or have fundamental issues that should be avoided.  We don’t see any structural issues within the high yield market (default rates are expected to remain tame and the outlook for Corporate America is stable to improving) and investors need yield within their portfolio; thus we see an actively managed high yield allocation as a viable way for investors to generate that yield.

Posted in Peritus

Is Another Period of Industry Contagion in the High Yield Market on the Horizon?

Over the past couple weeks, we’ve heard several comparisons to what we are seeing today in the high yield market, to the energy-related decline we saw a couple years ago, with people questioning if this is just the beginning.  We believe these situations are very different and don’t expect some hiccups in a couple industries today to lead us to a broad decline.

In the late summer and early fall of 2014, oil prices moved from highs topping $100 on WTI to prices in the $70s.  On November 28, 2014, OPEC decided to not cut production in the face of this and we saw oil fall a further 10% in just that day and fall 40% over the two months following that decision.1  Energy securities, bonds and equities alike, began to get hit.  For the first several months, we saw the high yield market hold in pretty well.  But by the summer of 2015, that energy weakness had spread to the broader high yield market.  Between the end of May 2015 through when we saw the high yield market bottom on February 11, 2016, we saw the high yield market fall almost 13% in just over nine months.2

Going into this decline in oil prices, we saw Energy as the largest industry concentration within the high yield market, at over 18% of the total high yield market.  As energy prices accelerated their decline, and other commodities along with it, which were another 5% of the high yield market, people became increasingly weary of the high yield space and the selling that was at first contained to energy and commodities spread to the broader market.3

Over the past couple weeks, we have seen declines in the high yield market, again centering on a few specific industries, here namely some weak earnings in healthcare and telecom.  And with that, we’ve heard numerous people compare what we are seeing now to what we saw three years ago in energy—back then it started out being contained to energy but then eventually spread to the broader market.  Is this time the same, whereby we could see huge declines in the broader market because of problems in these specific sectors?

We don’t believe so.  First off, the industry concentration is significantly less.  Energy and commodities together were about 23% of high yield market prior to their decline, and today, we see healthcare as about 9% of the market and telecom about 4%, for a total of 13%.4  Secondly, “energy” is a more homogenous industry than healthcare in that you have a huge portion of that industry tied to the price on two commodities:  oil and gas.  As prices in these and other commodities precipitously declined, it impacted everyone from the producers to the servicers—the price of oil alone fell 75% from its highs.5  Additionally, defaults accelerated in these sectors, with 75% of total 2015 and 80% of total 2016 default and distressed exchange activity related to energy and other commodities.6

Yet, healthcare and telecom are MUCH more differentiated industries.  Just because hospitals are seeing some pressure, it doesn’t mean that drug companies, diagnostic imaging companies, outpatient facilities, oncology companies, etc. are going to face a problem.   Very different dynamics impact these various sub-segments within healthcare.  Similarly with telecom, this includes software and electronics producers as well as wireline, wireless and satellite companies.  And I don’t think under any imaginable scenario, the pricing these providers are getting is going to fall 75% as we saw with oil prices.  We also don’t see a big spike in default risk in these industries like we certainly saw with the energy space.  Yes, earnings are weaker and spreads in these credits had been very tight/yields very low, so they are adjusting to this fundamental reality.  But we aren’t hearing, not do we expect to see a wave of defaults related to these issues.

The fact is that, yes, certain companies within these industries today are feeling pressure, and some of these companies are large individual issuers and well known/well covered within the high yield market, so are widely held and are garnering the headlines.  But broadly speaking, these issuers are still a tiny portion of the entire market.  Corporate bond prices have been moving up over the past year and a half, and spreads/yields hit a multi-year low in October, so we are seeing things adjust in certain securities and some profit taking.  People are paying attention to fundamentals, which we view as a positive and we believe supports our case for active management within the high yield sector.  We believe that active investing, whereby portfolio managers are paying attention to what credits are held and look for value, rather than investing in many of the overvalued or susceptible credits within the index, is essential in the high yield space.

1  Reference prices based on WTI prices, sourced from Bloomberg (CL1 COMB Comdty).  Prices over $100 in July 2014 and in $70s by November 2014.
2  Returns based on the Bloomberg Barclays Capital U.S. High Yield Index, which covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). Returns for the period 5/31/17 to 2/11/16.
3  Industry concentrations sourced from Acciavatti, Peter D., Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “High-Yield Market Monitor,” J.P. Morgan, North American High Yield and Leveraged Loan Research, July 1, 2014, p. 20.
4  Acciavatti, Peter D., Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “High-Yield Market Monitor,” J.P. Morgan, North American High Yield and Leveraged Loan Research November 1, 2017, p. 19.
5  Based on WTI prices, as sourced from Bloomberg, with a high of $106.91 on 6/16/14 and low of $26.21 on 2/11/16.
6  Acciavatti, Peter D., Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “Default Monitor,” J.P. Morgan, North American High Yield and Leveraged Loan Research, January 4, 2016, p. 4 and January 3, 2017, p. 4.
Posted in Peritus

Today’s High Yield Market

During October, we saw the general high yield market hit multi-year lows on spreads; however, in the first part of November, we have seen that reverse.  Over the first half of November, some softness has emerged in the high yield market, as money has flowed out of the space and spreads and yields have moved higher, and with it discussion in the financial media as to whether there are real issues within the high yield market, positioning it for a sustained fall, and if this is a precursor to an equity decline (as high yield is often seen as a leading indicator).

We have seen these periods of high yield market weakness and the same sort of discussion several times already this year—first this past March and again in August.  The stories were the same, outflows, followed by a back-up in spreads/yields, and financial commentators worrying “the end” is near, only to have the weakness be met with buying after a few weeks and the high yield market resume its move up.  Will this time be the same and we’ll see a fairly quick reversal with buyers coming back in, or are there real, fundamental issues within the high yield market?

Ironically, I think our answer is yes to both questions.  As active player in the market, we see that the general fundamentals remain solid and we don’t see any pervasive cracks emerging within the broad high yield market.  However, there are problems in specific industries and companies.  The recent weakness we have seen has been largely centered in certain industries, namely healthcare and telecom.  Over the past few weeks we have seen weak earnings reports from a few large high yield debt issuers in these industries, as well as company specific news such as a failed merger in one high profile issuer.  The market is punishing companies for weak results or unfavorable news, which we believe makes active investing all the more important.  But it is important to note that we are NOT seeing widespread fundamental cracks in the high yield market or systemic overhangs as we have seen in prior cycles (such as the massive deals getting done and levering up of companies as we saw prior to the 2008 crash).

Overall, we see the recent weakness in the high yield market as an indication of a healthy market.  Yes over the past few years, spreads and yields in the high yield market have been run up as investors search for yield, creating overvalued situations in many cases, but the last few weeks have demonstrated that we are still seeing some of the ups and downs that you’d expect in a market where investors are rationally making decisions.  Below we outline some of the relevant considerations that we believe are significant for investors as they look at the high yield market—from market technicals, such as money flows and new issue activity, to market fundamentals, including default rates/outlooks, credit metrics, and credit liquidity:

  • Money Flows: We have seen weeks when money has flowed into the market and weeks when money has flowed out, and in total, the market has seen outflows of over $8bn so far this year from mutual and exchange traded funds, which would indicate to us that this isn’t a market that is being blindly “chased.”  Investors are not just throwing money at the asset class.
  • New Issue Activity: Even in the midst of the recent weakness in the high yield market and outflows, we are not seeing new issue activity abate.  Deals across the credit spectrum and for various use of proceeds are getting done.  A couple companies pulled deals because the market was demanding too high of an interest rate for their liking, but this indicates to us that the market is acting rational and not just waiving in deals at any price.  On the flip side, the strength of the new issue market indicates that there is still demand for these deals by investors, at the right price, and that companies still have access to capital to address a variety of needs, including refinancing, mergers and acquisitions, and investments in growth.
  • Default Environment: Default risk is one of the most important risks for high yield bond investors.  Default rates are well below historical average and are expected to remain low in the year ahead.  According to JP Morgan, the trailing 12 month default rate is 1.3% and is expected to remain low, around 2%, in the year ahead versus a historical average over nearly twenty years of 3.7%.1  Notably, nearly half of the defaults over the past year have come from three sectors: energy, retail, and healthcare.
  • Credit Metrics: Credit metrics as a whole are solid, with EBITDA and margins improving and coverage (EBITDA/Interest expense) and leverage (debt/EBITDA) reasonable.  For instance, the average quarterly leverage multiple over the last 10 years has been 4.3x, and currently we are at 4.1x.2   Again, we are not seeing the massive multiples being paid for deals or companies levering up as we saw prior to the 2008 credit crisis.
  • Liquidity/Maturities: As noted above, we have seen solid market technicals in terms of new issues, which is important in how it translates to individual company fundamentals.  Access to capital is essential in providing company’s liquidity and allowing them to address maturities.  With the persistent low rate environment and open new issue market, we have seen companies proactively addressing their maturities coming up in the next few years.  We are now left with a “manageable” 15.8% of the high yield bond and loans maturing in the next three years3—certainly not any sort of “maturity wall” that is of concern. Notably the Liquidity Stress Index, as measured by Moody’s, continues to trend downward, indicating liquidity strength among issuers.  A lack of liquidity and/or an upcoming maturity being unable to be refinanced can trigger a default in a security in many cases, thus we feel our current positioning bodes well for the continued low default rates.

Yields and spreads are widening.  In some cases, rightfully so.  We are seeing the market punish credits for bad numbers.  We are seeing prices fall in some of the more challenged industries.  But largely speaking, we believe the fundamentals within the high yield market remain intact.  The last couple weeks have proved to investors that fundamentals do matter and, accordingly, we see that as proving that active management is critical in the high yield market.

We believe that an active portfolio within the high yield market can offer investors attractive yield.  Additionally, we believe it pays for investors to be invested to continue to generate this yield—no matter what the price movement is for a security, corporate bonds are accruing interest/yield daily.  Timing the market has proven to be difficult, and this income can help offset price declines, and if we see a repeat of what we saw in March and August, we may well see the market quickly rebound and resume its upward move.

1  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 11/3/17, https://markets.jpmorgan.com.  Current default rate as of October 2017.  Historical default rate for the period December 1998 to October 2017.  Default rates include distressed exchanges.
2  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 9/26/17, https://markets.jpmorgan.com.  Based on quarterly leverage multiples for the period Q1 2008 to Q2 2017, and current leverage as of Q2 2017.
3  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 11/14/17, https://markets.jpmorgan.com.

 

Posted in Peritus

Finding Value

As an active manager, our investment strategy involves actively working to find value, rather than tracking a broad underlying index (passive management).  But just what does finding value entail?  We see a couple key areas where we see inefficiencies within the high yield market and where we feel we can find that value.  With our active strategy, we can pick and choose what we want to hold, in what portfolio allocation we want to hold it, and when we want to buy and sell.  We also believe on doing our own credit work and financial assessment of the core, alpha-focused securities in which we invest.

Just like there are popular names in the equity market, we see the same sort of market dynamic in high yield investing.  For instance, there are large, well-covered companies within the high yield sector that often have several tranches of bonds outstanding at any time, which can total billions of dollars in outstanding debt for just one company.  Research from the investment banks and other credit research providers often focuses on the larger issuers within the high yield market.  Smaller credits or companies new to the high yield market (first time bond issuers) tend to have few or even no one covering the security, leaving them “orphaned.”  Some high yield issuers also have public equity, while many do not and are private companies issuing public bonds.  Public bond issuers are required to provide their investors financials but these are not always publicly available as they are for equity issuers.  Getting information can involve tracking down the underwriter or calling the company to get on a private website to get that bondholder information.

Thus, not only does it involve time and energy to analyze the financial and company information, but it can even take time and energy to track down the credit information in the first place.  If an investor or manager is relying on the research put out by the investment banks and credit research providers, they could completely miss these off-the-run names.  Yet through our history we have found value in a number of these overlooked credits.

This certainly doesn’t mean that we are entirely focused on small credits that no one else has ever heard of—we have and do invest in credits across the tranche size spectrum, which includes many $500mm+ tranches.  But we are also open to finding value in areas others aren’t and don’t weight our allocations toward the largest issuers in the high yield market.  For instance, within the index, it is generally the companies that are the largest high yield bond issuers that weigh the most in the indexes (though there is sometimes a cap, such as 2%, of the index).  And with these large issuers weighing on the index, we see the same problem for many of the high yield index-based, passive products tracking the high yield indexes.  Amplify this with the fact that some of the larger passive high yield funds (such as the largest passive high ETFs), have size constraints per the underlying index that eliminate credits with a tranche size under $500mm or $400mm/$1bn in total debt outstanding.  So as these sorts of funds gain a larger share of the high yield bond retail market that can mean less interest in the credits that don’t fit these size parameter, which we believe further creates opportunities for active managers such as Peritus.

Additionally, we find value across the ratings spectrum.  We have learned over our decades of experience to place little credence in the ratings assigned to a credit by the ratings agencies.  Either a credit is “AAA,” and is money good, regularly paying its coupon and paying the investor the par back upon maturity, tender or call, or it is not and it is a “D” credit.  By looking behind the curtain into the company’s business and financials, we determine for ourselves if we believe the credit is money good and if the credit’s yield being offered to us compensates us properly, and invest accordingly.  Just because a credit is rated highly, doesn’t make it an attractive investment.  For instance, the headlines hit in early October that BB credits were trading well through the lowest spreads seen in over a decade.1  These low BB spreads are reflected in the low yields on many of the high yield indexes/sub-indexes with a high BB concentration, and passive strategies that follow these indexes. Yet, there are still many B and CCC credits that we view as money good and offering investors what we would see as attractive, reasonable yields.  As an active manager, we are not forced to invest in less desirable securities either from a very low yield perspective or from a credit concern perspective.

Investors need yield, especially with the low rates currently offered through the rest of the fixed income market (investment grade corporates, Treasuries, munis, etc.) and high valuations on dividend equities.  We believe that our active strategy of finding value without having to take on what we see as excessive risk can work to provide that yield for investors.

1  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 9/20/17, https://markets.jpmorgan.com.
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Off the Sidelines

Over the past months and years, the financial media and market commentators are constantly questioning whether the markets can continue their upward trend.  For instance, just a few month ago the concern was heating up with historically high valuations in equities and yields nearing multi-year lows for high yield bonds, along with the intensification of the North Korean rhetoric and political infighting, many believed that once everyone returned from summer, we’d see the perceived investor complacency replaced with volatility and potentially a leg down in “risk” assets.  Yet, this September proved to be one of the least volatile on record in some asset classes.

The fact is markets are unpredictable and timing the markets has often provide futile, and market-timing is getting all the more difficult as algorithms play a larger and larger role in dictating buy and sell decisions.  Yes, you may be able to avoid some losses if you time things right, but if not, you can miss on months and even years of upside.  In the high yield market, this is especially important as so much of the return generated comes from the income these bonds pay via the coupon payments.  But if you aren’t invested, you aren’t accruing this daily income, and over the years this income has proved to be a major contributor to total return.1

Looking back over the last 30 years, all of the return and then some has come from the coupon return, while the price return has been slightly negative.  So we read this as it pays to be invested.  There may be noise along the way, but over the long-term, the coupon income provided by high yield bonds is a major source of return.  This largely makes sense as most bonds are issued right around par ($100) and are generally called, tendered, or mature at par or above, with defaults or exchanges the primary outliers too this.

Not only does it pay to be invested, but we believe the coupon income you are getting also matters.  Yes, coupons/yields are below historical averages, but given we are nearly 10 years into this low rate environment, with the 10-year Treasury bond yield still sub-2.5%, these historically lower yields are understandable.  But in many cases, we are seeing corporate bond yields move down to levels that we believe don’t justify the risk.  Just this past week we were hit with headlines that BB spreads were at lows not seen in over a decade and 55% of the high yield universe trades at a yield under 5%.2

This is where we believe active managers such as Peritus can differentiate themselves and work to generate alpha for their investors.  A large portion of the high yield market is at these very low yields, but the entire market is not.  While the passive index-based high yield bond funds track their underlying index, and with that includes many of these very low yielding securities in their portfolio, we are not obligated to invest in securities where we see downside or a lack of value.  We can focus on what we see as attractive coupons and yields.

Bond prices go up and down, just as stock prices do.  But unlike with equities, bonds pay regular coupons to help cushion any downward price movement.  There have been many people over the past few years expressing concern as to whether the positive trend in high yield bonds can continue, and investors who might have already gone to the sidelines are losing on months and years of tangible coupon returns and income.  Yes, we certainly can’t say today’s high yield market as a whole is cheap, but we can say we believe there is still solid income and yield being generated by certain credits within the market and do not see any immediate catalysts to cause the market to hiccup.  But if and when there is a hiccup, we still have the coupons to cushion us leading to lower volatility than equities over the years.3

1  Bloomberg Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt.  Data for the period 9/30/87-9/30/17, using the price return, coupon return and total return, source Barclays Capital.
2  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 10/10/17, https://markets.jpmorgan.com.
3  Volatility as measured by the standard deviation for the Bloomberg Barclays High Yield Index versus the S&P 500 index, see our piece “High Yield Investing: Corporate Bonds versus Equities” for actual data.
Posted in Peritus

High Yield Investing: Corporate Bonds versus Equities

A company can issue debt (bonds) or equity (stock) as they look to gain access to capital markets.  Investors then have the options to buy either the bonds or stock.  It often seems that novice investors immediately think of stocks when they think of the concept of investing, but it is also important to understand just what a corporate bond is and how it is structurally different than equities.  And with those differences, we see certain advantages of high yield corporate bond versus stock investing.

A bond is a loan.  A bond investor is akin to a bank, giving the company money now with the expectation of getting paid back at a certain date in the future and earning an interest rate for loaning the money over the outstanding period.  But instead of this loan staying in the hands of one entity, it is then routinely divided and traded among investors over the life of the loan.  Equity, on the other hand, is ownership in the company, but doesn’t include an obligation to return the money paid for it in the future.

This US corporate bond market is a huge market, nearly $9 trillion1, with about $1.5 trillion of that in the high yield bond (non-investment grade) category.  If you include the large numbers of companies based overseas that issue US dollar bonds, the US dollar high yield bond market is nearly $2 trillion.2  And even if corporate bonds are not the first thing one thinks of when investing, this is an easily accessible market.  While high yield bonds have an active secondary market of trading, it is not done over an “exchange.”  Rather, bonds trade in a negotiated market, where trading relationships are important for managers in sourcing product.  Bonds generally trade in larger increments, thus, it can be hard to trade smaller batches of bonds, and investors won’t necessarily get the best pricing.  Because of this, pooled vehicles, such as high yield bond mutual funds and exchange traded funds, have become popular means by which retail investors can gain access to the asset class, with the funds holding a diversified underlying portfolio of individual bond holdings.

As follows, there are a number of structure features and benefits investors should be cognizant of as they consider the right asset mix between equity and corporate bond holdings:

  • Consistent Income: Corporate bonds have a set maturity date and an interest rate upon issuance, creating a contracted stream of income for bondholders.  Bonds typically pay this interest twice per year but trade with accrued interest, meaning that a buyer can buy the bond anytime before the paydate but would have to pay the seller the accrued interest up to that point.  Equities aren’t required to pay dividends—most actually don’t pay a dividend leaving investors to entirely rely on the stock price movement to create value/returns.  And for the stocks that do pay dividends, these dividends can be cut or eliminated by the company at any point as they are not contractual obligations but rather decisions subject to the Board’s discretion.
  • Finite Exit Strategy: Bonds are issued with a maturity date, which is the date at which the issuer is obligated to pay the bondholder back the “par value” of the bonds.  This finite exit strategy via maturity is one of the greatest features that we see for bonds versus equities, especially for value investors.  If you are an active investor and identify a security as undervalued, you aren’t left waiting in perpetuity for the market to realize that value.  With a bond, barring a default, you know that the maturity date gives you a final date at which point you’d realize that value, and that value may even be realized earlier via the call dates as we discuss below.
  • Capital Gains Potential: If a bond is purchased/trading at a discount to the par value, it may appreciate in value as it moves toward that maturity date, providing investors with capital gains opportunity.  However, most of the time investors don’t have to wait until maturity for a bond to be paid back. Companies generally choose to refinance or redeem their bonds at some point prior to that maturity date, but must typically pay the bondholder a “call premium” above par (pre-payment penalty) to do so.  This provides the opportunity for investors to earn a price even above par.  A potential investment return can be easily calculated for a bond using the interest rate and maturity date or earlier call dates and prices, so investors can have a clearer picture of their potential return prospects.
  • Priority Capital Structure Ranking: The debt/bonds rank ahead of stock/equity in a company’s capital structure.  This ranking means that bondholders have a priority claim on the company’s assets and get paid first in the event of a default or bankruptcy.  With this priority, the debt in a given company is considered less risky than the stock of the company.
  • Historically Lower Volatility/Risk Adjust Outperformance: As noted above, high yield bonds benefit from their consistent income and capital gains potential and the historical return profile of high yield bonds has been similar to that of equities but with 30-40% less risk (as measured by standard deviation), leading to the high yield bond market’s risk adjusted outperformance versus equities.3

Corporate bonds are a huge market, and high yield bonds are a sizable portion within it.  High yield bonds generated consistent, tangible yield for investors which can’t be easily cut or eliminated, have a finite exit strategy allowing the path to generating value to be more clearly ascertained, have a priority in the company’s capital structure, and historically have outperformed equities on a risk adjusted basis.  Equities aren’t the only game in town for generating return, as evidenced by the high yield bond market’s historical return profile above.  We believe that including an actively managed high yield bond fund that is focused on finding the value this asset class has to offer as part of your portfolio can provide attractive yield and return potential for investors.

1  From the publication “Outstanding U.S. Bond Market Debt” release by SIFMA, data as of 12/31/16
2  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.
3  Bloomberg Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). 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. S&P 500 index data sourced from Bloomberg, using a total return including dividend reinvestment. Annualized Total Return and Standard Deviation calculations are based on monthly returns. Return/Risk calculated as the Annualized Total Return divided by Annualized Standard Deviation. Data as of 6/30/17.

 

Posted in Peritus