Too Far Too Fast?

We have seen a pretty sizable bounce back in the high yield market off of its February 11th lows, with spreads declining and prices rising.1

CS HY index 2-11 to 5-12-16

This leads to the question, have we come too far too fast?  We believe that answer to that is a no.  While of course there may be periods of stepping back, as is natural, and healthy, in any market, we believe there is still room for the high yield market to run up further from here.

First off, spreads are nowhere near their historical cyclical lows, either seen this cycle or in past cycles, nor are they near historical averages.  First, let’s look at this cycle.2

CS STW 2009-2016

Since the end of 2009, the average spread to worst on the high yield index is 581bps, with a high spread level of 914bps on 2/11/16 and a low of 391bps on 6/23/14.  This compares to a current spread to worst level of 685bps, meaning there is currently over 100bps of premium versus this cycle’s average.

If you look at this relative to the history of the high yield market, going back to 1986, and including prior periods when we saw massive spikes in 2008 that skew the averages upwards, our current spread level of 685bps compares to a 30 year average of 586bps and 30 year median of 531bps.3

CS HY STW 1986-2016

So relative to history, today’s high yield market does not seem expensive as we are still sitting above these averages and medians.

But this “value” assessment needs to be in the context of also looking at risk, and we view defaults as that primary risk.  As we have discussed before, default rates in the high yield market as a whole were undoubtedly expected to increase this year. And we are certainly seeing that with total high yield default rates now hitting the 5% mark.  However, defaults by and large have been contained to the commodity sectors (energy, metals/mining).  We are currently seeing a slew of energy players missing coupons and undertaking debt for equity exchanges, and some of these are huge players in the high yield market (thus in the indexes and index-based products).  For instance, Linn Energy defaulted on $5.7bil in bonds and $0.5mm in loans, Peabody Energy on $4.8bil in bonds and $1.2bil in loans, and rounding out the top three defaults year-to-date, Sandridge Energy on $3.6bil in bonds.  However, outside of the commodity space, issuer default rates haven’t moved much over the past few years and remain near historical lows.4

CS HY defaults 5-11-16

So while we believe we have seen contagion on the pricing side, with the concerns in the energy space leading to the entire market being priced down late last year into early 2016, we are not seeing contagion on the default side.  Credit Suisse is projecting default rates to rise to 6% by early next year, peaking in early 2017, and then falling.5  They also note that historical high yield market bottoms (whereby the cycle yield highs are hit) have proceeded the spikes in defaults by about 12 months during past cycle peaks.6  If history holds, this means that if default rates were to peak for this cycle in Q1 2017, then we would have presumably seen the peak in yields in Q1 of this year.  Only time will tell, but we do know markets are forward looking mechanisms and given the problems in the energy sector, expectations for defaults to rise are well telegraphed.

On the technical side, we have seen things improve with both strong inflows and issuance up over the last three months since the February low, which indicates that people are coming back and embracing the asset class.  But this hasn’t been a one way trade, with some periods of notable outflows over the past couple weeks, which we would view as a healthy market.  Like any market, you see these ebb and flow, but overall prices and spreads have held in well since hitting these recent highs.

While there will be periods of ups and downs, we believe that we are still in the midst of a recovery in the high yield market.  We have seen a swift rebound in commodity related names over the past few months, with the energy sector now up 13.3% and metals and mining up 17.8% year-to-date, which has undoubtedly helped the reported YTD total high yield return of 6.8% given together these are a sizable portion of the index.7 However, we have seen much less significant moves in other sectors, with many names in the broader high yield market still trading at what we see as attractive yields and with bonds at discounted prices, which we believe still provides ripe picking for active investors looking for value in this asset class.

Over the past year we have been underweight energy which has somewhat muted our performance during this rally over the past few months, but now that we have growing confidence we have seen the bottom in oil prices, we have selectively added names in the midstream and refining sub-sectors, areas that we believe allow us to capitalize on the rebound in energy, without having direct price exposure, as while we believe we have seen the bottom, we don’t believe oil will now be a one way trade up.  While this energy and commodity rebound has helped bond prices, it has come too late and still leaves prices too low for many producers and servicers, which leads to the expectations for defaults to continue to accelerate over the next year.  As defaults mount, we would expect that to have an impact on the performance for the index-tracking products that have a sizable exposure to commodities, given the underlying indexes have notable commodity exposure.  We believe this is an environment where active management can separate itself and those that are able to lessen their exposure to this risk will outperform.  We believe there is still attractive income and value to be had in this asset class for fundamentally focused investors and we remain focused on capturing that value for our investors.

1  Data sourced from Credit Suisse.  Historical spread and price data covers the period from 2/11/20166 to 5/12/2016.  The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. “Spread” referenced is the spread-to-worst.
2  Data sourced from Credit Suisse.  Historical spread data covers the period from 12/31/2009 to 5/12/2016.  The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. “Spread” referenced is the spread-to-worst.
3  Data sourced from Credit Suisse.  Historical spread data covers the period from 1/31/1986 to 5/12/2016.  The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. “Spread” referenced is the spread-to-worst.
4  Fer Koch, Miranda Chen, James Esposito, and Chiraag Somala, “CS Credit Strategy Daily Comment,” Credit Suisse Fixed Income Research, May 11, 2016, p.2.
5  Fer Koch, Miranda Chen, James Esposito, and Chiraag Somala, “CS Credit Strategy Daily Comment,” Credit Suisse Fixed Income Research, May 11, 2016, p.2.
6  Fer Koch, Miranda Chen, James Esposito, and Chiraag Somala, “CS Credit Strategy Daily Comment,” Credit Suisse Fixed Income Research, May 11, 2016, p.3.
7  Data sourced from Credit Suisse, as of 5/12/16.  Year-to-date return covers the period from 12/31/2015 to 5/12/2016.  The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market.
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High Yield Market Technicals: The New Issue Market

We continued to see the broader high yield market rebound in April after hitting multi-year lows in mid-February, despite bankruptcies accelerating as we had expected. Looking at market technicals, as we have seen buyers and interest come back into the high yield market, evidenced by recent inflows into the asset class, we are also seeing the new issue market open up over this period, allowing for higher coupon and slightly lower rated deals to get done and a higher volume of new deals, which as we note below is important given our allocation to newly issued bonds. However the jury is still out on whether the lowest rated, highly levered companies will be able to get refinanced—the new issue market has opened up, but is still fairly conservative. Given this, we continue to expect defaults to accelerate in the most vulnerable industries as access to capital for many of these weaker firms is limited.

As we have talked about in many of our recent writings, beginning in December 2015 we began strategically allocating a portion of our portfolio to newly issued bonds in an effort to improve portfolio liquidity and diversification in response to general liquidity concerns among high yield investors following some recent regulatory changes (see “Strategy Adjustments: New Issue Allocation”). Again, as we have spoken about, the genesis of this investment strategy was based upon our observation and experience that newly issued bonds tend to be very liquid in the months following issuance, as banks generally support their deals and many funds ultimately look to include these new tranches in their portfolio (for instance, a passive fund may purchase the security once it is included in the fund’s underlying index). We began to implement our strategy to allocate a portion of the portfolio to new issues beginning in December and continued to build out that strategy over the following couple months.

While we believe this strategy has provided us with added liquidity, diversification, and stabilization of the portfolio, it has resulted in a reduction in income generated by this segment of the portfolio. While we have no set coupon parameters and the interest rate environments can have an impact, historically speaking we generally invest in bonds with coupons ranging from about 7-11%, with of course some names outside of this range. However, since we began implementing our new issue strategy in December through March, the average coupon on the new issued bonds in the broad high yield market was approximately 6.8%.1 During this period, we saw the majority of new issue coupons in the 4.25-6.5% range as it was primarily only very high quality, BB-type, deals getting done.

Additionally, interest rates were falling over this time, and generally speaking, corporate bonds are priced off of comparable maturity government (risk free) rates.2

5, 10 yr rates Dec 15-Apr 16

In looking at how Treasury yields reacted to recent economic numbers, investors are likely going to have to get used to low yields, as when comparable Treasury yields are near historical lows, yields on corporate debt securities will follow.

Also as we began implementing our strategy in December 2015 and January and February 2016, total new issue volume was very low relative to recent history. It wasn’t until we got further into March and April that we saw new issuance volume rebound to more normalized levels.3

High Yield Bond New Issuance

HY issuance April 16

We are selective and don’t participate in every new issue, especially avoiding some of the few much higher coupon issues in which we saw significant/outsized risk. However, when issuance is low, especially during the time in which we were trying to build out our strategy, we were faced with fewer options for investment, causing us to decide to take some of the lower coupon names, even some sub-5% coupons, so that we could stick with building out the strategy given the broader benefits we saw from it.

However, we are now starting to see interest re-emerge in the high yield space and the issuance dynamics dramatically improve, whereby new deals are spread more broadly across the ratings spectrum and coupons offered are increasing. Just in the last month alone we have seen the average coupon on all new issuance increase about 35bps from the average we saw in the prior four months.4 Additionally, monthly volume has more than doubled the last two months relative to what we saw in the prior three months. Yes, there are still some aggressive deals getting done where we see too much risk and we are avoiding. But on the other end of the spectrum, with the strategy already built out, we are now in the position of replacement, taking off prior new issues, often that trade at premiums, to roll into the more recent new issues, giving us more flexibility in passing on some of the lower coupon issues and the ability to be more selective in the deals we participate in. Our strategy is to continue to roll prior newly issued bonds into the more recent new issues so that this allocation can always stay focused on bonds issued in the last few months. So we would expect the income generated from this segment of the portfolio to improve over what we have seen in recent months given the better coupons of late.

As we have mentioned above, our strategy is to sell out of prior new issues into more recent new issues, with the potential of selling at premiums. While the coupon may be lower relative to the rest of the portfolio, having a bond move up 3, 4 or even 5 points during a two or three month holding period certainly has the potential to provide what we view as an attractive total return.

Our total allocation to new issue bonds will vary depending on the market environment. We see it not only as a tool to add liquidity, but also provide stability to the portfolio. If we were to see the market trade down, we would expect that these holdings to see much less price volatility. This is exactly what we saw most recently during February when the rest of the market took a step down and what our historical analysis has indicated.

As an active manager we have the flexibility to address the market environment in which we find ourselves, working to minimize the relevant risks while still focusing on providing our investors with what we see as an attractive total return. Liquidity has become a real risk in today’s market and we are working to proactively address. Additionally, while we are selective as to what bonds we purchase in the secondary market, we are also selective as to what new issues we purchase—in both cases focusing on where we see value. This flexibility and ability to be proactive and selective in how we allocate our investment dollars is especially important in today’s high yield market and we see it as a major advantage of our active investment strategy; the passive, index-tracking funds that focus on holding whatever is included in an underlying index don’t have this same luxury. As we move forward, we are starting to see the coupons offered by new issues improve off of recent levels and we anticipate this strategy to continue to provide the portfolio as a whole with added liquidity and lower volatility.

1 Based on fixed rate high yield bonds with issuance dates (per Bloomberg) between 12/1/15 and 3/31/16 that were included in the Bank of America High Yield index.
2 5-year and 10-year US Treasury yields for the period 12/1/15 to 4/29/16.
3 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High-Yield Market Monitor,” J.P. Morgan North American High Yield Research, May 2, 2016, p. 8.
4 Based on fixed rate high yield bonds with issuance dates (per Bloomberg) between 3/31/16 and 4/28/16 that were included in the Bank of America High Yield index.


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High Yield Investing: Risk and Outcomes

We have been active in the credit markets for decades and we see the primary risk for credit investors is default.  While interest rates play a role in all asset classes, they historically have a very limited effect on a portfolio of high yield loans and bonds given the higher yields these securities offer and their low duration relative to other fixed income asset classes, such as investment grade and municipal bonds. So that leaves default as the primary risk.  Defaults are going to rise off a very low base, but this is primarily due to expectations for double digit defaults in the energy and metals and mining sectors, while defaults in the rest of the high yield market are expected to be around 2-3%, which remains below long-term historical averages.1

High-yield bond and leveraged loan default forecast

HY bond and loan default projections Mar 2016

But what is important for fixed income investors is that defaults are only part of the equation.  Unlike stocks, bond and loan holders often recover a significant portion of their money as they work through the restructuring process.  In fact, depending upon where one purchased the bonds or loans, a default could potentially even result in a gain.  Historical default recoveries are provided for both bonds and first lien loans below.2

High Yield Bond Average Recoveries

HY bond recoveries 2015

1st Lien Leveraged Loan Average Recoveries

Loan recoveries 2015

So in summary, loans have on average recovered 69 cents on the dollar in a default, while bonds have recovered around 41 cents on the dollar.  If you use J.P. Morgan’s expected default rates of 6% and 3% (bonds/loans), you would have a theoretical loss rate of 3.5% for bonds and 0.9% for first lien loans using these historical average recoveries.  Therefore a combined portfolio (50/50 bonds and loans) would have a theoretical loss rate of 2.2%.  If you had a beginning yield of 8.5% (what we would see as a rational number in today’s market), you would have a net or risk adjusted theoretical return expectation of 6.3% before any fees.3

But the news gets a great deal better.  Again, that default rate number is the expectation for the market as a whole, which includes metals, mining and oil and gas.  As we noted above, the bulk of defaults will be concentrated in these industries.  So a thoughtful investor can lessen their default risk by avoiding many of these industries.  Just as important, investors in bonds and loans have a number of ways to generate potential capital gains, and potentially lower loss rates, by buying these securities at significant discounts to par ($100), and these discounts are readily available in today’s high yield market.

The great thing about fixed income investing is the outcomes are relatively finite.  They include the following:

  1. Maturity:  All bonds and loans have a maturity date requiring the company to pay back principal to investors on this date.
  2. Call:  Bonds often have a call feature, allowing the company to refinance or otherwise pay back the bonds prior to maturity.  The investor is required to give up the bonds subject to a predetermined call price, which can include call premiums above the par maturity.  Typically, this will start in year four or five of a bond’s life.
  3. Poison Put:  This is formally known as a change of control covenant.  Many high yield bonds and loans have this covenant by which if the company is acquired (change of control), the bond or loan holder has the right to “put” the securities back to the company, forcing them to repurchase the bonds typically at a price of $101.
  4. Tender:  At any time a company can launch a tender offer for their securities.  However, in this case, unlike the call schedule which is contractual, the holder is not required to sell unless they like the tender price and want to sell their bonds back to the company.
  5. Default:  This can be technical in nature (tripping a covenant) or it can be fundamental, where the interest or principal payment is not met at the scheduled time or within the grace period.  Interest stops accruing at that point and the company can work out a restructuring plan in or out of bankruptcy court.

So if an investor is buying their securities at discounts to par, four of the five of these events may generate capital gains in addition to the interest income the investor is receiving.  The main differences between debt investing and dividend-based investing in equities are the contractual nature of the cash flows—dividends are not legal contracts but set by the Board quarterly, while bond interest is a contractual obligation—and the built in exit strategy via maturity in fixed income securities.  With equities you can be waiting forever for value to be realized and prices to go up, while in fixed income investing, we have a set date, maturity, at which we will get our money back (barring a default) and potential upside on top of it if there is an early call or tender.

As we recently discussed in our piece, “Zero Sum Game,” we believe that the equity market is positioned for a fall due to high valuations in the face of limited revenue and earnings growth.  We also expect demographics to compress equity valuations over the longer term.  However, we believe the high yield market currently offers investors attractive value and is positioned well for the environment ahead.  To read more of our thoughts on financial markets and the role equities and fixed income will play going forward, see our piece “Zero Sum Game.”

1 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Default Monitor,” J.P. Morgan North American High Yield Research, March 1, 2016, p. 5.
2 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2015 High Yield Annual Review,” J.P. Morgan North American High Yield Research, December 30, 2015, p. 16.
3 This scenario is provided for informational purposes only, actual results may be material different depending on actual default rates, recovery rates, fess, and bond and loan pricing and yield, among other factors.
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The Selective Energy Opportunity

After working to sizably cut our energy allocation in early 2015 as we expected the volatility in oil to continue, we are now selectively adding a few energy names to our portfolio.  Since we have been clanging gongs for a long period of time on the avoidance of high yield bonds financed by US exploration and production (E&P) companies operating in shale basins, has anything changed now that many of these bond prices have collapsed?  Not really.  While we have looked at survivors in the space, it remains a difficult business model to finance with debt and we are already starting to see a wave of defaults in this energy sub-segment, and expect we will see many more.  Ironically, after this restructuring cycle, many of these companies could be financially viable as they have no debt costs to service, which we believe is one of the reasons US production will not collapse going forward.  From the work we have done, $40-$45 oil and limited debt to service could allow these companies to exist even with the drilling treadmill they are on, as costs have come down and efficiencies have improved.

The continued issues surrounding E&Ps have created opportunities in other sub-segments within energy.  The opportunities we are primarily focused on relate to the contagion trade.  By this we mean connected businesses that have been sold down well below what we feel is justified but have different business models.  Midstreamers including pipelines and downstream (refineries)—the companies that process, refine, store, and transport the oil and gas produced by the E&P companies and other chemicals—are examples where we see potential value.  We don’t see huge cash bleeds or defaults on the horizon in many of these connected businesses, and we  see it as a way to benefit from potential upside in oil without having direct exposure to prices.  Many of the midstream players are master limited partnerships (MLPs), which may have to cut or eliminate their dividends.  But by doing so, they are conserving cash to the benefit of servicing their debt.  We also see a likely consolidation cycle coming where investment grade buyers (the TransCanada-Columbia deal as an example) who have a very low cost of capital acquire these high yield companies, allowing them to refinance the debt, capturing massive interest cost savings, and buy this infrastructure cheaper than they can build it, which presents upside for existing debtholders.

Chapter 11 is currently being used as a capital markets tool to reduce debt levels—even for companies that might be able to pull through this current oil pricing environment with existing liquidity, many are instead pre-emptively filing bankruptcy to reduce debt levels.  We see this is a dangerous environment for many bondholders in shale E&P and associated service providers.  90% of defaults so far this year are commodity related.1  Energy is over 13% of the high yield market2 and we do expect defaults to remain concentrated in this sector.  However avoiding energy entirely isn’t the answer.

The current opportunity in selective credits associated with the energy sector actually rhymes with a trade we executed on back in 2002-2003 involving the telecom, media and technology (“TMT”) meltdown.  The victims back then weren’t E&P companies but the Competitive Local Exchange Carriers (“CLECs”).  When they melted down, they dragged down the whole telecom sector, just as we see today.  This included cell tower companies and rural cellular companies, which is where we saw opportunities and focused our commitments.  Those turned out well, while the CLECs themselves basically vaporized.  The “obvious” bargain generally turns out to be the value trap.  But then, as we see now, when you see an entire sector/sectors take a hit, there is generally attractive opportunity to be had somewhere in the space and as a value-based investor we feel it is prudent to see where that value may be.

While in many cases debt will be wiped out and/or equitized, these E&P companies are not going away and we don’t expect a collapse in US production.  These companies will restructure, eliminate debt, and re-emerge from bankruptcy, all the while continuing to produce product to be processed, refined, and transported.  We spoke a few weeks ago about a new high yield index-based exchange traded fund that excludes energy.  Yes, this may help investors avoid the larger concentration of defaults, but it also removes some of the opportunities in the space—yet again another example of why we see active management as so essential in this asset class.  As we conduct our own fundamental analysis and work to gain a true understanding of the business and industry dynamics, we have always been value-based investors, often thematic investors, looking for those companies that we see as under-valued, producing what we see as a healthy yield and capital gains potential for our investors.

1 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, April 29, 2016, p. 55.
2 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, April 29, 2016, p. 4.
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High Yield Market Fundamentals

As we look at the high yield market, we see decent market fundamentals.  While it would be a normal occurrence to see companies re-lever themselves after six years into a cycle, we have seen little of this type of bad behavior with total leverage metrics near historic lows.  Interest coverage has also remained on the high side (meaning more cash flow to service debt) as companies have been able to refinance at lower rates.1

Leverage Ratios

HY leverage ratios Q3 2015

Coverage Ratios

HY coverage ratios Q3 2015

So while we have diatribes about Armageddon in the high yield space from Jeff Gundlach and Carl Icahn earlier this year, we believe they are silly and unsupported outside of the oil and gas industry.  Note the following funds flow chart which shows significant outflows from high yield bond mutual funds over the past three years.2  This hardly supports the notion of an overbought or popular asset class, as many of the pundits have seemed to claim in the early part of 2016.

HY mutual fund flows 12-31-15

The loan market is no different.  The basic difference between loans and bonds is that loans are floating rate, while bonds have fixed rate coupons.  After a massive inflow in 2013 (based on taper tantrums and the notion that interest rates were going significantly higher), the last two years have seen very significant outflows.3 This has caused much of the loan market to trade at a hefty discount to par, thus giving investors the opportunity for potential capital appreciation in addition to the coupon interest.

Loan fund flows 12-31-15

Broader loan market activity and issuance relies significantly on collateralized loan obligation (CLO) issuance.  Thus, the loan market has been further pressured by proposed “risk-retention” rules that require CLO managers to own 5% of the total value of their structures.  Only a handful of large managers have the ability to do so today.

As we have discussed in our recent piece, “Zero Sum Game,” legislatively and technically the markets for loans and bonds are broken.  Yet we believe this has created a very compelling opportunity for investment as the price decline and spread expansion we have seen in these markets over the last year is largely driven by these technical factors not fundamental weakness (outside of commodities).  After hitting multi-year high spread and yield levels in mid-February, we have started to see buyers come back into the high yield bond market as they recognize the value to be had.  With this, we believe we are past the worst in the high yield market, yet we still see many bonds trading at notable discounts and with what we see as attractive yields.  The high yield market has started to stabilize and we believe still offers attractive value for investors, and as an active manager, we are positioned to take advantage of the opportunities in this market.  See our recent piece, “Zero Sum Game,” to read more about our take on financial markets and the opportunity we see in high yield debt.

1 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2015 High Yield Annual Review,” J.P. Morgan North American High Yield Research, December 30, 2015, p. 152,154.  Leverage ratio is the company’s debt divided by earnings before interest taxes depreciation amortization (EBITDA).  Coverage ratio is EBITDA divided by the company’s interest expense.
2 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2015 High Yield Annual Review,” J.P. Morgan North American High Yield Research, December 30, 2015, p. 127.
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US Financial Markets: Demographics and the Income Opportunity

We are in the midst of a global shift in demographics as the Baby Boom generation ages and faces retirement, causing a need for reduced volatility in their investments.  We believe this creates real issues for future money flows.  We have seen it reported that approximately 75% of global equity markets are owned by pension plans and retail investors, both of which are likely to dramatically reduce stock exposure going forward.  

Of this, pensions (which we have seen reported account for about 45% of global equities alone) are expected to increasingly focus on portfolio immunization, whereby they look to match the maturity of their assets and liabilities, which forces these plans to turn to credit versus equity.

On the retail side, as we have previously discussed in our piece “Of Elephant and Rates,” which was written two years ago, at the time, estimates were that nearly 75% of global retail assets would be owned either by those retired or near retirement within five years.1  This is a huge number, and as people in this demographic enter or near the retirement phase, they tend to focus on capital preservation and income generation, which we expect will cause investors to rotate out of equities into credit.

We believe that demographics are destiny.  As the population ages, they will no longer be focused on taking on risk to generate higher returns via equity markets, but rather turning to the income and lower volatility provided by fixed income.  While we expect this to prevent interest rates from significantly increasing as the demand for fixed income increases in the years and decades to come, we also expect it will result in less demand (or outright liquidations) and lower valuations for equities.

So while we believe that there will be little to drive further equity market valuation and price expansion over the next year and beyond (see our piece “US Financial Markets:  Fundamentals and the Outlook for Equities”), we do believe the high yield market can be part of the solution for investors focusing on income.

The high yield market offers a yield to worst of 8.4% and a yield to maturity of 8.6%, far surpassing the yields offered by various other fixed income options.  Additionally, high yield bonds have a lower duration, indicating less sensitivity to interest rate moves.2

FI yld, duration

While the high yield offered by these corporate bonds is commensurate with the higher perceived risk, if you look at actual performance, high yield bonds have also outperformed the other listed fixed income categories over the last quarter century.  High yield has posted a 25-year return of 8.3% versus the sub-7% return for corporate investment grade and municipal bonds and negative returns for the 5-year Treasury.3

FI 25 yr returns

Over the long term we think it is likely that equity valuations will begin to compress and stocks will begin to lose their long term appeal as both baby boomers and institutional investors continue to pursue yield and capital preservation strategies.  We believe that income focused investors should consider an allocation to high yield bonds, with its relatively high income generation, as an equity alternative to complement their fixed income allocation. To read more about our thoughts on the demographic changes ahead, our outlook for equities, and alternatively the opportunity we see in the high yield market, see our piece, “Zero Sum Game.”

1 See our piece “Of Elephants and Rates,”, January 2014, p. 4-5.
2  The BofA Merrill Lynch US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market. The BofA Merrill Lynch US Municipal Securities Index tracks the performance of US dollar denominated investment grade tax-exempt debt publicly issued by US states and territories, and their political subdivisions, in the US domestic market. The BofA Merrill Lynch US High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market.  Data as of 3/31/16, sourced from Bloomberg.
3  Data for the period 3/31/1991 to 3/31/2016, sourced from Bloomberg.
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High Yield Bond Investing: Understanding Yield and Default Rates

We’ve always viewed default risk as one of the primary risks in high yield investing.  Unlike stocks, bonds have an end date and value via their maturity date and maturity price of par.  There may be a lot of price noise in a bond along the way, but over time the price would generally drift toward this maturity price as you get closer to the maturity date, or even higher toward a higher call price if an early call is expected.  However, a default (or distressed exchange) would be something that derails this end return.

Defaults certainly need to be considered as investors allocate money to the high yield market, or any fixed income security for that matter.  However, in assessing default risk, investors need to consider the potential default losses in the context of the yield being generated by the portfolio.  Yield can potentially go a long way in making up for default losses.  For instance, if the market as a whole is offering higher yields, investors can withstand a larger amount of default losses and may still generate what we would see as a decent return.  This is an important consideration as investors evaluate today’s high yield market, as we believe the yield currently offered by high yield bonds more than compensates investors for default risk.

Let’s evaluate some theoretical scenarios.  We’ll look at a high yield portfolio in which the underlying securities have an average price of $90 (90% of par), maturity of five years, coupon of 7.25%, and annual current or distribution yield of 8% for the initial year.  If we assume the portfolio appreciates in equal dollar annual installments to move from the $90 price (90% of par) on the underlying securities to a maturity price of $100 (100% of par) by the end of the five years and we assume all income is reinvested immediately, we get the following theoretical return scenarios:1

Return scenarios 4-14-16

Then if we factor in some sort of default assumptions on top of that, the theoretical returns are as follows:2

Default assumptions 4-18-16

So even in a very dire 10% default rate and 25% recovery per year for five years, a theoretical 1.5% annualized return is generated, and if that recovery on the 10% default rate per year moves toward historical levels of 40%, a theoretical 3.1% return is generated, which is twice what is currently offered by 5-year Treasury3.  Never in the history of the high yield market have we seen defaults stay at double digit levels for multiple years in a row.  Even during the financial crisis, we saw default rates hit all-time highs for about a year, but then quickly fall to historically low levels for many years to follow4, so by no means do we see this multiple years at a 10% default rate as a realistic scenario.

HY default rates 2-26-16

We’ve seen projections for US corporate default rates ranging from 4%-6% in 2016, depending on whose numbers you use.5  If we take the midpoint, in the scenario above, assuming a 5% default rate per year for the next five years and 40% recovery, the theoretical annual return would be around 6.4%.  This may well be too conservative given, again, we haven’t seen this many sustained years in a row of higher defaults and it doesn’t account for any early calls at premiums for the holdings, which is potential upside.

Furthermore, the projected default statistics of around 5% are looking at the corporate debt market as a whole.  Yet, energy and commodities are about 16.6% of the high yield indexes6 and defaults in these sectors are expected to see a huge spike, while the rest of the high yield market is expected to remain at below average default rates.  So if you are able to build a portfolio with much less commodity and energy exposure than the general market, then your default and loss rates may well be lower.

With the yields offered by today’s high yield market, we believe investors are more than compensated for the default risk ahead, especially for active managers who can reduce their allocations to the most vulnerable securities/sectors, namely in energy and commodities.  We believe investors have the potential to generate what we see as an attractive return in today’s high yield market even in the face of increasing default rates.

1  These calculations are hypothetical and are provided for illustration only. Actual results may be materially different. These calculations assume all holdings mature in exactly 5 years and do not account for the fact a portfolio would have debt securities with various maturities or early redemptions via call or otherwise may occur.  These calculations assume that the price appreciation is equally distributed per year over the entire five year period, moving the price on the underlying securities from $90 (90% of par) to $100 (100% of par), so assuming a $90 portfolio value, it would increase $2 per year to total a portfolio price value of $100 at the end of year five.  These calculations also assume that the 7.25% coupon on par remains constant on a percentage basis, while the current yield decreases as the portfolio price as a percentage of par increases.  Coupon income generated is assume to be immediately reinvested a the current portfolio price as a percentage of par.  These assumptions do not account for fees, expenses, price variations, and yield variations, among other factors, and assume that no companies default on their principal or interest obligations or that securities are bought or sold over the holding period.
2  These calculations are hypothetical and provided for illustration only. Actual results may be materially different. These calculations evaluate specifically the potential loss rate relative to the accreted portfolio value (moving from 90% to 100% of par in equal installments over five years, with the value adjusted for par loss rates) and do not consider any further portfolio factors or changes, such as the variability of prices and yields of non-defaulted and defaulted securities or the time frame for bankruptcy work out, among various other factors.  Default losses are assumed to occur at the end of the year for each annual period and are accounted for as a decline in portfolio value.  Loss rates not default rates are used as any recovered value in the default is assumed to be available for reinvestment.  Recoveries are assumed to be immediate.  These scenarios also include the same assumptions noted in footnote 1, with various adjustments made due to par loss rates and do not account for fees and expenses.
3  5-Year US Treasury rate as of 4/7/16.
4  Acciavatti, Peter, 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, February 26, 2016, p. 45.
5  For instance, Credit Suisse projects 5% (Fer Koch, Miranda Chen, James Esposito, and Amit Jain, “US Credit Strategy Outlook,” Credit Suisse Fixed Income Research, December 21, 2015, p.18), J.P Morgan projects 6% (Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” March 1, 2016, p. 5) and we’ve seen rating agency projections closer to 4%.
6 Based on the J.P. Morgan US High Yield Index.  Acciavatti, Peter, 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, March 18, 2016, p. 49.
Posted in Peritus

US Financial Markets: Fundamentals and the Outlook for Equities

The US dollar and bond markets will continue to benefit from a flight to quality trade keeping rates much lower than expected by many.  However, this is not because we see the US economy performing exceptionally well; rather, just less poorly than most.  We also see the beginning of the end of the bull market in stocks which began in 2009.  Importantly, we see a very negative long term trend for equities in general over the next decade.

Let’s begin with a look at some important historical data.  Stock returns over the long-term have averaged about 6.5% for US investors.  I believe that most investors would be very surprised at this number.  This takes into account the last 115 years.1

Real Stock Market Return

Note that the past ten and 20 year numbers are in line or slightly below the long term averages.  However, the past five years have shown a return significantly in excess of this historical average for the U.S.2


Another observation that is important for Canadian investors.  The past five and ten year periods encompass the highest average oil prices in history, yet equity investors have made almost no money investing in the Canadian stock market.  Is it any wonder that the best Canadian institutional investors have but token allocations to Canadian stocks and are instead turning to the US and other markets?

We believe regression to the mean is law in investing.  Turing back to US equity markets, on the back of the outperformance for the past five years, we believe that returns over the next few years are likely to be well below historical averages of 6.5%.  A brief look at beginning valuations tells us why we believe this to be the case.3

Shiller pe

We are now at valuation levels seen only twice before: once before the Great Depression in 1930 and the second spiking in 2000 after the internet bubble and then remaining elevated from there leading up to the financial crisis of 2008.  While valuations are key, we all understand that things can continue to be over-valued or become more over-valued for long periods of time, but at some point, markets will wake up to the reality, and often over-correct.  As we sit today, we believe that holding equities is not investing, but speculation.  What is well known by investors today is that both revenue and earnings growth is now effectively non-existent.  So much of the equity returns we have seen over this period have been nothing but increasing valuations based on money flow algorithms, which in turn were triggered by very low interest rates.  Interestingly, the valuation explosion has happened at a time when corporate profits as a percent of GDP have been at their all-time high.4

US Corp ProfitsWe have had a long run of productivity (jobs being replaced by machines or outsourced to low wage jurisdictions/countries) and had a huge dividend from lower interest rates (debt being refinanced at lower rates) but all good things come to an end.  We concur with recent research from Morgan Stanley that suggests labor will begin to take a larger share of the cost pie, hurting profitability going forward.  Labor forces are shrinking across the globe as population growth in both developed and key emerging economies slows.  Nowhere is this more evident than here in the U.S.5

Baby Boom

With unemployment rates falling below 5%, it is a matter of time before wage pressures begin to build.  And with the economy firmly pointed in the direction of services (i.e. healthcare), the ability to do more with less reaches its limits.  In summary, in the face of sky high valuations, we believe a lack of revenue growth and shrinking profit margins will all play a role on limiting future equity returns.

We believe US equity markets are ripe for a fall in 2016.  Valuations remain elevated in the face of no revenue or earnings growth.  Another factor at play will be profit margins (unsustainably high), which will likely suffer from increasing labor rates (including higher minimum wage rates) further pressuring earnings.  However, we believe the high yield market offers investors an attractive alternative to equities.

Outside of energy and commodities, we view the high yield debt market as undervalued given the fundamental backdrop relative to the yield and price discounts currently available.  Leverage ratios are stable and interest coverage ratios have been improving.  Additionally, defaults are expected to remain below historical averages outside of the energy and commodity sectors.6  We believe the high yield market, often a leading indicator, has already felt its pain due to the economic environment and is now starting to stabilize, offering what we see as a compelling opportunity.  However, we feel active management is essential in this market as investors need the ability to avoid certain securities/sectors and embrace others, rather than following a broad index. If you need any more evidence of the risks we see for these passive, index-tracking products, especially as it relates to energy, just look to iShares planning to launch a high yield ETF that excludes energy credits. We don’t think this sounds good for the hundreds of millions of dollars in existing high yield index-tracking products.  Active management matters.

We believe the high yield bond and loan market offers income focused investors a way to generate a steady income stream and the potential for capital appreciation to help drive long-term returns.  We see this as an attractive alternative to equities, where we expect the pain is in the beginning stages.  To read more about our thoughts on the outlook for equities, and alternatively the opportunity we see in the high yield market, see our piece, “Zero Sum Game.”

1 Inker, Ben, “Just How Bad Is Emerging, and How Good is the U.S.?”, GMO Quarterly Letter, Q3 2015, p. 9.  Copyright GMO.
2 Inker, Ben, “Just How Bad Is Emerging, and How Good is the U.S.?”, GMO Quarterly Letter, Q3 2015, p. 10.  Copyright GMO.
3 Source: Data sourced from, as of March 7, 2016.
4 Inker, Ben, “Just How Bad Is Emerging, and How Good is the U.S.?”, GMO Quarterly Letter, Q3 2015, p. 15.  Copyright GMO.
5 Goodhart, Charles, Manoj Pradhan, and Pratyancha Pardeshi, “Could Demographics Reverse Three Multi-Decade Trends?”, Morgan Stanley Research, September 15, 2015, p. 24.
6 See the piece “Zero Sum Game” for full data and source details.
Posted in Peritus

Strategy Adjustments: Sell Discipline

As we noted last week, we have made some strategy adjustments as we work to help improve liquidity and dampen volatility.  Along those lines, we have implemented a sell discipline.  While as active managers we are always monitoring our holdings and evaluating our upside versus downside, we now are including an additional risk overlay that involves specifically re-evaluating our holdings once a $70 price is breached.

Through our many years of experience in the high yield market, we believe that $70 is the price point where bonds begin to be viewed as “stressed.”  Due to some of the regulatory changes, including the likes of Dodd Frank/Volcker among others, we have seen many securities gap down well below this price once it breached the $70 level, thus we believe re-evaluating at this point and potentially selling depending on our analysis may help reduce our portfolio volatility.  We will be highly sensitive to this $70 level going forward.

It should be noted that should we decide to sell a security for breaching this price point, these are often higher yielding/income generating names by the nature of the bonds at such a deep discount; thus, a potential sell and reinvesting in a lower yielding/more stable credit could result in lower income generation.   However, we see this process a tool to help us avoid future defaults and pricing downside, serving us well over the long run in terms of potential principal protection and reduced volatility.

We have been deep value investors through our history and have faced periods of volatility before, but given the new liquidity paradigm in which we are operating, bonds seem to gap down faster today than in the past and we are seeing many companies entering a restructuring preemptively while still holding large cash balances on their balance sheets.  We believe this is a notable paradigm shift in our sector and feel it is prudent to adjust accordingly.

Market environments are continually changing and investment strategies should have the flexibility to evolve through various markets.  We believe these efforts position us well to take advantage of the yield offered by the high yield debt market, while operating within the current market challenges as we actively work to protect principal and attempt to reduce volatility.


Posted in Peritus

Strategy Adjustments: New Issue Allocation

Investing is a dynamic process and managers must adjust to the market in which they find themselves.  We have done just that with some recent strategy adjustments.  To address the liquidity issues and concerns within the high yield market, we have instituted a strategic new issue allocation (see our piece “Liquidity Management” for further details), as our research has indicated that new issues tend to be very liquid and stable credits in the months following the issuance.

For a little bit of background on the liquidity issues, as we have discussed before, recent regulations have impacted and eliminated a great deal of market making support for the secondary high yield market.  The primary regulations that have an impact are the Basel accords and the Volcker Rule within the Dodd Frank bill:

  • Basel II+III—The banking provisions that increased capital and liquidity requirements to hold credit rated BB and lower.
  • Volcker Provision—The law inside Dodd-Frank that eliminated proprietary trading, which by its nebulous design has all but eliminated dealer market making.

The SEC has said an area of their focus pertains to secondary trading in bonds/loans and whether there was sufficient liquidity.  They are now looking at further ways to address the amount of “illiquid” bonds/loans within portfolios, but the challenge remains as to defining “illiquid” in a way that can be clearly quantified and monitored.  For instance, some of the big mutual funds and index tracking products have hundreds and upwards of 1000 holdings, and some trade rarely.  With Volcker and other regulations, we have seen added volatility, as we are at times seeing moves in bonds/loans from $2 – $20 or more in a day.

After completing our research and testing our thesis, we began implementing the new issue allocation in December, though it became a more significant allocation in more recent months due to market and economic dynamics.  Through our analysis, bonds seem to be very liquid in the days and months after issuance as the banks that brought the deal to market typically support their own deals, as well as other funds often add it to their portfolios thus helping keep a bid under the bonds.  Additionally, the company filings have been made in order to get the paper into the public markets, meaning they are generally well vetted upon issuance.  In today’s high yield primary market, by and large the higher quality new deals are the only ones getting done, which has resulted in lower coupon income for this allocation versus what we traditionally have generated (many of the coupons we have seen on the new issues are about 5-7.5%, with a select few outside of this range).  However, we believe this allocation provides the additional liquidity and price stability we intended and helps dampen portfolio volatility, so we believe a bit of yield sacrifice is worth it.  Part of this strategy is to continue to roll into more recent new issues, so we continue make efforts to sell previous new issues at premiums as we roll those proceeds into the newly issued bonds.  Along these lines, while we may have a shorter holding period, part of the goal with the strategy is to also have some capital gains potential as well over this holding period, providing what we see as an attractive total return.  The allocation to new issues will be determined by market dynamics and how big we feel it needs to be.

While the new issue allocation has resulted in some lower income generation, we believe it better positions us for the long term as we work to address liquidity concerns and provide more stability to the portfolio.  We feel we have taken steps to address some of the issues that face managers and investors of late, and continue to work to provide an investment strategy and process that fits the market environment.  Dynamic markets require dynamic, active investing.

Posted in Peritus