Mid-Year Update

In like a lamb, out like a lion seems to be an accurate description of the first half of 2015. As we sit in the second week of July, Greece and China have changed investor psychology (risk-off). The overall deflationary threat globally has likely changed the timing of Federal Reserve interest rate hikes as well. Oil has once again rolled over and is likely to test 2014/early 2015 lows.

Recent spread widening for high yield bonds and loans caused by events in Greece and China gives investors what we see as an outstanding entry point and we believe that these assets need to be bought aggressively. Outside of energy (domestic oil and gas exploration and production, and certain oil services companies), we expect default rates to remain well below average. In this environment, we believe that an active and thoughtful portfolio of high yield bonds and loans should continue to outperform various asset classes, including equities and investment grade corporates, for the rest of 2015, just as the high yield market has outperformed in the first half. For more of our thoughts and strategy for today’s market and outlook going forward, click here to read our “Mid-Year Update.”

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Upcoming TV Appearance

Tim Gramatovich will be a guest on the Business News Network today, July 14, 2015, at 2pm ET.

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Actively Navigating Energy Markets

We, like the vast majority, were surprised by the swiftness and severity of the decline in oil prices in late 2014 and into early 2015. As we re-evaluated our holdings several months ago at the oil pricing reality in the $50s and $60s, we decided to strategically eliminate much of our energy exposure on concerns that further price volatility was on the horizon and questioned the sustainability for some of these companies to maintain the income stream on their bonds and dividends given the price reality. While we did generally see a slow and steady move up in oil prices over the second quarter, the first few days of the third quarter once again shows us how quickly prices can move in this space, and how it continues to catch investors off guard. Be it due to China, a deal potential deal with Iran, Greece, or recent U.S. production numbers, Monday alone we saw a nearly 7.5% decline in oil prices.

While we are still long term believers that oil prices will ultimately rise from here, we have stated that we believe that may take the better part of a year to happen on a sustainable basis, so are only focused on those names that we see as able to manage through the currently low price environment. One of the central aspects of our original thesis with oil was that many Canadian producers would be benefiting from the spread compression (reduced discount) in Western Canadian Select (the price used for Canadian producers) versus West Texas Intermediate, and despite the price decline in oil, we do see this thesis playing out. Canadian producers also benefit from the fact that oil is priced in US dollars and their costs are in Canadian dollars, so as we see a decline in the Canadian dollar and an increase in the US dollar, the actual price received and profitability of these producers is better than what the general oil market price implies.

On the flip side, we have and will continue to caution investors against many of the shale oil producers that we see as vulnerable at current oil price levels given the high decline rates on their legacy wells, meaning they need continued capital to keep producing. Many of these companies may have been able to make it through these first couple quarters of 2015 relatively unscathed as they benefit from the hedges they put in place in prior years at much higher prices, allowing them to still generate some reported “cash flow” (which in itself can be deceptive as it often doesn’t factor in capital expenditures), those hedges are staring to roll off and these companies now have to face today’s oil price reality. Furthermore, many of the service provides to this space are also vulnerable, as they face pricing pressure from customers and a drop off in rig counts and drilling activity. This recent article from a major financial publication clearly highlights many of the concerns that we have been vocal about.

Because many of the index-based high yield ETFs are constructed based upon size of bond tranches or maturities for the securities within the broad market, not the fundamentals of the underlying companies, we believe they will be unable to avoid what we see as the coming destruction in the shale oil industry. The various high yield indexes have about 16% to 18% of their portfolio in energy1, making it the highest industry allocation and this industry includes many names related to shale that we see as potential defaults or impaired capital structures.

There will be selective opportunities in the energy space but Monday’s market action has proven that the volatility is not behind us and that investors need to be concerned about broad energy exposure that often comes with broad market investing. Be it navigating the current energy market, or the extensive macroeconomic and global issues confronting today’s financial markets, we believe that active management is essential. Passive products give you broad diversification, but we believe that diversification can come at a cost—here we view it as allocating to a sub-sector within the high yield bond market that we see as particularly vulnerable. But there are also some great opportunities for yield that we see within the high yield market, many of which not at all related to energy, so avoiding the space altogether doesn’t make sense either. You need people behind the scenes paying attention to market action, focusing on company fundamentals, and positioning in the portfolio accordingly as you navigate through high yield investing.

1 For instance, energy is 16.85% of the JP 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 Credit Research, June 26, 2015, p. 56.
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No Bubble Here

We often hear the word “bubble” thrown around when people are taking about various financial markets, asset classes, and sectors. But just what does the word really mean? In looking at the various definitions of an economic or speculative “bubble” you see a few main themes. First, a bubble typically entails a rapid expansion followed by a swift retrenchment. Second, a bubble implies security prices moving much higher than is warranted by fundamentals or the intrinsic value of the security. Additionally, a bubble encompasses a belief that demand for the securities and the security prices will continue to rise—until the bubble bursts.

Recently we have seen market pundits and the media cavalierly throw around the word “bubble” when taking about equity markets in general, the IPO market, biotech equities, Chinese equities, and even our own high yield market, among others. Yes, we have seen a large rise in these various markets off their bottom, but you need more than a rise in a market to constitute a bubble. As the various definitions of the word note, a bubble is when we see the prices rise dramatically above what is warranted by fundamentals or a security’s true/intrinsic value. That means that a price rise alone doesn’t justify a “bubble,” but it must be measured against some sort of valuation methodology.

First, let’s look some valuations in the broad equity sector. In terms of the equity market, P/E ratios are a common way to view equity valuations. If we look at a trailing 12-month S&P 500 P/E ratio going back to 1957, we see the current ratio is 20.2x versus a historical median of 17.42x.1

SP 500 PE ratio 6-30-15

While this is a trailing 12-month PE ratio, let’s look at a forward 12 month P/E ratio2, as we know markets are often forward looking mechanisms:

Factset P-E 6-24-15

Here we currently sit at 16.7x versus a 10-year average of 13.8x. So by these valuation measures, the S&P does look expensive. For instance, on the forward P/E, it is worth noting that we are higher than where we were going into the 2008 financial crisis. Does this qualify as a “bubble”? Expensive, certainly. Due for some sort of correction? Likely. But a completely “bubble”? That case is a little harder to make, as looking at the nearly 60 years of history, while we are above the median levels, we are not near the extremes. And even in an expensive broader market, that doesn’t mean that active managers are not able to select a focused portfolio of 50-100 individual securities that still offer investors value. We believe it is during these sort of times that active management has the most value.

Turing to the high yield market, looking at spreads is a good way of looking at market “valuations.” Below we profile a nearly 30 year history of the high yield market:3

CS HY spreads 6-29-15

So currently we sit at a spread (spread-to-worst over comparable Treasuries) of 539bps, a little bit above the 520bps median over this nearly 30 year period. So how can someone make a “bubble” argument when we aren’t even below the historical median level? Certainly looking at the 2006/2007 period, there was that argument to be made, as we were spread levels sub 400bps and even 300bps, bottoming at 271bps in May 2007 before things started to turn in 2008. On the “fundamental” side, during this 2006/2007 period, corporate leverage metrics were elevated and management teams were aggressive with their spending. M&A deals were being done at ridiculous multiples with buyers putting in very little equity, further adding to corporate leverage. Yet, spreads continued to grind lower, until investors woke up to the reality and wanted to get paid for the risk they were taking. And then, as in many market “adjustments,” we saw the market over-correct in 2008/2009. Today, we are back around historical medians, despite a well below average default rate, reasonable fundamentals in the underlying companies, and what we would view as generally conservative management teams. Today we believe investors are getting adequately compensated for the risk they are assuming.

Another aspect we often see in “bubble”-like markets is that they are basically a one-way trade up, as investors seemingly ignore reality and valuations, until the market crashes into free fall. However, over the past several years in the high yield market, we have seen various periods of spread and yield tightening, followed by sells offs and spread/yield widening.4

CS 4yr spreads 6-30-15

This natural ebb and flow would certainly indicate to us that investors in this space are at least reacting to changing market conditions and dynamics, which we see as healthy.

Finally, generally a “bubble” implies people blindly throwing money at the sector in a frenzied buying spree. Be it bubbles from hundreds of years ago, like the tulip bubble, or the more recent dot-com or housing bubble, we saw investors piling into these areas with the mentality that these markets would only go up. However, we see no such mania in today’s high yield market. In actuality, we have seen only $1.2 billion in inflows into high yield mutual and exchange traded funds so far this year, this after over $20 billion in outflows from the space in 2014.5 Definitely no manic buying here.

So broadly speaking, we don’t see the high yield market as expensive, much less in “bubble” territory. Yes, there are individual credits within the space that we see as over-valued, trading at yields that we don’t believe compensate investors for the risk in those securities, but as active managers, we are able to avoid these areas. Addressing and managing this risk can come in the form of not purchasing high duration/low yielding credits that expose investors to much more interest rate risk. Or it can take the form of avoiding highly levered companies or sub-segments of the space where we have fundamental concerns or questions about the company’s long term ability to service their debt, such as the concerns we have been vocal about with many of the shale-related energy producers that are large issues within the high yield market.

While there are certain areas of the financial markets, such as equities that we see as expensive, and maybe even some areas globally where the word “bubble” may apply, such as the massive run up and swift re-pricing we have seen in Chinese equities over the past few weeks, we view today’s high yield bond market attractively valued, and nowhere near a “bubble.” We have been managing money in the high yield bond market for over two decades and have seen a variety of market cycles. There have been times in the cycle where everything seemed expensive and in order to get any sort of yield you had to take on excess risk. That is not today’s market. As an active manager, we believe there are plentiful opportunities to build a focused portfolio of attractively yielding high yield bonds and loans, without taking on excessive risk.

1 Data sourced from wwww.multpl.com, “S&P 500 PE Ratio” covering the period 4/1/1957-6/29/2015. Current PE is estimated from latest reported earnings and current market price.
2 FactSet, “Earnings Insight,” June 26, 2015, p. 25.
3 Data sourced from Credit Suisse, as of 6/29/15.  Historical spread data covers the period from 1/31/1986 to 6/29/2015.  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 Data sourced from Credit Suisse, as of 6/29/15.  Historical spread-to-worst and yield-to-worst data covers the period from 7/02/2012 to 6/29/2015.
5 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, January 5, 2015, p. 7. First half numbers provided by various market sources.

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History Lesson: The Performance of Various Asset Classes During Periods of Rising Rates

As a high yield manager, we have recently heard a number of people saying (we believe incorrectly) that our market is set up for doom if rates rise.  Rather, history would indicate quite the contrary.  Looking back to 1980, we have seen 15 calendar years in which increase rates increased (here measured by an increase in the yield on the 5-year Treasury), and here is how various asset classes have performed during those 15 annual periods:1

Returns in Periods of Rising Rates

The long-term numbers show that over those 15 years since 1980 where we saw Treasury yield increases (i.e., interest rates rose), high yield bonds had an average return of 13.6%.  This compares to only a 4.4% average return for investment grade bonds and 2.3% for municipal bonds over the same period, both of which are more interest rate sensitive (higher duration) asset classes.  Equities also posted a strong return over the periods of rising rates, yet while we haven’t seen much of a correction in the equity markets over the past month or so on the higher rate concern, we have seen the high yield bond market impacted and outflows from the asset class.

It seems the data is clear that high yield bonds have historically not only provided investors with solid returns during these annual periods of rising interest rates, but has also outperformed more duration sensitive asset classes like investment grade and municipal bonds over these periods.  We believe that investors concerned about the impact of rising rates on fixed income markets should be more concerned with these higher duration asset classes.  Further, we believe that the misperceptions out there that higher rates spell doom for the high yield market and the reaction we have seen in many selling the asset class may create a better entry point for those who understand the historical data and are willing to embrace this market.

For more on how the high yield bond market has historically performed during periods of rate increases and various strategies for investing during periods of rising rates, see our piece “Strategies for Investing in a Rising Rate Environment.”

 

1 High yield and investment grade data sourced from: Acciavatti, Peter Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “2008 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 2008, p. 113; “High-Yield Market Monitor,” J.P. Morgan, January 5, 2015, p. 3; and “2014 High-Yield Annual Review,” J.P. Morgan, December 29, 2014, p. 292. Treasury data sourced from Bloomberg (US Generic Govt 5 Yr).  The J.P. Morgan High Yield bond index is designed to mirror the investible universe of US dollar high-yield corporate debt market, including domestic and international issues.  The J.P. Morgan Investment Grade Corporate bond index represents the investment grade US dollar denominated corporate bond market, focusing on bullet maturities paying a non-zero coupon.  S&P 500 data sourced from Bloomberg. Barclays Municipal Bond Index covers the long-term, tax-exempt bond market (source Barclays Capital).
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No Massive Rate Move on the Horizon

Markets remain laser focused on the Fed and rates, but should investors be so concerned?  Is a big increase coming?  In her press conference last week, Yellen didn’t seem to impart great confidence in the strength of the economy, consumer or job market, indicating the Fed is still looking for further improvement in these areas before they undertake much of a move in rates.  As part of their meeting, they revised downward their GDP forecast to growth rate of 1.8-2.0% for the year, down from their previous estimate of 2.3-2.7%.  What seems to be clear is that the Fed remains “data dependent” in their interest rate policy stance, and the data just isn’t there to support an aggressive rate move.  As much as everyone seemingly wants to end this zero interest rate policy that we have been stuck in for the past seven years, the economic strength just isn’t there yet.

Instead of an imminent move in September, the market chatter is now turning to just one rate rise this year, starting in December.  And Yellen was clear in the press conference that they would not be following any methodical approach to the rate rise, so it seems she has no expectation that once one rate increase is undertaken, that means sustained rate increases at each successive meeting.

This week’s Fed meeting affirms our belief that an aggressive rate increase is not on the horizon.  They may undertake a quarter point or two this year to get the ball rolling, but from their own indications, the economic conditions still have room to improve before they do too much.

For all those concerned about a big increase in interest rates, it is important to understand the dynamics between the various government bond yields/rates and the actual rate the Fed has a direct impact on.  For instance, let’s take a look at the chart below that shows the difference between the yield on the 10-year Treasury bond and the Federal Funds Rate (the rate we are talking about when we say the Fed is raising rates):1

10yr vs Fed Funds

Looking back over the past quarter century, the average spread between the Fed Funds Rate and the 10-year Treasury yield is 1.49 bps versus a current differential of 2.20 bps.2  While the Fed Funds Rate is set by the Fed, the rest of the yield curve is set by market forces and outlook.  And markets are forward looking, so we believe there is a valid argument to be made that the current 10-year yield is already pricing in some rate move given the differential between the 10year and the Fed Funds Rate is already 70bps over historical averages; thus, when we see the Fed actually take action in moving the Fed Funds rate, we may not see corresponding moves in other areas of the yield curve.

So let’s say that the Fed Funds Rate increases by 50bps over the next six months, it seems there isn’t a strong argument to make that the 10-year will undoubtedly spike to over 3% or beyond, as that would be a full 1% or more above the historical average differential.  Looking out further, if we use this historical differential of 1.5bps over the Fed Funds Rate, and assume we end 2016 at a Fed Funds rate of 1.5-2%, that would put the 10-year yield theoretically at 3-3.5%.  So hardly a massive move in the 10-year over the next 18 months if we revert back to these historical averages; rather, a move that we think markets can definitely manage through.  And even for rates to move that far, based on the Fed’s own indications, we very well may need to see the economy improve from the more “moderate” level we currently are at, so that rate increase may even be optimistic.

So yes, we should be paying attention to rates, but we believe the hyper-concern and in some cases sheer aversion to asset classes we have seen in certain areas of the fixed income space, especially our own area of specialty, the high yield market, are unfounded.  We believe that markets will be able to manage well through this time, and investors willing to step in may be rewarded.

The high yield market has actually performed well historically during periods of rising rates. For more on this historical performance and various strategies for investing during periods of rising rates, see our piece “Strategies for Investing in a Rising Rate Environment.”

1 10-year US Generic Treasury Rate (yield) minus the Federal Funds Rate, data from 11/30/88 to 6/18/15, sourced from Bloomberg.
2 Average spread covers the month ending periods from 11/30/88 to 5/31/15. Current differential as of 6/18/15.
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High Yield Bonds and Interest Rates: History Does NOT Indicate Doom is on the Horizon

As investors assess their interest rate sensitivity for fixed income holdings, they often turn to the duration calculation, a measure of the sensitivity of the price of a fixed-income security to a change in interest rates. Per this hypothetical calculation, rates/yields and prices move in opposite directions, so when interest rates are increasing, that would mean that bond prices are falling, and vice versa in as rates fall.

Yes, per this calculation bond prices would fall as rates rise, but looking back over history, we have actually seen high yield bonds perform well during periods of rising rates. How can this be if bonds are supposed to fall when rates rise? There are a few shortfalls with this hypothetical duration calculation that we believe investors should keep in mind. First and foremost, investors need to take into account the coupon income that these bonds generate over the period of rising rates, which may help cushion any rate move impact and still provide the investor with tangible returns.

Second, interest rates generally rise during periods of an improved economic environment. When economic times are tough, we generally see the world’s central banks easing rates to help stimulate the economy. However, when economies start to improve, this gives these central banks room to start raising rates. Even talk on the Fed’s timing right now is “data dependent,” meaning the stronger economic data has to be there for the Fed to start taking action. And stronger economic activity generally is favorable for corporate profits, credit metrics, and company fundamentals alike. Thus, during these times of rising rates and economic expansion, high yield bonds may also benefit from spread compression, meaning the prices of the bonds may be bid up on the improved fundamentals or investor demand and the spread between the yield offered on these bonds and the comparable yield on the equivalent Treasury decreases. In essence, if spreads were constant that means high yield bond prices were declining/yields increasing in lock step with the rate/yield increases in Treasury bonds, yet if we see spread compression, that could mean that prices are holding firm to moving up to more than offset the Treasury yield move.

Let’s put some numbers to this. First, let’s look back at all of the historical full monthly periods when we have seen 10-year Treasury rates rise by 50bps or more over the preceding three and six months or 100bps over the preceding six months, with data going back to 1986 (when the high yield index data begins).1

Blog 6-17-15a

By these historical numbers, the assumption that high yield bonds perform poorly during times of rising rates appears to not be valid. In actuality, we have seen positive returns for this market as 10-year rates move. For instance, during periods when rates have risen 50bps over six months, the high yield bond market has posted a return of 4.5% over that six month period. Even during periods of rapid rate increases, with the 10-year yield increasing 100bps over a six month period, high yield bonds have posted an average return of 2.4%.

Then looking forward at the succeeding six and twelve months, we continue to historically see high yield bonds post positive returns in the periods following these rate moves for the 10-year Treasury:

Blog 6-17-15b

While the 10-year is a widely quoted rate, if we look at equivalent interest rate moves in full monthly periods for the 5-year Treasury, which is more in-line with the average maturity of the high yield bond market, we see similar results:

Blog 6-17-15c

Here again, positive returns and spread compression during the three and six month period of rising rates, even during periods where we see the 5-year rise 100bps over a six month period. Additionally, returns for the periods following these rate increases also remain positive:

Blog 6-17-15d

For instance, we see an average 11% return historically following periods when the 5-year Treasury rose 100bps or more over the preceding six months.

In all of these scenarios, it seems that history clearly indicates that rising rates don’t necessarily spell doom for the high yield bond market. Historical average returns for the high yield bond market have been positive during both periods of rising rates and during the six and twelve months following those rate increases, as this market can benefit from the coupon income generated and the better economic environment that often accompanies rate increases. We believe that instead of shunning the high yield bond market on the assumption that it is bound to fall if Treasury rates continue to increase, investors should instead view the recent weakness in the market as a better entry level to the asset class, as we believe investors may benefit from not only what we view as attractive, tangible coupon income and a potential benefit on improved economic conditions that often go hand in hand with rate increases.

1 5-Year and 10-Year Treasury data sourced from Bloomberg for the period 12/31/1985 to 5/31/2015. High Yield market data based on the Credit Suisse High Yield Index for the period 12/31/1985 to 5/31/2015. The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market.  Calculations based on month ending yields for 5-year and 10-year Treasuries and tracking the trailing three and six month full month moves in those rates (intra-month moves not accounted for). All months are included in which the previous move in Treasuries was above the indicated threshold, even if there were consecutive months that hit the threshold (time periods were not grouped together). All return and spread data based on month end data and analysis month over month (no intra-month analysis). Spreads used for the Credit Suisse High Yield Index is the spread-to-worst. Averages based on all of the individual monthly periods that meet the indicated thresholds. Past returns and spread moves are not an indication of future results.
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High Yield in a Rising Rate Environment: Yield, Duration, Correlation, and Economic Factors

With the move we have seen in interest rates (Treasury rates) over the past month and the concerns that this move up will continue, let’s look at the high yield market and how it has traditionally responded to rate moves. Historically speaking, the high yield bond market has performed well in a rising rate environment due to a number of factors.

Higher coupons and yields in the high yield space help cushion the impact of rising interest rates. High yield bonds, as the name would suggest, have traditionally offered among the highest coupons/yields of various fixed income instruments, corresponding to higher perceived risk. The following chart depicts the current yield-to-worst, coupon, and the spread over Treasuries for several fixed income asset classes.1

Yields, Duration 5-15-15

Let’s think about this intuitively for a minute. If you own a bond with a yield of 3% and interest rates move up 1% that would obviously have a meaningful impact, as we are talking about a move equivalent to 33% of your total yield. However, if you instead have a starting yield of 6.0% on a bond and interest rates move that same 1%, you are looking at significantly less impact, at about a 17% change in yield. So the higher the starting yield, the less interest rate sensitivity.

High yield bonds have shorter durations than other asset classes in the fixed income space. Duration is a measure of sensitivity to changes in interest rates that incorporates the coupon, maturity date, and call features of a bond. The fact that 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, typically provides the high yield sector with a shorter duration, thus theoretically less interest rate sensitivity, versus other fixed income asset classes.   We’ve profiled some duration comparisons below:2

Duration 5-15-15

The prices of high yield bonds have historically been much more linked to credit quality than to interest rates. Historically, interest rates are increasing during a strengthening economy and a strong economy is generally favorable for corporate credit and equities alike. Due to the nature of the high yield bond market, the major risk on the minds of investors is generally default risk (not interest rate risk), causing them to be much more concerned with the company’s fundamentals and credit quality than interest rates. When the economy is expanding, profitability, financial strength, and credit metrics generally improve. So a stronger economy would undoubtedly be a positive from a credit perspective and would indicate lower default rates, meaning likely improved prospects for the high yield market.

Even in today’s environment of minimal economic growth, we are still seeing solid fundamentals for corporations and a well below average default outlook for the next couple years:3

 Default Projections YE 2014

High yield bonds are negatively correlated with Treasuries. This means that as Treasury prices fall as interest rates increase, high yield would theoretically experience the opposite change (increase) in pricing. Additionally, while high yield is still positively correlated to investment grade, it is a low correlation; yet, we see a stronger correlation between investment grade and Treasuries. As noted below, over the past 15 years, high-yield bonds and loans exhibit correlations to the 10-year Treasury bond of -0.25 and -0.38, respectively, versus a far higher correlation of +0.55 for high-grade bonds.4

15 yr correlation as of YE 2014 Expanded

Given these low or negative Treasury correlations versus other asset classes, especially the more interest rate sensitive asset classes such as investment grade, an allocation to high yield bonds may help improve portfolio diversification and potentially lower risk depending on the mix of assets.

For more on how the high yield bond market has historically performed during periods of rate increases and various strategies for investing during periods of rising rates, see our piece “Strategies for Investing in a Rising Rate Environment.”

1 Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). U.S. 5 Year Treasury Note is the on-the-run Treasury (source Bloomberg). Barclays 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). Barclays Municipal Bond Index covers the long-term, tax-exempt bond market (source Barclays Capital). All data as of 5/15/15. The yield to worst is the lowest potential yield that can be received on a bond, without the issuer actually defaulting, and includes the various prepayment options such as call or sinking fund. The spread is the spread to worst based on the yield to worst less the yield on comparable maturity Treasuries. The coupon is the annual interest rate on a bond.
2 Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). U.S. 5 Year Treasury Note is the on-the-run Treasury (source Bloomberg). Barclays 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). Barclays Municipal Bond Index covers the long-term, tax-exempt bond market (source Barclays Capital). All data as of 5/15/15. The Modified Adjusted Duration provided is a measure of interest rate sensitivity based on the yield to maturity date.
3 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review,” J.P. Morgan North American High Yield and Leveraged Loan Research, December 29, 2014, p. 14. 2014 default rates exclude TXU.
4 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 29, 2014, p. 298.
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Strategies for Investing in a Rising Rate Environment

Accurately calling interest rate moves has proved to be a difficult task for investors over the past few years. As we entered 2014, virtually everyone (except ourselves) expected rates to rise as the long awaited “taper” began. Yet, the opposite played out over the year with the 10-year Treasury rate falling nearly 75bps, only to fall further in the beginning of 2015 and subsequently bounce back over the last month. The only aspect of rates that can be accurately predicted is volatility. While we are not convinced that a rapid rise in rates is on the horizon, for the sake of argument, let’s assume that rates do rise from here. What does that mean for the high yield bond market and the various “strategies” out there to deal with rising rates? Historically speaking, the high yield bond market has performed well in a rising rate environment. Click here to read our recent piece “Strategies for Investing in a Rising Rate Environment.”

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High Yield Bonds: Rates and Returns

With a number of data points over the past month, including Friday’s better than expected jobs report, pushing the expectations for a September rate hike higher, concerns about the impact of interest rates on various asset classes is heating up.  It is important to keep in mind that if and when “rates” do rise, we are talking about the Federal Funds Rate which we expect will primarily impact the short end of the yield curve, and less so those 5-year to 10-year maturities that relate more to the high yield market.  While we aren’t convinced that we will see a big spike in these longer term rates, we have certainly seen much volatility over the past month and a half.

As we have written about on numerous occasions, historically we have seen high yield bonds perform well during periods of rising rates.1  We would attribute this to a number of factors, including the relatively lower duration (a measure of interest rate sensitivity) of the high yield bond market versus other fixed income asset classes2, the higher starting yields this market generally provides, and high yield bonds tend to be more driven by the fundamental backdrop, and rates are usually rising during periods of improved economic times, which bodes well for credit fundamentals.

Not only has high yield historically performed well during periods of rising rates, some expectations we saw for 2015 forecasted rates to rise and high yield bonds to still post what we would view as decent performance.  For instance, at the end of 2014, J.P. Morgan published this forecast:3

With our rates team forecasting a 90bp increase in 5-year Treasury yields to 2.60% by YE15, high-yield bond spreads are forecasted to tighten 90bp to end 2015 at T+450bp (absorb 100% of rate increase). A forecasted spread of T+450bp compares to a low for this credit cycle of T+393bp in June (2014), and typical spreads of between 300-400bp in a low default backdrop…And using these targets, our 2015 full-year return forecast for high-yield bonds is 7.0%.

While certainly these are merely projections for the broader high yield market and actual results can always vary, it does go to show that we aren’t the only ones expecting high yield to weather a potential interest rate increase.  Spreads for high yield bonds currently sit at 513 bps4, so well above the “typical spreads” they note above for this sort of default backdrop.  This compares to spreads of 540 bps when they made this forecast in December 2014.5  So we have seen some spread compression so far this year, but according to them we would still have room to compress further.  And then on the 5-year Treasury yield side, even with all of the volatility we have seen over the past couple months in rates, the 5-year yield currently sits at 1.64%, versus closing out 2014 at 1.65%.6

So we certainly don’t see it as a foregone conclusion that all fixed income asset classes, including high yield bonds, will perform poorly if rates do rise this year, as history and expectations for the high yield bond market would indicate otherwise.  Other fixed income asset classes have historically been more correlated and sensitive to interest rates, but we haven’t historically seen those same issues in the high yield bond market.  We would agree instead that spread compression can occur this year, due to the improved fundamental backdrop that would cause rates to rise, and that, along with the tangible coupon income the high yield bond market provides, could more than offset a potential rate impact.

1  See our writings “Strategies for Investing in a Rising Rate Environment” and “High Yield in a Rising Rate Environment: Duration and Yield” for historical returns data.
2  See our commentary “High Yield in a Rising Rate Environment: Duration and Yield” for relative durations of various fixed income asset classes.
3  Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, Chuanxin Li, and David Common, CFA. “2015 High Yield Bond and Leveraged Loan Outlook.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 5, 2014, p. 15-16.
4 Acciavatti,  Peter D., Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update.”  J.P. Morgan, North American High Yield and Leveraged Loan Research.  May 29, 2015, p. 1.  Spread referenced is spread-to-worst.
5  Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, Chuanxin Li, and David Common, CFA. “2015 High Yield Bond and Leveraged Loan Outlook.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 5, 2014, p. 5.
6  Based on the 12/31/14 and 6/4/15 5-year Treasury rates, source U.S. Department of Treasury.
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