Is It Really that “Smart” or “Strategic”?

“Smart” or “strategic” beta.  The name sounds enticing; as an investor of course we all want to be smart and strategic.  In the ETF world, we’ve seen a number of “smart beta”/”strategic beta” funds recently launched.  These funds are positioned as a twist on the traditional indexing approach, a hybrid between passive and active management.  While they generally continue to follow an index, these funds have specific construction criteria that weed out securities that don’t fit their set “rules” or “factors.”  It could be something as simple as constructing an ETF with an equal-weight approach versus a market capitalization weight approach for an equity index, or screen for companies with dividend growth or low volatility.  Or some smart/strategic beta ETFs focus on more detailed screening that include a number of “factors” (thus making them “multi-factor” smart beta ETFs).

The premise behind passive/index-based products is that they offer broad exposure to a market at a lower cost, while the argument for active management is that the human element and focusing on individual security selection can allow for the ability to outperform an index.  These smart/strategic beta vehicles claim to be a means to enhance portfolio returns and reduce risk versus the index as they try to exploit market inefficiencies with their “factors” and offer a lower cost alternative to active investing.  Others say that this is just a means for those managers/issuers to charge a higher fee then they would for a pure index-based product.  The concept is relatively new, so only time will tell.  Additionally, we have seen some people question as to whether this sort of vehicle would result in much higher transaction costs given the monthly (or more frequent) rebalancing to fit the criteria.

While this vehicle type may work in some segments of investing, such as screening out for lower volatility securities within a broader equity index or changing the weight of a security from capitalization weighted to equal weighted, we aren’t convinced that this model really adds much to the high yield market.  For instance, there was a recently issued smart beta ETF that screens for liquidity and credit quality.  We haven’t seen the specifics as to what criteria they use, but generally speaking, we feel putting on arbitrary limitations within the high yield market isn’t wise.  What if you are screening for securities based on “credit quality” using credit ratings?  But in that case, who’s to say the credit ratings are accurate?  We believe the ratings agencies should not be relied upon to determine the true credit quality of a company—they are reactive not proactive, often exclude key factors (for instance, we’ve seen them exclude a company’s cash balance when assessing leverage and liquidity), and not to mention we have all certainly seen the ratings agencies get it wrong (the sub-prime crisis evidence alone).  Rather investors should look at the company’s fundamentals, understanding the outlook and other factors impacting the company as they determine the credit’s quality and prospects.  While not billed as a smart-beta ETF, some of the passive ETFs within the high yield market do have certain criteria that they use that narrows down the index, namely the size constraints. For instance, the two largest passive high yield ETFs have size constraints that limit their investments to primarily bonds that are over a $500mm tranche size in one case and over $400mm tranche size/$1bil in total debt issued by the company in another case.  Our experience has been that size doesn’t necessarily equate to liquidity (if that is the concern and the reason for the size focus) and we have always felt these sort of limitations put investors at a disadvantage as it eliminates a sizable portion of the high yield market and what we see as many attractive investment opportunities within that eliminated portion.

High yield debt investing is a dynamic process. We believe that true active management and fundamental analysis is necessary in this market, with someone looking at an issuing company, analyzing it as a whole (not just a few “factors”) and making an investment decision; computer models alone can’t paint the full picture nor can some rules-based criteria.  We believe that alpha comes from the individual credit decisions and the portfolio construction as a whole, and with that we believe the “smart” or “strategic” investing within the high yield bond and loan market is true active management.

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Investing by Duration

With all of the talk of the Federal Reserve taking action and raising rates in the next couple months, investors naturally are considering how they position their portfolios. Duration is one metric fixed income investors often pay attention to as they assess a potential interest rate impact.  Duration is a measure of interest rate sensitivity (the percentage change in the price of a bond for a 100 basis point move in rates), so the lower the duration the theoretically less sensitive that bond/portfolio is to interest rate movements.

By the nature of the shorter maturities and higher yields, the high yield bond market generally has a shorter duration than investment grade and municipal bonds, meaning high yield bonds are less sensitive to interest rate moves. Yet even within the high yield bond market we are seeing some products and vehicles with a lower duration than others.  Like most aspects of investing, you don’t want to consider duration in a vacuum, investing only according to what vehicle has the lowest duration. As noted above, duration measures a price change due to a rate move, but the price changed needs to be coupled with the portfolio’s yield to get a better idea of the expected return under various scenarios. Let’s look at some of scenarios to see how this plays out.

First, let’s hypothetically say you could achieve a portfolio with a duration of 2.25 years, so a 100 bps change in rates over 6mos would mean that the price of your portfolio would theoretically decline by 2.25%. If your starting current yield on the portfolio was 6.5%, meaning you theoretically generate 3.25% of income over that 6mos, then you are looking at a theoretical net gain of 1% (3.25% – 2.25%) over the period of rising rates. However, if you can build a portfolio in the high yield bond and loan market investing according to both maximizing yield and considering duration (keep in mind, loans are floating rate obligations so can serve to lower a portfolio’s duration), let’s say you can build a portfolio with a duration of 3.0 years and a current yield of around 8.5%. In this case, your theoretical sensitivity to a 100bps movement over 6mos would be a price change of 3.0%, but you would be theoretically generating 4.25% of income over the 6mos, so your net theoretical gain would be 1.25%. If that 100bps interest rate movement is over a year instead of 6 months, that yield benefit gets even larger, putting you at a theoretical net gain of 4.25% for the hypothetical short duration portfolio versus a theoretical gain of 5.5% for the higher yielding portfolio.1 And of course, if rates don’t move or even decline from current levels, then the higher yielding portfolio would not only benefit from the higher starting yield but potentially a theoretical positive price movement per the duration calculation.

Below we graphically depict a this and other scenarios that show how duration and yield would theoretically interplay during periods of rising rates for a variety of scenarios.2

Duration 10-6-16a

So we see this as compelling evidence that investing purely according to a short duration strategy and not factoring in yield is not necessarily the wisest way to approach this environment.  At the end of the day, yield matters.  A higher yield can go a long way in making up for relatively small differences in duration.  Thus we believe there are benefits to having the flexibility to build a portfolio that not only maximizes yield but also lowers duration as not only a better way to address interest rate risk, but can also provide less interest rate sensitivity relative to the broader high yield market and other products without this same flexibility.  Furthermore, even if rates do rise, it very well can take longer than many expect as we have seen over the last year, making the argument for the higher yielding portfolio versus the purely short duration portfolio even stronger.  For more, see our piece “Strategies for a Rising Rate Environment.”

1 The duration and price movement relationships are theoretical approximates and calculations are provided for illustration only. These calculations assume that credit spreads, among other factors, remain constant and do not factor in any fees or expenses or changes in price movements for other reasons, including security fundamentals, etc. Actual results may be materially different.
2 The duration and price movement relationships are theoretical approximates and calculations are provided for illustration only. These calculations assume that credit spreads, among other factors, remain constant and do not factor in any fees or expenses or changes in price movements for other reasons, including security fundamentals, etc. Actual results may be materially different. Barclays High Yield Index as of 10/7/16, with “duration” based on the Macaulay duration to worst and “yield” based on a current yield assumption of average portfolio coupon divided by the average portfolio price.
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High Yield in a Rising Rate Environment

HY rising rates 1pg 9-26-16b

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Volatility Within the High Yield Market

In our conversations with investors and advisors, we sometimes hear concerns about volatility within the high yield sector expressed.  People seem to be okay with equities but aren’t sure if the high yield market is too volatile for them—seemingly under the impression that high yield bonds are much more “risky” and volatile than equities.  However, the actual data shows that looking back over the last 25 year history, high yield bonds have shown to have significantly less volatility (as measured by annualized standard deviation of returns) than equities (here represented by the S&P 500 Index).1

CS vs SPX 25yr 9-30-16

In actuality high yield bonds have had nearly half of the volatility of equities but with similar returns; thus on a risk adjusted basis (using the annualized standard deviation as the measure of risk) high yield bonds have significantly outperformed equities, as noted with a return/risk of 1.08 for the high yield bond index versus a return/risk of 0.65 for the S&P 500 index over this 25 year history.

While this may be true for the last twenty five years, does recent history paint a different picture?  In our writings we have discussed how the post financial crisis Dodd-Frank Bill and Volcker provision have worked to curtail market making efforts by the investment banks and in turn has led to higher volatility within the high yield market.  However, even looking over the last one and three years, it has continued to hold that high yield bonds show less volatility then equities.2  While the drag from high yield’s exposure to energy and commodities has negatively impacted performance in late 2014 through early 2016, bringing down the entire high yield market’s performance during the past three years, we still saw risk adjusted outperformance (return/risk) for high yield over that period.

CS vs SPX 1,3yr 9-30-16

Yes, along with the higher return potential, high yield bonds are more volatile than some other areas in the fixed income space (such as investment grade bonds); however, history has demonstrated that high yield bonds are less volatile than equities.  We believe that given the historical return profile, high yield bonds can be viewed as an alternative to equities but with less volatility, as evidenced by the historical risk adjusted outperformance versus equities over various periods.

1 Credit Suisse High Yield Index data from Credit Suisse. The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market, data sourced from Credit Suisse. S&P 500 numbers based on total returns, data sourced from Bloomberg. Period covered is 9/30/91 to 9/30/16. Calculations based on monthly returns and standard deviation is calculated by annualizing monthly returns. Return/risk is based on annualized total return/annualized standard deviation. Although information and analysis contained herein has been obtained from sources Peritus Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and other fixed income securities involves various risks and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.
2 Credit Suisse High Yield Index data from Credit Suisse. S&P 500 numbers based on total returns. Calculations based on daily returns and standard deviation. Return listed is for the actual return for 9/30/13-9/30/16. Standard deviation is the annualized number based on the daily returns and an assumed 250 (251 for 2016) trading days per year. Return/risk is based on annualized total return/annualized standard deviation.
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High Yield Market Conditions

As we all know, the Fed held rates steady last week and while they kept the door open for a December rate hike, they certainly didn’t indicate it is a foregone conclusion.  There are a number of important data points to watch over the coming months, not to mention an important election, which may well impact the outlook for markets and rates.  So just how is the high yield market positioned in this environment?

First, we believe that that high yield market remains an attractive area for investors looking for income and yield.  While we have seen strong performance for high yield so far this year and spreads come in from the 2016 lows, we still see value here and further room for spread tightening.  As we argued at the time, the decline in high yield that we saw in late 2015 and early 2016 was way overblown given the fundamentals of many of the credits in the high yield space.  Yes, at the time, energy and other commodity prices were in free fall and the entire high yield market seemed to be taking cues from that as selling pressure was widespread across industries.  In the months since the February lows in the market, we have seen stability in energy and other commodity prices and have seen investors begin to pay attention to fundamentals once again in non-commodity credits.  The issues in commodities are now well known and the impact from these prices on the companies is visible, while the stable fundamentals outside of commodities is also visible.  Commodity related defaults have been by and far the major source of the spike in defaults so far this year, and now seem to have peaked, as defaults have begun to decline in the most recent month.  All the while, default rates in non-energy/commodity credits remain near historic lows.

On the technical side, we believe we are seeing a healthy market in terms of retail fund flows.  It certainly hasn’t been a one-way trade in flows into exchange traded and mutual funds over the recent months, with money blindly flowing into the market.  Rather, we have seen many weeks of inflows, but also some weeks of outflows, in some cases large outflows—a give and take that you’d expect during normal, healthy market conditions.1

Weekly Fund Flows 9-23-16

Yet, interest remains strong in the primary market, as we have seen pretty steady new issuance over the past few months (of course excluding the seasonal end of summer slowdown).  This is allowing companies to lower interest rates and extend bond maturities, which we believe further positions the issuing companies well for the future.

The Fed action, as well as actions by central banks in Europe and Asia, indicate this low rate environment will continue for now.  In the midst of this, we believe that today’s high yield market is offering attractive yield, especially compared to many other asset classes out there, to investors given the fundamentals of the underlying credits.

1 Leverage Commentary and Data,  Based on weekly reported fund flow information, including Jon Hemingway, “HY funds outflows moderate to $273.5M this week,” 9/22/16; Jon Hemingway, “HY funds see $899M of inflows in latest week,” 8/18/16; Matt Fuller, “US HY fund flows turn negative with ETF-heavy outflow,” 5/26/16.
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Rates and the Curve

This past week the weaker economic data seemed to put more at ease that the next rate increase isn’t coming when the Fed meets on Wednesday, yet rate talk continues to dominate market conversations and markets will be waiting for what is said on Wednesday as to if a December increase is likely.  As rates do ultimately rise at some point, we would expect to see a larger move in the shorter rates, but don’t expect to see a huge spike in the medium to longer term rates (5 and 10-year Treasury rates)—in short, we’d expect a flatting of the yield curve.  Ever since the Fed began their tapering in 2013, we have started to see the yield curve beginning to flatten.1

Yield Curve 9-16-16

The Federal Funds Rate and rates and US Treasury debt are independent of each other.  Federal Reserve action changes the Federal Funds Rate, which is an interbank lending rate.  This in turn can impact market expectations for rates and market psychology, and market forces (investor demand) in turn “set” the rates on US Treasury debt.  For instance, if investor demand lessens for Treasuries and they all of a sudden require to get paid more to hold Treasuries, this causes Treasury yields (rates) to increase.  In our own high yield market, “spreads” are priced off of comparable maturity Treasury rates, so it is these 5- and 10-year rates that are in focus for us.

With the most recent Fed chatter, we have seen the 10-yr move about 30 bps up from its 2016 lows of 1.37 bps in early July to 1.7 bps today, with an almost 30bps move in the 5-year Treasuries over this period as well.2  Yes, this renewed rate talk does bring an immediate market reaction in US Treasury rates; however, we don’t expect to see a sustained and significant spike in the longer-end 5-, 10-and 30-year rates, even if/when the Fed takes further action in raising the Federal Funds Rate over the next year.  We would expect the shorter-end of the curve to be impacted by Fed action, but we’d expect the longer-end of the curve to continue to be constrained by a number of factors, including the following:

  • Global Growth: We are in the midst of a weak global demand outlook and a weak global economic environment.  China has been slowing, quantitative easing is still underway by the ECB hoping to get things going in Europe, and the Bank of Japan has been even more aggressive in their intervention.  Demand worldwide is tepid, impacting corporate profits and demand her at home.  Retail sales, industrial production, and GDP growth have been anything but robust here in the US.  In short, we certainly don’t have a strong economy that the Fed needs to temper and that the strong “data” the Fed looks to may be hard to come by in order to make much of a rising rate argument.  These longer dated Treasuries certainly take their cues from the data as well.
  • Global Rates: We expect that historically low, and in some cases negative, rates on sovereign debt throughout much of the developed world compared to our rates and economy will cause a continued demand for much higher yielding US Treasuries.  For instance, investors are in essence paying to have their money held for 10-years in Japan, Switzerland, and Germany.  Much of the rest of Europe has rates sub 0.5%, while the UK, even if the face of all of the Brexit uncertainty has rates under 1%.
  • Global Demographics: The population is aging and with that investors will become more and more focused on capital preservation and income generation causing them to rotate from equities into fixed income.  Additionally, as pensions focus more on liability driving investing (matching assets/income with upcoming liabilities/payouts), stability and calculated income will be key. We are already in the beginning stages of this and expect it to continue (see our pieces “Zero Sum Game” and “Of Elephant and Rates”), causing a demand for fixed income assets in the years and decades to come.

While we may see some continued near-term volatility in the 5- and 10-year rates on this resurgence of Fed-speak, we ultimately don’t expect the see a sustained upward swing in these yields.  We expect that the yield curve will flatten and in this low yield environment investors will continue to search for yield, and we believe that with the yields offered by high yield bonds, this remain an asset class investors should consider as they look for this yield.

1  Based on US Department of Treasury data, as of 12/31/13, 12/31/14, 12/31/15, and 9/16/16.
2  2016 low on 7/5/16 versus rate as of 9/16/16.
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What we Know

All eyes are on September 21st.  Just over a week or so ago, people seemed to feel a September rate hike was unlikely, now over the course of a week and a bit of hawkish Fed-speak, many now seem to believe September may actually be in the cards.  On Friday we saw security prices fall across the board, with both risk assets and Treasuries taking a hit.

Financial markets across the world have been taking their cues from central banks for years now, and last week was just another example.  Over the week, the ECB (European Central Bank) decided they would not take further easing measures at this time.  We know the Federal Reserve wants to at some point begin raising rates, thought timing uncertain.  What happens if the Federal Funds Rate increases 25bps or even 50bps over the next six months?  Do Treasuries all of a sudden spike?  For instance, could our 10-year move up 0.5% or even 1%, even in the face of rates for 10-year government bonds below zero to slightly above that in many other developed nations around the globe?

In 2013, we saw the “taper tantrum” as the Fed started tapering off their quantitative easing measures, with the 10-year yield/rate beginning its move up in May 2013 from around 2% to end 2013 at 3% only to see bond yields fall back to just over 2% by the end of 2014.  The move in 2013 was all in anticipation that the Fed would be lessening their easing measures over time and rates would eventually rise, though all of the “tapering” occurred during 2014 as Treasury rates were actually falling off their 2013 highs and that first actual Federal Funds Rate increase didn’t come until two years later.  In 2015, we saw the 10-year Treasury open the year around 2.2% and had lots of ups and downs, as anticipation about the first rate hike began to gain momentum, with yields peaking at just under 2.5% in June 2015 and staying above 2% until starting its steady decline in late December and into January 2016 after the Fed undertook their first increase on December 16th, 2015.  It would seem over the last few years, the anticipation has taken more of a toll on markets than the reality of a rate rise.  Will this time be the same?  Are we seeing a move up in Treasury yields in anticipation of some Fed action, only to see Treasury yields fall once they actually move?  It may well be given the global environment we are facing.

We know a few things that I believe should help us frame how we view a rate increase.  First, we know that this is a VERY measured Fed.  Given their past actions, I don’t think we would expect any aggressive action from them.  We know they want to raise rates to at least start somewhat on that path and give them some policy tools for the future should markets decline, but if they did take an increase and the market all of a sudden started tanking, we would expect they’d hold off on further increases until they saw market stabilization.  As recent history has shown, they certainly don’t have blinders on to market reactions to their policy moves.

We also know that rates across the globe are exceptionally low.  Yes, the German 10-year has moved back into positive yield over the past few days but still hovering around zero, while Japan and Switzerland remain negative.  And yields through much of the rest of the developed world are around 1% or below.  If US rates were to move up much, it seems likely to us that buyers from around the world would step in and buy our bonds on the back of our comparatively better economy—and we’d expect this buying activity would constrain the upward move in Treasury yields.

We also know that economic data has had its own fits and starts over the past several years; we haven’t seen a sustained strong and upward movement. And we know this Fed is “data dependent.”  If the data does take a clear path toward improvement and the Fed does see further room to raise rates above and beyond one or two rate increases over the next year or so, investors need to keep in mind that increase will be in the face of a clearly improving economy.  And an improving economy is generally good for markets, so that could provide an offset to higher rates.  Given how measured and slow to act today’s Fed is—for instance, even if we get a September rate increase, it would have been more than nine months since the previous hike—and the fact that global growth continues to stall and domestic data hasn’t shown consistent strength, we don’t think that the data will be there for a massive rate increase in the foreseeable future.

We will at some point need to come out of the environment of quantitative easing and low rates.  It took from 2008 to December 2015, so seven years, for the Fed to make their first move and it may well take years for them to move rates materially off these historical low levels, barring no further cyclical downturn in the meantime, at which point they may need to revert back.  We do expect any sort of move up to be slow and measured and think it is very likely in this economic environment that we may well be one and done for the time being.  Equities are trading at historically high valuations in the face of declining earnings, so we feel that a correction there is likely overdue and warranted, whether it be to a potential rate increase or something else.  In the high yield market, we continue to see valuations (spreads) still around historical median levels (see our piece “Looking for Yield?”) and if we look at history, high yield bonds have actually performed well during raising rate environments (see our piece “Strategies for Investing in a Rising Rate Environment”).

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Looking for Yield?

After a rough start to the year, following a negative 2015, the high yield bond market has reversed course and posted strong returns year-to-date, now up 15.0% through the end of August1.  This compares to a return of 7.8% for the S&P 500 index2.  Is the run over for high yield?  We certainly don’t think so.

A few things to keep in mind.  Yes, some of the strong return in the high yield index (and likely the S&P 500 too) has been energy induced.  As we have previously noted, energy and commodities are a notable portion of the high yield index and as energy recovered off the mid-February lows, we have also seen high yield recover.  However over the past few months we have seen oil prices range bound, though volatile within that range, and high yield still going up even when energy prices were going down (see our piece “Breaking the Correlation”).  Looking at just the last three months, the high yield market has still outperformed equities with the Barclays US High Yield Index up 5.8%3 and the S&P 500 up 4.1%4, all the while oil prices (WTI) were down nearly 9%5.  And looking at the YTD performance of high yield bonds of 15.0%, this market is still up 11.7% excluding commodities6.  So certainly energy prices aren’t the only driver of return for high yield.

One of the biggest current draws we see in high yield is the yield advantage we see it offering versus other areas of fixed income and equities.7

Yield Comps 9-6-16

As demand and prices for high yield bonds have increased so far this year, we have seen the yield come in; however, the yield offered by high yield bonds still far surpasses that offered by other asset classes—twice that offered by investment grade, three times the (dividend) yield offered by the S&P 500 and nearly four times what is offered by the 10-year Treasury.

For the naysayers and those that question whether there is more room for the high yield market to go higher from here, it is important to keep valuations in mind.   In terms of valuation, it is well known that equity valuations are currently high relative to history so don’t appear to be cheap by anyone’s measure, while high yield bond spreads are currently right about at the 20-year median levels.8  Also, on the default side of things, we are starting to see defaults decline in the most recent month after accelerating over the past year.  As we have noted in the past, default rates have increased this year by and large due to energy and other commodity related defaults.  Excluding these commodities, default rates are currently only 0.5% for the rest of the high yield market versus historical high yield default averages near 3.5-4%.9

Potential Fed action is an overhang on markets, but even if the Fed were to undertake another rate hike in the coming months, we don’t expect that to tangibly mean much for high yield bonds.  We would expect high yield bonds to weather an increase better than equities and we’d also expect any rate move to be very small.  The Federal Reserve is being anything but aggressive with their interest rate increases.  We saw the first rate increase in nearly a decade last December, and even if they were to do another rate hike in September, which seems doubtful, it would have been nine months since the last hike.  We all know they want to raise rates, but the economic data is forcing them to be extremely measured in doing so.  By their reading, they have seen some improving data, so maybe another rate increase in justified in their minds, but we don’t see much more beyond that in the near- to medium-term.  We remain in an environment of a weak global economy and negative yields through much of the rest of the developed world, which we believe will ultimately constrain domestic rates (Treasury yields) no matter what small movements the Fed makes in the Federal Fund Rate.  It’s these Treasury yields, primarily the 5- and 10-year, which are more relevant for high yield bond investors, not the Federal Funds Rate.  We think it is just as likely for the 10-year Treasury yield hit 1% as it is 2%…there are just so many global pressures that we wouldn’t be surprised to see the 10-year Treasury yield take another step down, no matter the “Fed speak.”

So as we enter September and investors look where to position themselves for the rest of the year, we believe the high yield market is an attractive area to consider.  Valuations appear reasonable in the face of low defaults in much of the market (outside of commodities) and yields double and triple some of those available from other asset classes.

1  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High-Yield Market Monitor,” J.P. Morgan North American Credit Research, September 1, 2016, p. 4,  Based on the J.P. Morgan U.S. High Yield Index, covering the period YTD through 8/31/16.
2  Data sourced from Bloomberg for the period 12/31/15-8/31/16.
3  Data from Barclays, based on the Barclays US High Yield Index as of 5/31/16-8/31/16.
4  Data sourced from Bloomberg for the period 5/31/16-8/31/16.
5  Data sourced from Bloomberg for West Texas Intermediate, for the period 5/31/16-8/31/16.
6  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High-Yield Market Monitor,” J.P. Morgan North American Credit Research, September 1, 2016, p. 4,  Based on the J.P. Morgan U.S. High Yield Index, covering the period YTD through 8/31/16.
7  Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). 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). U.S. 5 and 10 Year Treasury note yields sourced from the U.S. Department of Treasury as of 8/31/16. Yield used for the High Yield and Investment Grade Index is the Yield to Worst, which is the lowest, or worst, yield of the yield to various call dates or maturity date, data as of 8/31/16.  S&P 500 dividend yield sourced from as of 9/6/16.
8  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High-Yield Market Monitor,” J.P. Morgan North American Credit Research, September 1, 2016, p. 12,  Based on the J.P. Morgan U.S. High Yield Index, current spread of 564bps as of 8/31/16 versus 20-year median of 573bps.
9 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High-Yield Market Monitor,” J.P. Morgan North American Credit Research, September 1, 2016, p. 3,  Based on the J.P. Morgan U.S. High Yield Index.
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The High Yield Market: Market Size, Ownership, Funds, and Opportunities

The entire U.S. fixed income market (municipals, Treasuries, mortgages, corporates, federal agency bonds, money market, and asset back securities) totals over $41 trillion.1

FI Asset Class 3-31-16

Corporate credit (high grade, high yield bonds, and floating rate loans) is about $9.3 trillion of this pie. The high yield bond market is a growing piece of that corporate debt piece, now at $1.61 trillion.2

HY Market Growth 8-24-16

If you add in high yield floating rate loans, that includes another nearly $1 trillion and together high yield bonds and loans account for almost 30% of corporate debt.3

Leveraged Loan Market growth 8-24-16

The number above includes only institutional loans, but if you factor in other non-investment grade term loans and bank-held facilities, you get a broader loan market size of $2.3 trillion.4  One thing is clear, that the high yield debt market is a growing market, and one that cannot be ignored for fixed income investors.

As we look at just who owns high yield bonds, the three largest categories of owners are pension funds, insurance companies, and retail mutual funds, all of which have relatively similar size of ownership at just over a quarter of the market each.5

Who Owns HY 2015 8-24-16

With this we see both institutional and retail customers as active in the space. High yield ETFs account for about 13.5% of the total $271 billion “retail” high yield fund base6, which includes the much larger mutual fund counterpart, and ETFs account for about 2.8% of the broader high yield market and have been around the level for the last four years and loan ETFs less than 1% of that total market.7

ETF Ownership 2015 8-24-16

While a very small portion of the total market, the place of high yield ETFs within the broader high yield bond market has been a discussion point over the last year, with some critics speculating that some wider-spread selling in high yield ETFs could cause a collapse in high yield markets due to “liquidity” issues. We have previously explained how recent regulations post the financial crisis have led to less market making and lower dealer inventory of bonds, and the impact that has had on markets (see our piece “Understanding Market Liquidity”, “The Pricing Issue in High Yield“).

Flows in and out of these “retail” mutual and exchange traded funds (though we know that various institutions are buyers of mutual and ETFs as well) can be volatile week over week, but again, these flows pale in comparison to size of the total market.  For instance looking back over 2015, the largest weekly reported weekly retail (exchange traded and mutual fund) flow totaled around $3.8 billion8, and looking at fund flows over the past six months, which include both the largest and second largest weekly fund inflow on record, these flows were still sub $5 billion9, which compared to a $1.6 trillion market means it is about 0.3% of the total market, so seemingly miniscule.

Weekly Fund Flows 8-10-16

Over this period, the largest ETF-related flow was $2.3bil, so less than 0.015% of the total market.  Interestingly, with the increased difficultly in sourcing and buying bonds post the new regulations, we have seen situations recently where institutions turn to buying ETFs and then take the underlying bonds on redemption (in-kind redemption of security versus cash) as a way to quickly and easily gain exposure to the underlying bonds; rather than trying to build a portfolio on their own.

Not only do we see ETFs benefiting from their in-kind redemption mechanisms, in this environment of lower dealer inventory and heightened price volatility, we believe that high yield ETFs provide an advantage over mutual funds during more volatile times because ETFs trade/price intra-day, so we would argue provide a more accurate and true pricing mechanism for going in and out of the high yield market than mutual funds that only trade at the end of the day.

We see the high yield bond and loan market as an important part of the fixed income asset class, especially in this global low yield and high domestic equity valuation environment.  We believe that high yield ETFs provide investors great accessibility to the asset class. And while the recent regulations may add an element of volatility to the market, we would view this volatility as an opportunity for active managers like Peritus who have the ability to capitalize on discounts and can be intentional about the credits they invest in.  We have seen the high yield market stabilize over recent months but we believe that there are still attractive opportunities within the market.

1 From the publication “Outstanding U.S. Bond Market Debt” release by SIFMA, data as of 3/31/16.  Koch, Fer, Miranda Chen, and James Esposito.  “CS Credit Strategy Monthly,” Credit Suisse US Credit Strategy.  April 11, 2016, p.16, 42,
2 Koch, Fer, Miranda Chen, and James Esposito.  “CS Credit Strategy Monthly,” Credit Suisse US Credit Strategy.  April 11, 2016, p.16, 42,
3 Koch, Fer, Miranda Chen, and James Esposito.  “CS Credit Strategy Monthly,” Credit Suisse US Credit Strategy.  April 11, 2016, p.16, 42,
4 Koch, Fer, Miranda Chen, and James Esposito.  “CS Credit Strategy Monthly,” Credit Suisse US Credit Strategy.  April 11, 2016, p.41,
5 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2015 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 29, 2015, p. A152,
6 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2015 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 29, 2015, p. 125,
7 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2015 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 29, 2015, p. 130,
8 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2015 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 29, 2015, p. 126,
9 Leverage Commentary and Data,  Based on weekly reported fund flow information, including Jon Hemingway, “HY funds see $899M of inflows in latest week,” 8/18/16; Matt Fuller, “US HY fund flows turn negative with ETF-heavy outflow,” 5/26/16; Matt Fuller, “Investors dump record $5B of retail cash into US HY funds,” 3/3/16.
Posted in Peritus

Breaking the Correlation

Oil prices began their decline in late 2014 and accelerated over 2015 into early 2016.  As we got into 2015 and early 2016 we were see a dynamic whereby declining oil prices were causing contagion to the entire high yield market.  Here is what we wrote in January 2016 (from “The Pricing Issue in High Yield”):

As per what has caused and is causing high yield bonds and loans to fall in price, this dates back to 2014 when oil prices started to drop.   The various high yield indexes had somewhere between 15% and 18% of their holdings related to the oil industry at the time depending on what index you looked at.1  Investors began to worry and began to withdraw funds from this asset class as -$7.1B left bonds and -$16.4B left loans in 2015.2  With this, high yield managers had to provide liquidity to those investors that were exiting the asset class and this introduced another issue: liquidity.

With the implementation of the Dodd Frank regulations and the Volcker rule going into full effect in July, liquidity in the secondary market is not what it once was.  Mutual fund and exchange traded fund (ETF) managers,  authorized participants (APs) that handle the creation and redemption process for ETFs, hedge fund managers, institutional investors, and others managing and trading high yield debt had to work harder to find buyers for their bonds/loans.  To keep portfolios in balance during periods of withdraws, portfolio managers had to liquidate portions of securities across the board in some cases, even selling their best securities in their portfolios, thus pressuring the broader market and resulting in virtually the whole market being repriced lower. 

The situation we were facing at the time was that the energy fears were causing people to exit high yield in general, which in turn was dragging down the entire market.  Outside of energy and commodities, we were seeing prices gap down 5, 10, 15 or even more points on no change in fundamentals due to this selling pressure.  As oil began to stabilize and bounce back beginning in late February and March 2016, we started to see high yield bond prices also stabilize and improve.  In short from late 2014 through much of 2016 we have seen a strong correlation between high yield bond prices and oil prices.3

WTI vs HY Price 8-12-16

However, over the last few months, we are seeing this correlation breakdown, whereby high yield has continued to increase during a period when we saw oil prices falling.4

WTI vs HY Price 8-12-16, 3mos

Since the bottom in February 2016, we have seen a strong rebound in the prices of energy related bonds, but we have also seen many other bonds that went down due to then energy contagion bounce back up as well—in the case of the latter, down for no fundamental reason and now back up as fundamentals reassert themselves.  Fundamentals matter and investors are waking up to the attractive yield much of the high yield market offers, especially in the face of low, and in some cases negative, yields for much of the rest of the fixed income asset class.

Energy and commodities still remain a large portion of the high yield index and various sub-sectors of energy and commodities remain depressed, but those issues are now well telegraphed and are no longer gripping investors with fear and causing them to leave or avoid the high yield market entirely.  Bankruptcies in the energy and commodity sectors have increased dramatically and will likely continue, but it is becoming more and more clear which companies are able to handle the current pricing environment versus which ones are not, as we are now going on nearly two years of price declines.  All the while defaults in the rest of the high yield market remain well below historical averages.  Yes we may well continue to see volatile energy prices, but we don’t expect the entire high yield market to get drug down in the process as we saw last year.  There are names to avoid in energy as well as opportunities in the space, just as there are some credits that we see as overvalued or carrying too much risk relative to the yield in other industries, but there are also very attractive yielding opportunities within high yield.  We believe that an actively managed approach to high yield bonds and loans can position investors well for yield generation moving forward and we view this market as offering investors an attractive alternative to equities trading at high valuations in the face of no growth and to fixed income sectors that offer little in the way of yield.

1 For instance, energy was 16.6% of the J.P. Morgan High Yield Index as of December 2014. 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. 18,
2 Fuller, Matt, “US HY funds net small inflow to close 2015 after three big outflows,” January 4, 2016, S&P Capital IQ, LCD News. Fuller, Matt, “Outflows from loan funds stay heavy to close 2015,” January 4, 2016, S&P Capital IQ, LCD News,
3  Data sourced from Bloomberg and covers the period 6/30/14 to 8/12/16.  WTI is West Texas Intermediate closing price.  High Yield is represented by the Bank of America Merrill Lynch High Yield Index, with the average price on the underlying bonds used. The Bank of America Merrill Lynch High Yield Index monitors the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.
4  Data sourced from Bloomberg and covers the period 5/31/16 to 8/12/16.  WTI is West Texas Intermediate closing price.  High Yield is represented by the Bank of America Merrill Lynch High Yield Index, with the average price on the underlying bonds used.
Posted in Peritus