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 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 can 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, https://research-and-analytics.csfb.com.
2 Koch, Fer, Miranda Chen, and James Esposito.  “CS Credit Strategy Monthly,” Credit Suisse US Credit Strategy.  April 11, 2016, p.16, 42, https://research-and-analytics.csfb.com.
3 Koch, Fer, Miranda Chen, and James Esposito.  “CS Credit Strategy Monthly,” Credit Suisse US Credit Strategy.  April 11, 2016, p.16, 42, https://research-and-analytics.csfb.com.
4 Koch, Fer, Miranda Chen, and James Esposito.  “CS Credit Strategy Monthly,” Credit Suisse US Credit Strategy.  April 11, 2016, p.41, https://research-and-analytics.csfb.com.
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, https://markets.jpmorgan.com.
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, https://markets.jpmorgan.com.

 

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, https://markets.jpmorgan.com.
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, https://www.lcdcomps.com/.
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

Loans: Understanding The Floating Rate

As we have previously noted (see our piece “Today’s Floating Rate Loan Market”), we see investing in the loan market as predominantly a way to expand our investment universe. High yield debt issuers have the option to issue bonds, loans, or both.  We see cases where companies take out bonds with loans or vice versa, take out loans with bonds, so by having the option to include both, we are able to access the companies where we see attractive metrics and yield no matter the security type, and in cases where a company issues both bonds and loans, loans are secured and rank higher the company’s capital structure so may allow for the ability to invest in a lower levered piece of the capital structure.

However many see loans primarily as a way to reduce your interest rate risk.  Yes, loans are floating rate securities and provide the portfolio with a duration benefit given this floating rate.  Yet, investors must understand to what the “floating” rate is tied.  Bank loans are generally based on short-term LIBOR rates, which doesn’t tie very closely to longer term 5- and 10-year Treasury rates, the more relevant rates for high yield bond investors.  And in turn, those Treasury rates are reflective of interest rate moves and the Fed speak we see here at home.

Over the past year, we have seen the 10-year Treasury rate move down over 75bps over this period1, while LIBOR rates have more than doubled, moving up 46bps.2

LIBIR rates 7-28-16

Treasury vs LIBOR 2.5yr 7-29-16

So again, while the 5- and 10-year rates are the more relevant rates for high yield bond investing, the chart above clearly shows that these rates here in the U.S. don’t closely correspond to 3-month LIBOR rates and the two rates don’t necessarily move in the same direction, as evidenced by the volatility we have seen in U.S. Treasury rates over the past three years, all the while LIBOR was flat until starting its spike upward a year ago.

Over the past few weeks we have seen LIBOR move to its highest level since 2009.  While such a rapid rise is certainly not a good sign, as the spike could be seen as an indication of concerns about the financial system and interbank funding, there is a bit more going on right now.  Rather LIBOR is currently being impacted by some market regulations for money market mutual funds that go into effect in October.  This is resulting in a currently lower demand for short-term securities now that we are in the 90 day window before these regulations become effective, which is in turn pushing up LIBOR rates—as with most securities, when demand goes down, higher yields are often offered to attract buyers.

Many, if not most, floating rate bank loans have LIBOR floors, generally ranging from 0.75-1.5%.  This means as short-term LIBOR rates hit 0.75%, this is starting to have an impact on the rates floating rate loans are paying, so while Treasury rates remain near historic lows and many, including us, are skeptical as to whether we’ll see any material move in domestic interest rates anytime soon, we could actually start to see rates on these LIBOR-based loans start to increase.  For instance, LCD recently noted that by count of loans, 227 of 1225 or 18.5% have floors of 75bps.3 So a loan investor may have coupon income that is increasing despite no interest rate moves by the Fed, and if and when we start to see rates increase here at home, it is anyone’s guess as to what LIBOR will be doing.

As we have noted in previous writings, despite the belief by some that rising rates spell doom for all fixed income investing, high yield has actually performed well during rising rate environments (see our piece “High Yield Bonds and Rate: Duration and Yield” and “Strategies for Investing in a Rising Rate Environment” for further details and data).  For instance, in 2013, the last annual period in which we saw a meaningful increase in US Treasury rates, floating rate loans returned 5.3% versus 8.2% for high yield bonds.4  Even with the 10-year Treasury yield increasing by over 1.2% and the 5-year Treasury increasing over 1.0% (both over 50% from the beginning of year yield)5 in 2013, the high yield market, helped by higher initial starting yields, still outperformed the loan market.

While these are floating rate securities, we don’t see investing in floating rate loans as the perfect panacea to rising Treasury rates/domestic interest rates given that different dynamics impact these rates versus the LIBOR rate to which floating rate loans are tied.  However, currently we are seeing attractive prices/yields/discounts in selective loans and increasing rates in some cases.  As a whole the loan market has historically offered lower yields relative to bonds (given the priority of loans versus bonds in a capital structure), yet we still see selective, attractive opportunities within this market.  We believe the flexibility to include loans in our portfolio allows us the ability to expand the investment universe to virtually all high yield debt issuers and purchase where in the capital structure we see the best risk/reward balance as we take advantage of the attractive opportunities for active investment we see in both today’s bond and loan market.

1 Data based on 10-year Treasury level of 2.29% on 7/29/15 versus a level of 1.57% as of 7/28/16.  Data from U.S. Department of Treasury.
2 Data as of 7/28/16, LIBOR data sourced from Bloomberg.  Treasury data sourced from the U.S. Department of Treasury website, Daily Treasury Yield Curve and LIBOR data sourced form Bloomberg.
3 Park, Andrew, “LIBOR rates rising above 75 bps to impact 24% of LL100 loans,” Leveraged Commentary & Data, https://www.lcdcomps.com/.
4  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Leverage Loan Market Monitor,” J.P. Morgan North American High Yield and Leveraged Loan Research, January 2, 2014, p. 1, https://markets.jpmorgan.com/?#research.na.high_yield.
5  Data sourced from the U.S. Department of Treasury website, Daily Treasury Yield Curve Rates, comparing 12/31/13 to 12/31/12.
Posted in Peritus

Today’s Floating Rate Loan Market

We are high yield debt investors.  While our focus over the decades has been on investing in high yield bonds, we also do allocate a portion of our portfolio to floating rate bank loans.  Over the past couple decades, these two markets have grown significantly and now together represent almost 30% of corporate credit.1

Breakdown of US FI 3-31-16

We see the inclusion of loans primarily as a way to expand our investment universe.  When a high yield issuer comes to market, they have the option of issuing loans or bonds or both.  In some cases a company may elect to issue only loans.  For instance, over the years we have seen many of the companies that we hold bonds in decide to take out the bonds with a loan, leaving loans as the only option in the capital structure.  Having the ability to invest in loans enables us to continue investing in a company that we like and accessing companies that are loan-only issuers.

Including loans in our portfolio also gives us the flexibility to invest up and down the company’s capital structure, wherever we believe the best opportunity for yield relative to risk is offered.  In some cases, this has resulted in us investing in the secured loans at the top of company’s capital structure rather than the bonds.

A secondary benefit of floating rate loans is that they are, well, floating rate.  So this means that they carry a much lower duration and can be used as a means to lessen the interest rate risk within a portfolio.  It should be noted that the floating rates are generally based off of short-term LIBOR, not Treasury rates (with the 5- and 10-year Treasuries as the more relevant rates for high yield bond investors), and many loans carry LIBOR floors.

As we look at today’s floating rate loan market, there are a few notable dynamics.  We’ve talked at length in the past about some of the ramifications of recent regulation on the high yield bond market; however, there is another regulation that is currently have an impact on the loan market.  This is the “risk retention” rule as part of the Dodd-Frank rule.  As a bit of background, CLOs, or collateralized loan obligations, historically have been among the largest buyers of leverage loans.  Effective December 24th, 2016, as the rule now stands, CLO issuers will be required to hold 5% of their CLO structure.  Managers are already in the process of working to comply, and it has resulted in a significant drop in CLO issuance as some would be or existing issuers may not have the capital to comply with this rule.  In fact, CLO issuance has declined approximately 50% so far this year.2

We have seen a slowdown in this natural source of CLO demand, and that has been coupled with the fact that many have sold out of the loan market as they don’t expect rates to be increasing significantly anytime soon.  July was only the second month since May 2015 that we saw an inflow into loans, with a total of $23bil leaving this market since May 2015 and $6.2bil leaving the market year-to-date.3  So while we have seen interest in the space pick up the last few weeks, the trend has been decidedly negative over the past year plus.  With this pressure on demand, we believe the floating rate loan market has become a bit less “efficient,” whereby creating what we see as some attractive opportunities for investment.  We are seeing loans at discounts with reasonable yields.

By and large the high yield bond market has historically outperformed the loan space, and has also outperformed so far this year, and we have and continue to make the high yield bond market as our primary area of focus for investment.  However, our active strategy allows us the flexibility to take advantage of the selective opportunities that we see within the floating rate loan market, whereby we can expand our investment universe, invest up and down the company’s capital structure depending upon where we see the best return relative to risk, and take advantage of some of the attractive discounts and yields that we see in the loan space, all the while helping to reduce duration (interest rate risk).

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  Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Leveraged Loan Market Monitor,” J.P. Morgan North American Credit Research, August 1, 2016, p. 7, https://markets.jpmorgan.com/?#research.na.high_yield.
3  Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Leveraged Loan Market Monitor,” J.P. Morgan North American Credit Research, August 1, 2016, p. 7-8, https://markets.jpmorgan.com/?#research.na.high_yield.
Posted in Peritus

High Yield Bonds and Rates: Duration and Yield

With another Fed meeting on the horizon this week, the topic of rates has again come into focus.  While in just a matter of months, markets have seemed to quickly move from the expectation that we’d see a few rate increases this year, to a big drop in Treasury rates and the market participants questioning if given all of the global uncertainties and some weaker domestic economic data if we’ll see even one rate increase for the entire year.

While we don’t see that domestic economic data or global conditions support much in the way of rate increases over the coming year, one thing we know over the last several years is that interest rate moves, as reflected by Treasury yields, have been extremely volatile and surprised nearly everyone. We don’t view interest rate risk as a primary risk for high yield investors, though it is a consideration in fixed income investing and one primary way to evaluate interest rate sensitivity in the fixed income asset class is with duration.  Duration is a measure of the price change of a fixed-income security in response to a change in interest rates. Per this calculation, rates and prices move in the opposite direction, so an increase in rates would produce a theoretical decline in price. Below are the durations and yields for various fixed income asset classes.1

FI yields 7-22-16

As you can see in the chart above, municipal bonds and the 5-year Treasury carry a duration near 5 years, investment grade bonds have a duration of over 7 years, and high yield bonds offer the lowest duration of 4 years, meaning the high yield asset class carries the lowest sensitivity to interest rates. In other words, all else equal, a given increase in interest rates will hypothetically move the price of investment grade bonds down significantly more than high yield bonds.

The number of years to maturity for the asset is one factor in determining duration, but the starting yield also plays an important role.  Municipals offer a yield to worst only slightly over that generated by the 5-year Treasury, both under 2%. The yield to worst on the investment grade index is under about 3%, while the broader high yield index offers a yield to worst of twice that, at 6.6%. So not only do high yield bonds offer the lowest duration, they also offer the highest yield. So how does that play into a rising rate environment? Well, it means that high yield bonds are much less interest rate sensitive than these other fixed income alternatives. And while the traditional adage in fixed income is that as interest rates go up, prices on bonds go down, that doesn’t factor in the yield being received which may outweigh the price decline, all else equal. So investors need to consider both yield and duration.

Looking back through history when we have seen rates rise, we have certainly not seen weak returns in the high yield market. For instance, in the 16 years that we have seen Treasury yield increases (rates rise) since 1980, the high yield bond market has posted an average return of 12.4% (or 9.3% if you exclude the massive performance in 2009). This compares to an average return of 4.3% (or 3.4% if you exclude 2009) for investment grade bonds over the same period.2

 Returns, Int Rates

Intuitively this makes sense because generally rates rise during periods of economic strength, and a strong economy is generally favorable for corporate credit. Historically we have seen the prices of high yield bonds much more linked to credit quality than to interest rates.

We believe that high yield bonds are positioned well for the rate uncertainty ahead. If rates don’t move much further for the year, then you have a much higher starting yield for high yield bonds, and if rates do increase some, which would expect to be on the back of improved economic data, the high yield asset class has a much lower duration (we should note that the 5- and 10-year Treasury rates are much more relevant for investors in high yield rather than the Federal Funds rate set by the Fed).   Furthermore, also including floating rate bank loans in your portfolio can serve to further reduce your duration.  For more on interest rates and high yield debt investing, see our piece “Strategies for Investing in a Rising Rate Environment.”  Right now we see many attractive opportunities for investment for active managers in the high yield bond and loan space.

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). Barclays data as of 7/22/16 and Treasury data as of 7/22/16. Yield to Worst is the lowest, or worst, yield of the yield to various call dates or maturity date. Duration is the change of a fixed income security that will result from a 1% change in interest rate. The duration calculation is based on the yield to worst date, using Macaulay duration for the various Barclays indexes and Bloomberg calculated duration to workout for 5-Year Treasury.
2 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 4, 2016, p. 15. 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.  See https://markets.jpmorgan.com/?#research.na.high_yield.
Posted in Peritus

First Half Update

After seeing prices indiscriminately marked down virtually across the board in the second half of 2015 and first couple months of 2016, general high yield market sentiment improved beginning in late February, helped by oil prices stabilizing and the realization any material change in interest rates is not on the near-term horizon.  We are now seeing a rebound in bond prices and returns throughout the high yield market for the various indexes, as the solid fundamentals for many credits outside of energy remain intact.

We now have a full six months under our belt with some of the recent strategy adjustments, primarily our new issue allocation that we began implementing last December.  As a reminder, with the banking regulation changes that went into effect in 2015 and liquidity concerns across the market, we implemented this strategy to proactively address these concerns.  Our research and experience had shown bonds tend to be the most liquid in the first several months after issuance as the institutions bringing the new debt to market are using their capital to support those deals in the secondary market and then in the months following you often see indexers and insurance companies adding exposure, providing another bid to these securities; thus we decided to strategically allocate a portion of our portfolio to new and newly issued bonds.  In the first six months of the implementation, we are seeing the intended benefits in terms of improved liquidity and lessened volatility.  We have and will continue to roll out of prior purchase every few months into the newest issued bonds, and so far we are finding we are also able to sell the majority of the positions we exit above par.  As we move forward, we see the ability to implement a strategy along these lines as a definite advantage of having a portfolio of actively managed bonds.

We also continue to allocate a portion of our portfolio to floating rate loans.  In many cases, the loans are at the top of the company’s capital structure and are less volatile, often providing stability.  We continue to see further opportunity in the loan space as we move forward, as many first lien loans have been sold off as investors have realized the floating rate aspect to those are not needed as rates are not going up any time soon; yet these are often companies with very low leverage that are trading at nice discounts, providing reasonable yields.

The remaining portion of our portfolio is our “alpha” bonds—our traditional fundamentally driven, value approach to credit investing whereby we are investing in bonds in which we see an attractive yield relative to the risk.  We are now seeing that  company fundamentals are being rewarded by the market.  By and large we are seeing generally stable revenues and earnings (which we measure by EBITDA, earnings before interest, taxes, depreciation, and amortization) outside of energy and commodities.  It should be noted that the high yield market consists largely of domestic (North American) focused companies, thus we have much less international exposure than we’d expect to see in many larger, multinational companies that are prominent in the equity indexes and issuers of investment grade corporate bonds.  We have had our concerns about the state of the global economy, as there is little in the way of catalysts to drive growth outside of the U.S., and apparently the IMF agrees, as they just lowered their global growth forecast, citing Brexit and the uncertainty it creates as one of the factors.

We believe that our active strategy fits well in today’s high yield market and as we move forward, as it affords us the ability to take advantage of what we see as the many attractive investment opportunities in both the bond and loan markets, all the while being able to work to address liquidity via smaller position sizes and the strategic new issue allocation.

1  Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update,” J.P. Morgan North American Credit Research, July 15, 2016, p. 1.  https://markets.jpmorgan.com/?#research.na.high_yield
Posted in news

High Yield Market Default Update

As we stand today, default activity year-to-date has already surpassed the par default level for all of 2015.  However, the defaults remain almost entirely in the commodity sectors—Energy and Metals/Mining—while outside of these segments, default rates remain at or near record lows.  Energy and metals and mining together comprise about 20% of the index, so this leaves about 80% where we continue to see a very benign default environment.  Putting numbers to this, JP Morgan is reporting a total par-weighted US high yield bond default rate of 4.7% (including distressed exchanges), but excluding commodities, this default rate falls to a mere 0.5%.1

As we have spoken about before, we see the double edged sword with energy—it is both an opportunity and a risk.  For the indexes, we are seeing a big spike and multi-year highs in defaults due to the high yield’s market large energy exposure.  But within the energy sub-segment, we also continue to see selective opportunities for investment and have been active in a number of names that we believe offer value and are positioned well, even in the current pricing and going forward.  While we would expect that we are nearing the peak on energy defaults and thus total default rates, we continue to expect default rates to remain elevated versus historical numbers as energy producers and service companies contend with low oil prices and we continue to caution investors that we believe an active approach, whereby the company’s fundamentals, hedging, breakeven points, and production location are assessed, is the best course of action for investment in this sector.

Then that leaves the remaining 80% of the high yield market.  While this market has had strong returns so far this year, we still believe there is room to run.  We believe the low default rate in this segment of the market is reflective of the generally solid fundamentals and reasonable capital structures we see for many of the issuers.  Again, we believe an active approach is still the way to operate in the broader high yield market as well, as you look at both a company’s fundamental prospects relative to the current bond price/yield level.  As we do this, we are seeing areas of value and real yield potential in the high yield market as we move forward.

1  Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update,” J.P. Morgan North American Credit Research, July 15, 2016, p. 1.
Posted in Peritus

Unprecedented Times

We are in the midst of unprecedented times.  Over the past week, we have seen the S&P 500 hit record highs and the US 10-year Treasury bond yields hit record lows.  We see headlines like “NIKKEI soaring on stimulus expectations,” and “$14 trillion at negative rates.”

Historically speaking, high yield bonds and equities are negatively correlate to Treasury rates.1

25 yr correlation 2015

This means that historically as Treasury prices are increasing/rates decreasing, equities are decreasing in price and high yield decreasing in price/increasing in yield, and vice versa, while Treasury prices are decreasing/rates increasing, high yield and equity prices are increasing.  Generally when we see this historical correlation play out most clearly is when we are seeing either economic prosperity and rates increasing (Treasury bond prices decreasing), while high yield and equities benefit from an improving economy.  Or on the other end of the spectrum, a “flight to quality” as investors abandon “risk” assets such as equities and high yield and pour money into the “risk free” treasuries due to market concerns.  While there is some “flight to quality” impacting the current Treasury rates, as there are certainly global risks to be concerned with, the biggest impact on rates seems monetary-policy induced.  Relatively speaking, the US bond market looks like one of the few places to even get a little bit of yield.

global rates 7-11-16

Just think of the huge overhangs in Europe, especially in the UK with their exit from the euro, but investors are willing to tie up their money for 10 years with these uncertainties at rates well under what is available in the US.  In a world where the latest statistic I heard was that $14 trillion dollars are trading at negative rates, including Japan, Germany, Switzerland, and some corporates, it is certainly unlike anything we have seen before, all the while money is being poured into equities.

With the S&P at all-time highs and Treasury yields at all-time lows, we believe the high yield market is one place where there is some value and return potential to be had.  Maybe equities continue to move higher for the time being, but with valuations (P/E ratios) where they are, we certainly don’t see a strong “value” argument to be made here.  In the high yield market, we often look at “value” as the “spread” over comparable maturity treasuries.  By this measure, the high yield bond market is certainly not anywhere near historical lows from a spread perspective, currently at 641bps of spread versus a historical low of 271bps.3

CS Spread to worst 7-8-16

High yield bonds also offer spread levels well in excess of their 25-year median and average levels.  In today’s low yield/low rate environment, we see further room for spread compression in the high yield market and see an actively managed high yield bond portfolio as an attractive option for investors looking to generate some yield and return potential.

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. 307.
2  Data sourced from Bloomberg, as of 7/11/16.
3  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. S&P 500 numbers based on total returns. Period based on month-ending data for 7/31/91 to 6/30/16, with the 7/8/16 final level added.
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Where to Go?

We are in the midst of a global low yield environment.  Yields on the 10-year bonds (yes, 10 years) for Switzerland, Japan, and now Germany are negative, and yields are under 0.50% for much of Europe.1

Global rates 6-29-16

With the Fed meeting and announcement earlier this month and the post-Brexit vote uncertainty, the US 10-year Treasury yield is now sub 1.5%.  In just a matter of a several weeks with one bad jobs report and the Brexit vote in the UK, we have gone from a likely interest rate hike this summer to many questioning if we’ll even see another hike this year…and even some talking of potential stimulus on the horizon.  So it appears that yields on government bonds will be stuck at these very low levels for the foreseeable future.

With the US 5-year Treasury currently yielding 1.0% and the 10-year sub-1.5%2, versus a core inflation number around 2%, where is an investor to go to generate some return?  Municipal bond yields are also under 2%, with this segment of the market currently yielding around 1.6%.  Investment grade isn’t much better, with yields there under 3.0%.3

Yields FI 6-28-16

In this low yield environment, it seems like investors are turning to equities as they just don’t know where else to go.  With dividend yields also right around 2%4, investors aren’t getting much in the way of income here either.  Their bet must be that equity prices will appreciate, but given the currently high equity valuations relative to history and the outlook for the global economy, we see little in the way of catalysts to move equities sustainably higher (see our pieces, “Positioning for Value” and “US Financial Markets: Fundamentals and the Outlook for Equities”); rather, we see downside risk in this asset class.

SP 500 Div Ratio 6-17-16

If you are trying to save for retirement, you need to be making a decent amount of money above and beyond inflation.  In the hunt for yield, we believe that the high yield corporate debt market offers investors an attractive place for investment.  As noted in the chart above, high yield bond yields, currently about 7.5% on the index, are well above those offered by other fixed income alternatives, including investment grade, treasuries, and municipals.  High yield has also outperformed these other fixed income asset classes over the past 25 years.5

FI 25 yr return BofA

Looking at high yield versus equities (S&P 500 Index) over the past 25 years, high yield has performed relatively equivalently with nearly half of the risk (as measured by annualized standard deviation), leading to high yield notably outperforming on a risk adjusted basis (return/risk).6

 CS HY vs SPX 5-31-16

As global risks increase with the Brexit implications on top of an already tenuous global economy we would expect this low rate environment to continue for the foreseeable future.  And given the large multinationals that dominate the equity markets and indexes, we do expect the lack of global demand and currencies to continue to have a drag on earnings.  However, in today’s environment of low yields virtually across the board, we view the high yield market as an attractive opportunity for those looking to generate some yield, as well as potential capital appreciation as much of the high yield market is priced at discounts to par.  We view valuations (spreads) in high yield as reasonable and issuers tend to be much more domestic/North American focused, so we would expect less exposure to the global environment/Brexit.  We believe high yield debt offers investors attractive return potential as we move forward.

1 Data sourced from Bloomberg, as of 6/29/16.
2 Data sourced from the U.S. Department of Treasury website, Daily Treasury Yield Curve Rates, and data as of June 28, 2016.
3 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 6/28/16.  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.
4 Data sourced from, http://www.multpl.com/s-p-500-dividend-yield/, monthly data from 1/31/80 to 6/17/16.
5 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.
6 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. S&P 500 numbers based on total returns. Period covered is 5/31/91 to 5/31/16. 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.
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Strategies for Investing in a Rising Rate Environment

Accurately calling interest rate moves has proved to be a difficult, and futile, task for investors over the past few years as we have seen wild moves and really no sustained direction.  The only aspect of rates that can be accurately predicted is volatility. As we look forward, we know the Fed wants to raise rates, though the primary impetus to do so seems to be to have room to lower them should they need to later, rather than strong economic growth supporting the need to do so.  The data for the “data dependent” Fed doesn’t clearly support a rate increase, and after last week’s Fed meeting, we seem to be getting further and further away from an increase.  While we are certainly not under the belief that a rapid rise in rates is on the medium-term horizon, for the sake of argument, let’s assume that rates do rise materially from here.  What does that mean for the high yield market and the various “strategies” out there to deal with rising rates?  Click here to read our piece, “Strategies for Investing in a Rising Rate Environment.”

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