No Bubble Here

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

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

First, let’s look some valuations in the broad equity sector. In terms of the equity market, P/E ratios are a common way to view equity valuations. If we look at a trailing 12-month S&P 500 P/E ratio going back to 1957, we see the current ratio is 20.03x versus a historical median of 17.43x.1

S&P 500 PE 1957 8-27-15

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

Factset 8-5-15

Here we currently sit at 16.5x versus a 10-year average of 14.1x. So by these valuation measures, the S&P does look expensive. For instance, on the forward P/E, it is worth noting that we are higher than where we were going into the 2008 financial crisis. Does this qualify as a “bubble”? Expensive, certainly. Due for some sort of correction? Likely. But a completely “bubble”? That case is a little harder to make, as looking at the nearly 60 years of history, while we are above the median levels, we are not near the extremes. And even in an expensive broader market, that doesn’t mean that active managers are not able to select a focused portfolio of 50-100 individual securities that still offer investors value. We believe it is during these sort of times that active management has the most value.

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

CS HY Spreads 8-25-15

So currently we sit at a spread (spread-to-worst over comparable Treasuries) of 646bps, well above the 520bps median and 582bps average over this nearly 30 year period. So how can someone make a “bubble” argument when we aren’t even below the historical median level? Certainly looking at the 2006/2007 period, there was that argument to be made, as we were at spread levels sub 400bps and even 300bps, bottoming at 271bps in May 2007 before things started to turn in 2008. On the “fundamental” side, during this 2006/2007 period, corporate leverage metrics were elevated and management teams were aggressive with their spending. M&A deals were being done at ridiculous multiples with buyers putting in very little equity, further adding to corporate leverage. Yet, spreads continued to grind lower, until investors woke up to the reality and wanted to get paid for the risk they were taking. And then, as in many market “adjustments,” we saw the market over-correct in 2008/2009. Today, we are above historical medians, despite a well below average default rate, reasonable fundamentals in the underlying companies, and what we would view as generally conservative management teams. Today we believe investors are getting adequately compensated for the risk they are assuming.

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

CS 4yr spreads 8-25-15

This natural ebb and flow would certainly indicate to us that investors in this space are at least reacting to changing market conditions and dynamics, which we see as healthy.  For instance, we have seen spread widening in the high yield market over the past couple months on China and commodity concerns—again, a healthy reaction as markets reprice risk.

Finally, generally a “bubble” implies people blindly throwing money at the sector in a frenzied buying spree. Be it bubbles from hundreds of years ago, like the tulip bubble, or the more recent dot-com or housing bubble, we saw investors piling into these areas with the mentality that these markets would only go up. However, we see no such mania in today’s high yield market. In actuality, we have seen over $3 billion in outflows in high yield mutual and exchange traded funds so far this year, this after over $20 billion in outflows from the space in 2014.5 Definitely no manic buying here.

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

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

1 Data sourced from www.multpl.com, “S&P 500 PE Ratio” covering the period 4/1/1957-8/27/2015. Current PE is estimated from latest reported earnings and current market price.
2 FactSet, “Earnings Insight,” August 5, 2015, p. 28.
3 Data sourced from Credit Suisse, as of 8/25/15.  Historical spread data covers the period from 1/31/1986 to 8/25/2015.  The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. “Spread” referenced is the spread-to-worst.
4 Data sourced from Credit Suisse, as of 8/25/15.  Historical spread-to-worst and yield-to-worst data covers the period from 8/24/2012 to 8/25/2015.
5 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High Yield Market Monitor,” J.P. Morgan North American High Yield Research, January 5, 2015, p. 7. First half numbers provided by various market sources.

Posted in Peritus

Market Repricing: What Has Changed?

We have seen extreme volatility over the past week, with a precipitous fall and rebound for equities. It is often said that the bond markets lead the way, and over the last month or so, we have seen spreads widen in the high yield market and Treasury yields decline, and now it appears that the equity markets, triggered by China, are catching up. But with all of this volatility, just what has changed in the last couple weeks in terms of the underlying security fundamentals, specifically in the high yield market?

Energy/Commodity Markets

Fears that with China showing signs of weakness, this could lead to lower demand for certain commodities, including oil. Many of these concerns are warranted and investors should be aware of what they own. As we have noted before, energy is the largest industry concentration within the high yield market, at about 15% depending on the index1, and investors, especially in index-based and passive high yield vehicles, should make sure they understand their exposure to the sector and analyze the fundamentals and prospects of their investments in the space at the current oil price levels. However, there may also be opportunities within the commodity sector due to these current events. For instance, gold has moved off of its lows and has actually rallied over the past three weeks. With the yuan devaluation, many foreign countries may turn to gold as a safe haven parking spot for their foreign reserves.

Given the risks in this space, investors need to be actively managing their allocations. There are likely some opportunities, but the recent global issues will have an impact on the fundamentals of many companies, leading to credits that should be avoided. Investors need to do the fundamental work to discern the opportunity from the falling knife.

Interest Rates

It is becoming increasing more expected that an immediate (September) move in interest rates is unlikely. Maybe some of the domestic data will continue to show some gains, but as we have noted in the past, this Fed has proven to not only be “data dependent” but also market dependent, meaning we wouldn’t expect them to do anything at the risk of sending markets down. So now that most market participants seem to be convinced any rate move will be delayed until later 2015 or early 2016 that may well become a self-fulfilling prophecy.

For all those concerned about a rate rise, that pressure appears to be easing as the first hike is likely pushed out and we would continue to expect any move will be very moderate in the nearer-term. As we have noted in the past, historically the high yield market is less sensitive to interest rates and has historically performed well in rising rate environments, yet given the market perception, right or wrong, that all fixed income securities will be hit if rates were to rise, we would view the easing interest rate fears as an incremental positive from a market psychology perspective.

Asset Valuations

We have seen a global repricing of risk, which we would view as a healthy reaction given that economies around the world are under pressure. While equity markets have faced havoc over the last week, we have actually seen spreads in the high yield market widening since the beginning of the summer.2

CS 2mos spreads 8-25-15

We are now at spread levels not seen since the summer of 2012, with the spread on the high yield index sitting at 646bps, well above the nearly thirty-year median level of 521bps and average level of 582bps.3

CS HY Spreads 8-25-15

We view the recent spread widening as a great opportunity for selective investments in the high yield space. While caution should be had in investing in certain bonds within the energy and commodity sectors, generally speaking we continue to see attractive fundamentals in the broader high yield market, despite the recent market volatility and global concerns. Importantly, much of the high yield market is domestic focused, and in many cases niche companies, so would not face the same sort of pressures from currency or weakening global demand faced by many of the larger, multinationals in investment grade corporates or lager cap equities. Additionally, we would see the currently lower prices/higher yields on high yield bonds as presenting us with a better entry point and with that, a lower risk proposition. Finally, we would expect that the currently moderate domestic economy and low inflation on the back of the commodity weakness will constrain rates, which should further help the high yield market from a market psychology perspective.

Whether or not we are at the market “bottom” is anyone’s guess, but we believe investors should capitalize on what we see as currently attractive spread/yield levels relative to risk in much of the high yield market and take advantage of the tangible yield and income this asset class produces.

1 As of 7/31/15, Energy was 15.3% of the Credit Suisse High Yield Index and 16.35% of the J.P. Morgan US High Yield Index. JPM source, Acciavatti, Peter Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, July 31, 2015, p. 51.
2 Data sourced from Credit Suisse, for the period of 7/1/15 to 8/25/15.  The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. “Spread” referenced is the spread-to-worst.
3 Data sourced from Credit Suisse, as of 8/25/15.  Historical spread data covers the period from 1/31/1986 to 8/25/2015.  The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. “Spread” referenced is the spread-to-worst.

 

Posted in Peritus

What Value are Credit Ratings?

If there was any question about it, the financial crisis of 2008 demonstrated to us all just how flawed the ratings process is, where AAA debt was suddenly in default and highly rated companies all of a sudden required bailouts seemingly overnight.  However in the aftermath, while there have been efforts to reduce our reliance on ratings, it has also become clear that changing that ratings process is exceedingly difficult, if not impossible.  They are ingrained in our system and ingrained in the way many people and institutions invest.

As we have previously discussed in our piece, “The New Case for High Yield: A Guide to Understanding and Investing in the High Yield Market,” we see several problems with credit ratings:

Investors should understand what the ratings agencies themselves say about their ratings. Among their various disclosures, the ratings agencies caution that their ratings are opinions and are not meant to be relied upon alone to make an investment decision, do not forecast future market price movements, and are not recommendations to buy, sell, or hold a security. So if these opinions have no value in forecasting where the security price is going and are not investment recommendations, what good are they? Candidly this is a question we have been asking for the past 25+ years. We see the ratings agencies as reactive not proactive, yet many investors in fixed income rely almost entirely on these ratings in making investment decisions.

Peritus views credit as either “AAA” or “D” and places limited value on the rating agencies and their methodologies, which we see as backward looking, reactive, and lag the market perception of risk (e.g., Worldcom, Enron, Lehman, AIG).  Peritus believes that many fixed income investors continue to use ratings as one of their primary investment tools, which we believe ultimately creates inefficiencies and opportunities in the high yield market for active managers.  For instance, some institutions have policies whereby a security is automatically sold once it is downgraded to a certain level.  The problem is that by the point, if there are issues, the market has generally already recognized them and taken the security price down.  And vice versa with ratings upgrades.  So, investors waiting to take action based on ratings moves would have likely already missed the boat to either sell at a higher price or buy at a lower price.

We believe that the best approach to credit investing is to be agnostic on the credit ratings.  This ratings agnosticism is central to our investment philosophy and process.  We believe that inefficiencies created by credit ratings have created an opportunity for those willing to step down on the ratings spectrum.  Investors need to do their own homework, undertaking their own fundamental and valuation analysis to determine the viability of a credit and when to buy and sell, rather than just taking the rating agencies’ word for it and trading accordingly. 

Credit ratings are not going away, as they are too ingrained in the system.  And frankly, we feel that is to our benefit.  Be it those that focus only investment grade or higher rated non-investment grade bonds, we will take advantage of others who blindly rely on these ratings to make investment decisions or who have investment policies that restrict investing in certain ratings category.  We believe arbitrary restrictions inhibit investment results.

Posted in Peritus

Why This is Not 2002 or 2009

Over the last 20 years, there have been two major default cycles. One in 2001/2002 and another in 2009.1

Default rates 4-10-15

There have been apprehensions that today’s energy market issues will cause another major default cycle for the broad high yield market, putting us back to periods like 2001/2001 or 2008/2009 when we saw a huge spike in defaults and a blow out in spreads. We don’t expect this to happen as today’s high yield market is very different from the market conditions that we saw during each of those periods.

2001/2002

During the late ‘90s and into turn of the century, markets were in the midst of the “dot.com” bubble. Telecom, media, and technology were going to revolutionize the world and businesses were getting both debt and equity financing based on business plans, with little in the way of revenue, let alone profits or cash flow to actually service the debt. As noted in the chart below, issuance in the media and telecom industry in the years leading up to the crash was around 40 to over 50% of all high yield bonds issued.2

New Issuance by Industry 2002 TitleNew Issuance by Industry 2002

New Issuance by Industry 2002 Footer

By the end of 2000, the media and telecom industry comprised about 35% of the total high yield index.3

As the bubble burst, defaults did spike, with defaults related to media and telecom alone over 44% of total defaults in 2001 and over 64% in 2002.4

Defaults by Industry 2002 Title

Defaults by Industry 2002

Similar to the 2001 period, today we face a problem industry: energy. In today’s high yield bond market, the energy industry currently comprises about 15-17%5 of the total high yield market, depending on the index referenced. So, this puts today’s problem industry less than half of what the problem industry was in 2001. Looking at a similar chart to the one above, let’s look at recent new issuance by industry.6

Issuance by industry 2014 Title

Issuance by industry 2014

While the energy industry has been the industry with the most new issuance over the past few years, it has only ranged from 14-18% versus the 40-57% of issuance we saw in media and telecom in the years leading up to its collapse, and we argue here that recent issuance has been largely for real businesses, not business plans (except in certain cases of shale producers) as we saw in the telecom bubble.

As we look at today’s high yield market, certainly the energy industry is a much lower portion of the total market than we saw media and telecom representing in the 2001/2002 period; thus, we believe issues in the energy space will be much more contained relative to what we saw in 2001/2002. Additionally we believe that the 85% of the high yield market not related to energy is largely positioned well from a leverage metric and liquidity perspective, as we have not seen aggressive financing or companies levering up their balance sheets, and near-term maturities are fairly minimal, so we’d expect non-energy defaults to be well below historical averages, as we have seen for the past few years. As we noted in one of our recent writings, J.P. Morgan provided the following detail on their default forecast, and we agree with their take:7

While maintaining a benign 1.5% 2015 default forecast for high-yield bonds and loans, we recently made adjustments to our 2016 default outlook due to the Energy sector. Specifically, we forecast the high-yield default rate to rise to 3.0% in 2016, based on an approximate 10% default rate in Energy (15% Energy market weight adds 1.5% to the default rate).

Importantly, they are projecting continued benign default rates excluding energy of 1.5%. With a 10% default in the energy sector in 2016, the default rate moves up to 3% for the total market. Even if JPM is being too conservative and we actually see a higher default rate in energy in the latter part of 2015 and 2016, we’d still expect the non-energy defaults to remain subdued.

2008/2009

Let’s turn our attention to the other default spike that we saw in 2008. In that case, it wasn’t a problem industry or even issues specific to the high yield market. The problems leading up to the 2008 crash were systemic through all financial markets and had to do with easy credit and massive leverage. This isn’t to say that the high yield market didn’t participate in the over-levering—it certainly did—but the problems in the high yield market weren’t what lead to the collapse.

Looking back at the 2006/2007 period, we are seeing a massive LBO (leverage buyout) wave, with acquisitions being done at massive multiples and being financed with huge amounts of debt and little in the way of equity, leading to high leverage levels for these companies and capital structures the companies need to grow into. During this time, high yield spreads, a measure of how we assess value within the high yield market, hit all-time lows of around 270bps.8 Then, we saw what many thought at the time was the world ending in late 2008 and it permeated through every industry, causing all-time highs for default rates in 2009.

Again, these were systemic issues pervasive though all financial markets and hitting a high yield market that was recently at all-time lows in terms of valuation. We don’t see the same conditions today. First, yes there are challenges in today’s market, be it slowing demand in China, falling oil prices, concerns about rising rates, or the Greek debt crisis, among others. These challenges have caused investors to be more cautious and more risk adverse, which is a healthy response. However, we don’t see any of these as catastrophic to bring the entire market into freefall and lead to the collapse in many businesses across the board. Yes, China is slowing down, and this will hit the profits of multinational companies and may likely hinder equity valuations, but it is important to note that the high yield market tends to be more focused on North America. If and when the Fed does ultimately act on rates, again, this may have a temporary impact on markets, but we certainly don’t see them taking aggressive action given the current economic environment and we wouldn’t expect them to do anything that would severely hamper markets, given how conservative and aware of market reactions/perception they have proven themselves to be.

It is also important to keep in mind all of the regulations put in place post the financial crisis and scrutiny given to leverage have left us in an environment of much less leverage system-wide. Even here in the high yield market, leverage multiples have remained relatively moderate and interest coverage multiples improving, as much of the new issuance done has been for refinancing and has been done at lower interest rates, improving cash flow generation potential for issuers. Additionally, high yield valuations (as measured by the spread-to-worst) are currently above historical median levels and never got near historical lows during this most recent cycle, such as we saw proceeding past default spikes.9

CS HY spreads 8-12-15

This is not 2001/2002 or 2008/2009. The energy industry is a much lower portion of the high yield market than we saw with the media and telecom space at the turn of the century and we don’t see a massive systemic issue on the horizon to bring the market down. We’d expect defaults to be contained largely to the energy market, with the rest of the high yield market positioned well. There are certain areas of the energy space that we caution investors to avoid, namely many of the shale producers and energy service providers. Yet the recent repricing of risk and the widening of high yield spreads offers investors what we see as attractive value for many of the non-energy names in this market. The high yield market lends itself to active investing, especially in times like this where investors can capitalize on the opportunities and avoid the problem areas.

As active managers, that is just what we are doing now and have done through our history. Back in 2000, we weren’t sold on the media and telecom hype, as we focused on real business that we could understand with real cash flow prospects. We largely avoided the space going into the meltdown, and were able to buy at huge discounts telecom related securities that we saw as ultimate survivors and expected to profit at the demise of others. Earlier this year we reduced our energy exposure well under the levels held by the indexes, and we may look to selectively increase our exposure to the space and capitalize on opportunities at deep discounts when the timing is right—but for now, there is much to avoid in this space, and plenty of opportunities in non-energy related high yield names providing what we see as attractive yields and a moderate default environment for active investors.

1 Acciavatti, Peter Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, April 10, 2015, p. 4-5.
2 Acciavatti, Peter, Tony Linares, Nadia Nelson, and Moliehi Pefole. “2002 High Yield-Annual Review,” J.P. Morgan, January 2003, p. 58.
3 Based on the Credit Suisse High Yield Index industry data as of 12/29/00. The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market.
4 Acciavatti, Peter, Tony Linares, Nadia Nelson, and Moliehi Pefole. “2002 High Yield-Annual Review,” J.P. Morgan, January 2003, p. 70.
5 As of 7/31/15, Energy was 15.3% of the Credit Suisse High Yield Index and 16.35% of the J.P. Morgan US High Yield Index. JPM source, Acciavatti, Peter Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, July 31, 2015, p. 51.
6 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 29, 2014, p. 63.
7 Acciavatti, Peter Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, April 10, 2015, p. 4-5.
8 Data based on the Credit Suisse High Yield Index. The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. “Spread” referenced is the spread-to-worst.
9 Historical spread data covers the period from 1/31/1986 to 7/28/2015.  The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. “Spread” referenced is the spread-to-worst.
Posted in Peritus

High Yield ETFs: Market Size, Money Flows, and Liquidity

The entire U.S. fixed income market (municipals, Treasuries, mortgages, corporates, federal agency bonds, money market, and asset back securities) totals $39.2 trillion.1 Of this, corporate credit is about $8 trillion. The high yield bond market is a growing piece of that corporate debt piece, now at $1.8 trillion2, and accounts for over 20% of total corporate bonds outstanding. If you add in high yield floating rate loans, that total high yield debt number moves to over 30% of corporate debt.3

HY market size 7-31-15

One thing is clear, that the high yield bond market is a growing market, and one that cannot be ignored. However, more recently much has been made of high yield exchange traded funds (ETFs), 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. However, these arguments for the high yield market’s demise due to these liquidity concerns appear greatly overblown to us.

It is important to keep in mind the size of the high yield ETF market relative to the entire high yield market. The three largest categories of owners of high yield bonds are pension funds, insurance companies, and retail mutual funds, all of which have relatively the same size of ownership at just under a quarter of the market each.4

HY Ownership 2014

With this we see both institutional and retail customers as active in the space. High yield ETFs account for about 12% of the total $300 billion “retail” high yield fund base, which includes the much larger mutual fund counterpart, and ETFs account for about 3% of the broader high yield market.5

Flows in and out of these “retail” mutual and exchange traded funds (though we know that various institutions are still buyers of mutual and exchange traded funds so it isn’t entirely retail) can be somewhat volatile week over week, but again, these flows pale in comparison to size of the total market. For instance looking back over the last six months, the largest weekly reported exchange traded and mutual fund flows that have been reported total around $3 billion6, which compared to a $1.8 trillion market means it is under 0.2% of the total market.

HY Fund Flows 4-30-15

HY Fund Flows 7-30-15

While in all markets we constantly see money flowing in and out, we don’t believe that here volatility of fund flows is necessarily the primary factor in the volatility in the high yield bonds prices/spreads; rather in the end fundamentals and market sentiment trump in high yield bond prices/spreads. Thus when you see that market sentiment changing or fundamental concerns emerging, you begin to see prices decline, in some cases more aggressively, just as we have always seen in past cycles.

Additionally, the concern that high levels of “hot money” in these ETFs will jump ship causing market disruption, appears to also be unwarranted. There has actually been little in the way of total money flows into exchange traded funds over the past couple years, so it would seem no recent piling of hot money into the space. As a point of reference, so far in 2015, a mere $450mm in total has flowed into high yield ETFs7 and in the full year 2014, a total of $53mm flowed out of high yield ETFs.8 Again, a blip relative to broader high yield market.

We believe the fear and concern recently expressed for high yield ETFs is misplaced. During times of fundamental or economic concerns or “risk off” trades, it is natural for prices to move down, and in some cases swiftly. That has always been the case for markets, but then again, we can also see swift moves up/recovery as market sentiment improves—markets tend to be manic. High yield ETFs have grown in popularity over the past several years, and while that has had an improvement in accessibility for retail investors, this ETF market is still small relative to the broader high yield market and we don’t buy the argument that this small piece of the high yield pie can lead to the market’s demise. Mutual funds have existed for decades and money flows in and out of those daily, and similar concerns have not been expressed for this market. We believe that if anything, high yield ETFs provide an advantage over mutual funds 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 believe that high yield ETFs provide investors great accessibility to what we see as a very attractive 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 who can capitalize on discounts. However, we do not expect this volatility to lead to a collapse in the high yield market and believe that investors who abandon this market due to some of these concerns are missing out on the tangible yield it has to offer and the historically better risk adjusted returns versus equities that the high yield bond market has provided.9

1 From the publication “Outstanding U.S. Bond Market Debt” release by SIFMA, as of 3/31/15.
2 Acciavatti, Peter Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, July 31, 2015, p. 42.
3 Source SIFMA as of 3/31/2015 for total corporate debt. Loan market size from Blau, Jonathan, James Esposito, and Amit Jain, “Leveraged Finance Strategy Weekly,” Credit Suisse Fixed Income Research, July 31, 2015. Loan market size of $1.986 trillion, for corporate bond and loan market of a combined estimate of $9.95 trillion.
4 Acciavatti, Peter Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, July 31, 2015, p. 300.
5 Acciavatti, Peter Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, July 31, 2015, p. 136.
6 Fuller, Matt, “Cash flow for US HY funds turns deeply negative,” July 30, 2015, and “Retail cash outflows from HY funds deepen with huge ETF influence,” April 30, 2015, S&P Capital IQ, LCD News.
7 Fuller, Matt, “Cash flow for US HY funds turns deeply negative,” July 30, 2015, S&P Capital IQ, LCD News.
8 Fuller, Matt, “Cash outflows from HY mutual funds offset by ETF inflow last week,” December 31, 2014, S&P Capital IQ, LCD News.
9 Risk adjusted returns in terms of annualized return divided by annualized standard deviation over various periods, see our piece “High Yield versus Equities” for actual data.
Posted in Peritus

Upcoming TV Appearance

Tim Gramatovich, Peritus’ CIO, will be a guest on Business News Network today, July 31st, at 3pm ET.

Posted in news

High Yield Default Outlook

With the energy markets once again taking a turn downward, we are seeing concern for the high yield market again escalating and talk of a spike in default rates heating up.  Yes, the energy industry does make up a large portion of the high yield market, in fact the largest industry holding within the space at about 14-17% depending on the index used.1 We do expect defaults to increase in this industry.  We have been very vocal in expressing our concerns and questioning the viability of many of the domestic shale producers and the companies that service them.

Given our expectation for continued volatility in the energy industry and expectation that it may well take the better part of this year until we see a more sustained recovery in this market, we did make the decision to significantly cut our own energy exposure earlier this year and are underweight relative to the broader market indexes.  However, we did maintain some investments in the space, as we do believe in the longer-term improvement in oil and see value in certain companies at current levels (see our piece “Mid-Year Update” for further detail).  The problem is that for many others, this improvement won’t be quick enough for them to sustain their capital structures.  For instance, hedges put in place at much higher prices in prior years are now starting to come off, meaning that companies will now start to face the full impact of the current oil price reality.  Additionally, we’d expect both pricing and volume pressure for oil services companies as the year progresses.

We do expect default rates to increase in the energy sector but expect them to remain moderate for the rest of the high yield market, continuing to trend well below average despite spread levels around historical averages.  During the second quarter, J.P. Morgan released the following detail on their default forecast, and we wouldn’t disagree:2

While maintaining a benign 1.5% 2015 default forecast for high-yield bonds and loans, we recently made adjustments to our 2016 default outlook due to the Energy sector. Specifically, we forecast the high-yield default rate to rise to 3.0% in 2016, based on an approximate 10% default rate in Energy (15% Energy market weight adds 1.5% to the default rate).

Default rates 4-10-15

They are expecting energy related defaults to increase to 10%.  However, excluding energy, they are expecting default rates to be 1.5%, about half of the historical average of 3.8%.

Just as we saw contagion from energy weakness translate to general high yield market aversion in Q4 2014, we are seeing the same again today.  However, just because there are apprehensions about the energy sector, it doesn’t mean the entire high yield market should be abandoned.  We believe that the spike in defaults will largely be contained to the energy industry and see the fact that much of the rest of the market is current being brought down along with it as an opportunity to purchase these non-energy companies at attractive prices.  We continue to caution investors that are exposed to the broad indexes/index-based products that have higher exposure to the energy sector and are not building portfolios based on fundamentals to do some work to better understand what they own.  However for active managers who focus on credit selection and fundamentals, we see the current environment as ripe for the picking.

1 The energy industry is 16.29% of the J.P. Morgan U.S. High-Yield Index.  Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, July 24, 2015, p. 59.
2 Acciavatti, Peter Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, April 10, 2015, p. 4-5.
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The High Yield Market: An Opportunity for Active, Long-Term Investors

It has been a tumultuous couple months in the high yield market. Since the first of June, we’ve seen spreads in the high yield market widen 75bps, putting them now solidly above historical median levels.1

CS spreads 7-28-15

We are also now sitting near the highest spread levels that we’ve seen over the last few years.2

CS 4-yr spreads, yields 7-28-15

Let’s take a look at a few of the factors impacting this market:

Interest Rates

The interest rate chatter started to reemerge in May and has since continued. We have been very vocal in our belief that much of this concern is unfounded, not only because the high yield market has historically performed well during periods of rising interest rates (see our piece “Strategies for Investing in a Rising Rate Environment”), but also because we don’t believe that we’ll see a rapid spike in rates.

Yes, the Fed will likely take some action over the next several months to get the ball rolling, but we don’t see that their own “data dependent” targets being met to justify aggressive and sustained rate hikes. Their inflation targets of 2% seem to be getting further away as we see energy and commodity prices fall. Yes, the unemployment rate is improving, but the labor participation rates are certainly not (nor are wages), which can make some of the employment face value improvements a bit deceptive. Additionally, earnings have been lack luster so far this season, which doesn’t seem to indicate that we are the in midst of strong economic growth. We’d expect any interest rate move to be moderate and believe the high yield market will weather it well, as it has historically done.

Liquidity

Much has been made recently of the “lack of liquidity” in the corporate bond market. While the Volker Rule officially went into effect on July 21st, banks have been preparing for years and trimming back their trading activities. Under this rule, banks are not able to engage in “proprietary trading” which means they are limited in their ability to trade for their own books, thereby reducing dealer inventories and subsequently market liquidity. Yes, this likely has led to heightened volatility within the high yield market.

However, history has shown us that pre or post Dodd Frank and the Volker rule, markets are generally volatile and choppy when we see the tides turn and the “risk off” trade emerge, just as we have seen over the past few weeks. When investor sentiment quickly turns and money outflows escalate, we have historically often seen outsized price moves in bonds, so it is certainly something that players in the space have experience in dealing with. It makes for good headlines for the financial media, but for long terms investors like us, we actually see periods of heightening volatility as an opportunity to buy assets on the cheap and wait for the rebound in the securities for which there is no fundamental reason for the price hit.

Energy, Commodities, and China

We have once again seen the energy markets take a hit, with oil prices touching below $50 again

and down nearly 20% since the beginning of the month. News of the collapse in the Chinese stock market and the implications for the broader economy there, as well as supply increases domestically and potentially from Iran down the road have all contributed to the recent decline. The troubles out of China and whether we will see a decreased demand from this commodity-intensive economy has also carried over into various commodity markets worldwide, including high yield issuers in this industry.

As we have pointed out on numerous occasions, the energy industry is the largest industry within the high yield space, accounting for about 14-17%3 of the market, depending on the index referenced. So certainly the decline in energy prices will hit a portion of the high yield market, but that doesn’t necessitate abandoning the entire market. Investors need to understand what they own and avoid the companies that are seen as most vulnerable. For instance, we have mentioned on numerous occasions that we see many of the domestic shale producers as especially vulnerable in this environment, given the capital intensity of their business models and high decline rates, as well as the companies that service them.

General Contagion….The Opportunity

While certain energy credits are justifiably getting hit, these various concerns are bleeding over to other areas of the high yield space in which there are no changes in fundamentals and/or prices are unjustifiably gapping down as the market overreacts. The most basic premise in investing in buy low and sell high. We see this general market contagion as an exceedingly attractive opportunity to acquired quality bonds and loans at lower prices.

Active, long-term value investors have the flexibility to avoid the names where fundamental concerns are warranted, as well as sell securities where prices may still be elevated and/or yields low and redeploy proceeds into names where we have seen spread widening and/or price declines that are not justified and wait for the rebound. Part of managing risk is not just buying the right names but buying at the right prices—we’d see today’s market as much more attractive and ironically even a lower risk proposition than when market conditions are in rally mode and everyone is trying to acquire overpriced securities. We believe that today’s high yield market is offering investors attractive value for active, long-term investors.

1 Data sourced from Credit Suisse, as of 7/28/15.  Historical spread data covers the period from 1/31/1986 to 7/28/2015.  The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. “Spread” referenced is the spread-to-worst.
2 Data sourced from Credit Suisse, as of 7/28/15.  Historical spread-to-worst and yield-to-worst data covers the period from 7/27/2012 to 7/28/2015.
3 The energy industry is 16.29% of the J.P. Morgan U.S. High-Yield Index. Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, July 24, 2015, p. 59.
Posted in Peritus

Mid-Year Update

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

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

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Upcoming TV Appearance

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

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