Understanding Market “Liquidity”

Liquidity is generally defined as the ability to purchase or sell an asset without causing a dramatic change in price. However, this definition can be misleading as throughout the history of markets, we have seen securities trade with big price moves, often on large volumes. News comes out and someone is the first trade of the stock or bond at say 30% below the previous price, and then other trades ensue. Markets at times are volatile. We can’t regulate risk out of the market, nor should we. Risk has been and will always be part of investing, but theory also holds that as investors take on risk so does the ability to generate returns. I don’t think we want to live in a “riskless” world whereby we are only generating what you could get on “riskless” government debt.

Liquidity has been a major topic of focus for investors considering allocating to the high yield bond market, especially given the heightened media attention the issue has garnered recently. The concerns with liquidity stem from market regulations put in place over the past few years. With the implementation of Dodd Frank and the Volcker Rule within it, along with Basel III, market making in high yield debt has been impacted. Dealer inventory now sits at all-time lows.1

Dealer Inventory as a % of Market

Dealer Inventory 2-5-16

As dealers have become significantly less of a force within market trading, times of sell pressure, such as we have seen over the past year, have resulted in more significant price markdowns. Buy and sell pressure has always existed in this market, in all markets for that matter, but it is becoming more pronounced given this new regulatory environment, which ironically enough was put in place with the hopes of increasing market stability.

While the perception is that these liquidity concerns equate to a lack of trading activity, the reality is that we are now seeing turnover in the high yield market back to pre-crisis levels.2

High Yield Market Turnover

HY Turnover 2-5-16

Trading activity is clearly occurring given the turnover number. However, the general market risk off mentality right now combined with the lack of dealer inventory has led to bigger price swings, and with that increased volatility within the market. Throughout the history of investing we’ve often seen bonds and stocks trade with big swings on factors such as weaker or stronger than expected earnings, competitive or product issues, or some other sort of news, or even just general market sentiment. For instance, it is not unusual to see stocks move 20, 30, 40% on massive volume—just because we see an outsized price move, it doesn’t mean the security is illiquid. Risk is part of investing and in volatile times, price swings can be big, and that is what we are seeing in today’s high yield market. We are seeing pricing issues, but we believe those pricing issues are creating opportunities (see our pieces “The Pricing Issue in High Yield” and “The High Yield Market Repricing: An Opportunity”).

As we discuss liquidity, many seem to point the finger at exchange traded funds (ETFs) as a big part of the problem. Keep in mind, ETFs comprise only about 3% of the almost $2 trillion total high yield bond market.3

High Yield ETFs own less than 3% of all outstanding HY bonds

HY ETFs percent of HY market 2-5-16

Of note, high yield bond ETFs have represented about 3% of the market for the last four years. It seems people are under the impression that ETFs have just recently become a bigger force in the high yield market and are all of a sudden causing liquidity issues; however, that is not the case.

Instead, we see ETFs as part of the solution as providers of liquidity to a market that has had periods of lack of buyers and liquidity issues in the past. As a recent Credit Suisse report noted:4

The year [2015] saw institutional investors increasingly frustrated by lack of dealer inventory, which hit record lows, making them resort to HY ETFs and CDX HY as place holders for new cash in the absence of secondary paper available. We think the extra trading and risk transfer capability that the HY ETF markets provides fills a liquidity void left behind by regulatory pressures on dealers.

The regulatory changes have altered today’s high yield market, bringing with them more volatility. This heightened volatility is here to stay and must be something that high yield investors contend with going forward. We believe this volatility is actually an opportunity for active investors who can look to take advantage of the outsized “liquidity premiums” offered to investors in today’s high yield market, whereby investors are able to capitalized on discounts and generate what we see as attractive yields due to market fear and volatility rather than fundamental weakness in many credits. Within this new framework, we believe ETFs give investors instant access to the high yield market and unlike mutual funds, ETFs trade throughout the day, giving investors a more accurate reflection of intra-day pricing dynamics and volatility. We believe ETFs provide investors a great way to access an asset class where we currently see attractive value to be had.

1 Flanagan, Chris, Hans Mikkelsen, Shyam S. Rajan, “The US Fixed Income Weekly: 2016 Fixed Income Outlook,” Bank of America Merrill Lynch, December 7, 2015, p. 264.
2 Koch, Fer, Miranda Chen, James Esposito, and Amit Jain, “US Strategy 2016 Outlook,” Credit Suisse Fixed Income Research, December 21, 2015, p. 21.
3 Acciavatti, Peter Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2015 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 29, 2015, p. 130.
4 Koch, Fer, Miranda Chen, James Esposito, and Amit Jain, “US Strategy 2016 Outlook,” Credit Suisse Fixed Income Research, December 21, 2015, p. 21.
Posted in Peritus

The Ratings Game = Opportunity

As we look at today’s high yield market, we are seeing a bifurcated market, and opportunity, in terms of the various ratings categories. During 2015, CCC credits were down 12%, or down 8.3% excluding commodities, while BBs were down just 0.2% ex-commodities. This has put the spread offered between CCC-rated companies relative to BB-rated companies ex-commodities back to levels not seen since the financial crisis, as pictured below.1

HY returns by rating ex-commodities          HY CCC/BB ex-commodities spread

2015 BB vs CCC

We have been vocal on our take on the rating agencies. We view the ratings process as flawed as it is often reactive not proactive, focusing on the past versus the future. Also, the dividing line between each ratings category, such as BB versus B or B versus CCC is so arbitrary and subjective. The ratings agencies themselves call their ratings opinions and say that investors should not solely rely upon them in them in making investment decisions. So often in our careers we have seen a company that we believe to be fundamentally solid, remain CCC-rated forever, all the while paying their bills, refinancing their bonds prior to maturity and issuing new debt, while we were able to pocket what we viewed as an outsized yield due to the rating. On the flip side, we’ve seen on many occasions bonds go from B swiftly to D or even a quick trip from investment grade to default. Investors need only look to the likes of Lehman, WorldCom, and Enron, as well as the AAA rated debt in the sub-prime crisis to have evidence of just how inaccurate the ratings agencies can be.  Even over the last day, we saw a rating agency take a bond down five notches from B+ to CCC- on concerns about a restructuring. Clearly the company’s financial condition did not deteriorate overnight—this was an oil and gas exploration and production company, and we all know oil prices have been in free fall for over a year now. All that to say, the ratings agencies can be very slow on the upgrade and the downgrade, as well as wrong in their assessment of true risk.

The reality is that investors often make allocations based on ratings; thus creating inefficiencies that lend themselves to active management within the high yield market. We believe investors who invest by these ratings alone are putting themselves at a disadvantage. Active managers that are able to dig into the fundamentals of the business and determine their own opinion on the financial condition and outlook for the company can assess if the credit is money good, thus in essence an “AAA” credit, or if the capital structure is at risk, thus a “D” credit. Just because a company is B or CCC doesn’t mean that it is on the path to a default; instead, that outsized yield may be an opportunity.

We see plenty of B and CCC rated companies with stable business profiles and generating free cash flow. The one size fits all rating approach doesn’t work well within investing. For instance, ratings agencies look at leverage, but often don’t factor in that certain industries always seem to run at high leverage levels but it is supported by the M&A transaction multiples we see in the industry. For instance, many credits in the food industry often seem to run at higher leverage profiles than many other high yield issuers and thus always seem to have lower ratings, but often these brands have strong value and M&A activity is at very high transaction multiples, more than covering the leverage. This along with the cash generating ability and generally recession resistant/stable business profiles have made these names attractive investments for us over the years despite the ratings. We’ve also seen cases where the ratings agencies assign a ratings based on the total leverage of a company, and not factoring in a huge cash balance for a much lower net leverage profile. Or when companies take advantage of big declines in their bonds prices and buy back bonds in the open market, the ratings agencies at times have considered these “selective defaults” despite the fact that the company has not defaulted on any obligation, the company is buying these bonds from are willing sellers, and the company is reducing their leverage profile and lowering their interest costs thus improving their long term cash flow generating ability by making these discount purchases. In short, we see the ratings methodology as flawed.

We have always believed the ratings process creates inefficiencies and opportunities within the high yield market and with the outsized decline in lower rated bond categories within high yield over the last year, we are seeing even more selective opportunities to take advantage of today. Certainly some of the lower rated paper is justifiably lower rated and in some cases, the yield generated isn’t worth the risk. But investors need to determine this for themselves. Investors need to analyze the company’s business fundamentals and financial profile and consider the company’s future prospects to assess if it is a money good credit or not, and make the investment allocations accordingly. We believe that today’s bifurcated market is creating opportunities that active, fundamentally-driven investors need to take advantage of.

1 Koch, Fer, Miranda Chen, James Esposito, and Amit Jain, “US Strategy 2016 Outlook,” Credit Suisse Fixed Income Research, December 21, 2015, p. 25.
Posted in Peritus

The High Yield Market Repricing: An Opportunity

Markets across asset classes and across the world have been in a seemingly free fall since 2016 began, with equities domestically and internationally, oil/commodities, and high yield bonds, among others, all facing big declines, all while US Treasury bond and US dollar prices have been spiking. The “risk-off” trade is in full swing as we sit in this third week of the new year.

As we recently wrote, we do believe there is further downside to be had in equities as the re-pricing to account for current global and economic conditions is just beginning there (see our piece, “The Equity Alternative”). However, the high yield bond market has been in the midst of repricing for well over a year now. Over this period, high yield bond yields have more than doubled off of the June 2014 level of 5.19%.1 Just in the first few weeks of this new year, we have seen yields in the high yield bond market widen by 103bps, putting us well above 10% for the first time since October 2009.1

JPM HY Yields 1-21-16

Year-to-date, spreads have widened 125bps and now sit at 882bps.3 This compares to the 20-year average spread level of 598bps and 20-year median spread level of 548bps.4

Spread to Worst 1-14-16

J.P. Morgan recently noted the following:5

Over the past 25yrs spreads have only been above 800bps slightly over 10% of the time (37 months) and notably, total returns were remarkably strong over the next twelve months in all but a few instances. The only two negative outcomes was if an investor bought high-yield bonds as spreads crossed 800bps in March 2008 (-20.1% next 12 months) or February 2001 (-0.2% next 12 months). The median and average total return over the next 12 months for high-yield bonds as spreads crossed 800bps was 24-25%.

 12 mos after spreads 800bps

      Source: J.P. Morgan

So really, the only significant one-year forward negative return was had for those that purchased high yield during the period that Bear Stearns was blowing up, which proceeded the prolonged downturn of the financial crisis by about six months. History would indicate that once the pain is taken and spreads hit these elevated levels, high yield bonds are quick to recover.

Historically we generally see these sorts of spread levels in high yield bonds as we are approaching/in the midst of a recession, where fundamentals are deteriorating (big profit declines, leverage increasing, etc.). We largely aren’t seeing that today, outside of energy and other commodities. Don’t get us wrong, the energy and commodity space are in a depression and there will be many defaults in this space, especially as we see oil around $30. These segments account for just under 20% of the high yield market. However, in the other 80% of the market we aren’t seeing fundamentals taking a big hit. For instance in the last full earnings reporting season (Q3 2015), we saw revenues increase 1.7% and EBITDA (earnings before interest, taxes, depreciation, and amortization) increase 14.2% excluding energy, metals, and mining.6 Given the lack of leverage in the system, we certainly don’t believe we are on the precipice of any sort of financial crisis. Rather markets around the world are adjusting to lower growth and the end of a commodity cycle. While we will certainly see slowing here at home, we don’t see a recession as likely.

We see the current situation as similar to the last time spreads surpassed 800bps, which was in late 2011 during the midst of the European crisis, when the world wasn’t sure if the European Union would survive. Markets at that time were also in “risk-off” mode as they are today, but a recession domestically was not occurring or imminent. During that period, spreads peaked at 861bps in October 2011. The 12 month return following the period when spreads first surpassed 800bps at the end of September 2011 was +19.5%.7

Fear and selling pressure in a market that is less liquid due to the post-financial crisis regulations put in place is creating a pricing problem in high yield—as funds go to market to meet redemptions, this is forcing prices down, in some cases significantly. We’d always expect to see prices go down when people are selling, but in today’s high yield market that is being acerbated by the fact that banks are not making markets like they used to and there is much less dealer inventory as a result of these regulations. We see it as more of a technical issue rather than a fundamental, systemic issue; a pricing problem rather than a credit problem. With the still solid fundamentals on much of the high yield market (ex-commodities) we see this as a buying opportunity to take advantage of the non-fundamentally driven pricing gaps; we believe it is certainly not the time to sell. While trying to time a market perfectly is often futile, with now double digit yields offered in the high yield market and spreads over 800bps, we believe this market offers selective value for active investors, positioning investors well for future returns and providing them with income/yield while they wait for the volatility to subside.

1 Acciavatti, Peter and Nelson Jantzen, CFA, “JPM High-Yield and Leveraged Loan Morning Intelligence,” J.P. Morgan North America Credit Research, January 21, 2016.  High yield index referenced is the J.P. Morgan High Yield Index.
2 Acciavatti, Peter and Nelson Jantzen, CFA, “JPM High-Yield and Leveraged Loan Morning Intelligence,” J.P. Morgan North America Credit Research, January 21, 2016.  High yield index referenced is the J.P. Morgan High Yield Index.
3 Acciavatti, Peter and Nelson Jantzen, CFA, “JPM High-Yield and Leveraged Loan Morning Intelligence,” J.P. Morgan North America Credit Research, January 21, 2016.
4 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, January 15, 2016, p. 15.
5 Acciavatti, Peter and Nelson Jantzen, CFA, “JPM High-Yield and Leveraged Loan Morning Intelligence,” J.P. Morgan North America Credit Research, January 21, 2016.
6 Acciavatti, Peter and Nelson Jantzen, CFA, “2015 High Yield Annual Review,” J.P. Morgan North America High Yield and Leveaged Loan Research, December 2015, p. 149.
7 Acciavatti, Peter and Nelson Jantzen, CFA, “JPM High-Yield and Leveraged Loan Morning Intelligence,” J.P. Morgan North America Credit Research, January 21, 2016.
Posted in Peritus

The Equity Alternative

Three weeks ago, we posted a market commentary arguing that the run for equities was over, as we saw little in the way of catalysts ahead (High Yield vs. Equities—Is This the End of the Run for Equities?). In the three weeks since, we have seen the S&P 500 fall 8.7%, the Dow is down 8.8%, and the Nasdaq is down 11.4%.1 It’s been a rough start to the new year to say the least!

The credit markets have been telling us for months that things weren’t as rosy as the equity markets seemed to believe, as evidenced by the divergence in returns over the latter half of 2015.2

2015 Returns HY, SPX

Now, equities are waking up to this reality and we expect it will take some time for them to adjust. The economy is struggling, growth and demand is stagnant worldwide, currency/foreign exchange is taking a toll on sales and profits, and energy and other commodity prices are in free fall. As we enter the earnings season, estimates are for a 5.3% decline in Q4 earnings for the S&P 500.3

With high yield, we aren’t reliant on growth or earnings; rather, we primarily need the company to continue to pay their bills, including our interest payment, and be able to be refinanced at the call or maturity date to realize our yield. As we face what many have termed an “earnings recession” we favor credit over equities, especially considering from a valuation perspective, high yield has already taken its pain, adjusting to spread levels that we last saw four years ago.4

4yr Price,Spread

Additionally, is it often an overlooked fact that on a risk adjusted basis (with risk measured by the standard deviation of returns) high yield bonds have historically outperformed equities. Here is a look at the last 25 years, where on a return/risk basis high yield has significantly outperformed equities.5

25 yr return hy vs spx

We view high yield as an equity alternative given the relatively similar historical returns profile, and in the year ahead, we would favor high yield bonds over equities. Credit markets led the way down and we’d expect them to lead the way up. While it’s impossible to perfectly time the markets, sitting on the sidelines means sacrificing the attractive yield we see as currently provided by high yield bonds. The high yield market is offering big price discounts to par and a yield closing in on 9.5% on the index6, and we see the potential to capture even more yield in an actively managed portfolio. As we sit today, we are back to spread and yield levels not seen since 2011 in high yield bonds, while the S&P 500 is back to its August 2015 levels. The high yield market has taken its pain and we believe now provides an attractive entry point for investors.

1 Index returns for the period 12/24/15-1/15/16.
2 High Yield based on the Bank of America Merrill Lynch High Yield Index, data for 12/31/14 to 12/31/15. S&P 500 data from 12/31/14-12/31/15. Data sourced from Bloomberg. 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.
3 Butters, John, “FactSet Earnings Insight,” FactSet, January 8, 2016, p. 3.
4 Spread to worst for Bank of America Merrill Lynch High Yield Index, data for 12/31/11 to 1/13/16. Data sourced from Bloomberg. 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.
5 High Yield based on the Bank of America Merrill Lynch High Yield Index, data for 12/31/90 to 12/31/15. S&P 500 data from 12/31/90-12/31/15. Data sourced from Bloomberg. 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. Return/risk is Annualized Total Return divided by Annualized Standard Deviation.
6 The yield to worst on the Bank of America High Yield Index is 9.43% as of 1/15/16.
Posted in Peritus

The Pricing Issue in High Yield

I talk with many professionals in the asset management business each week.  There have been a few recurring questions: where is the bottom in high yield and what is causing this downturn? Let me explain.

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.  Additionally, there was the fear that the Fed would raise rates and all yields along the Treasury ladder would rise.  We continually argued that this wouldn’t happen for a whole host of reason, the most obvious was being a very weak global economy (see our piece “Interest Rates: Moderate is the Word”).

As we sit here today, the Fed raised the Federal Funds Rate, oil is $33, the 10 Year Treasury is 2.17%, the Middle East is imploding and the world is not growing.  Various rating agencies and investment banks are forecasting 2016 default rates outside of energy/mining/commodities to be about 2%, nearly half the historical rate. Predictions are for the energy/mining/commodity segment to be about 10% or higher.3

If you are following my thought process here, we believe that what we have is a pricing issue, not a credit or fundamental problem. I will use a recent note from our research department as an example of what we are currently seeing in the high yield market.  One of our holdings had preannounced Q4 and 2015 numbers and the analyst noted the following:

Excellent free cash flow generation, good leverage metrics (3x and lower on a market adjusted basis) and meeting expectations.  For 2016 excellent free cash flows again but sales and EBITDA to be flat to down 8%.  These bonds price in the $60s for a yield to worst over 16%.  Is this distressed?  It doesn’t look distressed to me, but the poster child of a no-growth planet.

For those not familiar with the term, free cash flow indicates that the company is generating cash in excess of their operating expenses and capital spending, providing the company with additional liquidity. In this case the company reduced debt levels during the fourth quarter with their free cash flow. Certainly not something we would expect to see of a company in severe distress or on the verge of some sort of default. We instead see this as the reality of a broken market in high yield.

This isn’t an isolated case; rather, we are seeing similar cases in our own portfolio and within the broader high yield market.  There is not much growth in revenues/sales but profitability is decent, which as bond/loan holders is what we care about.  We want the company to continue to pay their bills and maintain access to capital in terms of revolver balances, cash on the balance sheet, and/or free cash flow. I can’t tell you when the negativity and weak pricing for high yield bonds ends but keep in mind, bonds and loans have call and maturity dates so generally, barring a default, which we would not anticipate in companies like the one profiled above, as we move closer to these call and maturity dates, bond prices would generally move toward the call and maturity prices of par or higher, providing coupon income along the way and potentially a capital gain as prices move. The question for you: is volatility going to keep you from adding a high yield position where you can collect what we see as an attractive monthly dividend/income while we patiently wait for these prices to reflect the reality of the solid fundamentals that we see in so many cases?

1 For instance, energy was 16.6% of the J.P. Morgan High Yield Index as of December 2014. Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High Yield Market Monitor,” J.P. Morgan North American High Yield Research, January 5, 2015, p. 18.
2 Fuller, Matt, “US HY funds net small inflow to close 2015 after three big outflows,” January 4, 2016, S&P Capital IQ, LCD News. Fuller, Matt, “Outflows from loan funds stay heavy to close 2015,” January 4, 2016, S&P Capital IQ, LCD News.
3 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 4, 2016, p. 9, for instance J.P. Morgan projects 1.5% ex-commodities and 3% total high yield defaults in 2016.
Posted in Peritus

Implied Default Rates for the High Yield Market

As we assess potential value in the high yield bond market, we believe it is important to consider both spreads and expected default rates. Current spreads offered by the high yield bond market are well above average and are now at multi-year highs, but is that just because we expect defaults to increase, so these levels are justified? We need to look at what the current spread levels imply in terms of default rates relative to expected default rates to properly answer that question. J.P. Morgan presents the math on the implied default rates based on current spread levels:1

Implied defaults 12-30-15

Current spreads are implying that default rates will be 6.6%, well above the historical default rate averages around 4% and well above the default estimates we have seen for 2016 ranging from about 3-4% (versus the default rate around 2% this year).2

What I think is most significant is looking at the breakdown of implied defaults for energy and ex-energy. Implied energy defaults of 14.4% don’t appear too off the mark, as we have seen projections in the low-double digits with the caveat that the default rate could increase if oil stays sub-$40. As we have spoken about at length before, we believe there are many high yield issuers at risk in the shale exploration and production segment of energy, as well as companies that provide services to these producers. With the high decline rates and capital costs in shale production, we expect liquidity to become tight in many cases, and are already starting to see defaults in the segment pick up. We are currently avoiding shale energy producers because of the unfavorable dynamics we see in the space.

However further looking at the breakdown of the implied defaults for the rest of the high yield market excluding energy it is way off the mark by our assessment. Default projections we have seen range from about 1.5-2% for the vast majority of the market that excludes energy, less than half of what the current spreads would imply as a default rate. Given this, we believe the current dynamics in the high yield market present an environment where active management is essential. This is a bifurcated market with the vast majority of the market that has relatively solid fundamentals and offering what we see as sizable discounts and yields in many cases. And then there is a segment of the market where extreme caution is warranted.

With the implementation of the Volcker Rule, the outflows that we have seen from the asset class, and all the negative headlines, we have seen prices in much of the broader high yield market fall for what we see as no fundamentally driven reason. Unlike prior downturns where we saw widespread credit issues and over-levering, we aren’t seeing that today. Other than in a couple selective industries, we see today’s high yield market as having a pricing problem not a credit problem. We believe this has created one of the better opportunities we have seen in our careers to enter the high yield market or add to your allocation. With spreads at multi-year highs, we believe there is value to be had for investors in this market but active management and a focus on fundamentals will be key to investing in the space as we enter 2016 and beyond.

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. 112.
2 See our piece “High Yield Bonds: The Energy Dilemma” for further detail on default projections.
Posted in Peritus

The Opportunity Cost of Not Investing

There have been a number of reasons investors have fled the high yield bond market over the past year, including concerns over interest rates, energy and commodity exposure, liquidity, and defaults. With this sell off, spreads have now increased to multi-year highs, putting spreads over 200bps above historical median levels.1

Spread, yld to worst 12-17-15

Not only are spreads at multi-year highs and well above historical medians, we are now sitting at yield levels also above historical medians despite the well-below average interest rate environment we are facing. With the current spread level, investors are getting a 339% premium for being invested in high yield bonds versus 10-year Treasuries.2

HY premium to 10yr 12-17-15

Historically speaking, this premium is on the high end, excluding the massive spike we saw in the midst of the 2008/2009 financial crisis. This indicates that investors are getting a sizable yield relative to the risk-free Treasury rate.

Looking at other fixed income segments, the spread differential between high yield bonds and investment grade bonds is also well above historical average and median levels.3

HY vs IG 12-17-15

Obviously the default environment is a factor when investors consider making an allocation to the high yield market versus investment grade bonds or “risk-free” Treasuries. However, as we have noted in other writings (see our piece “Implied Default Rates for the High Yield Market” and “Assessing Default Risk, Yield Matters”), we believe that default rates will increase but will stay below historical averages and investors are being more than compensated for expected default losses.

Additionally, as investors assess their fixed income investment alternatives in the face of what we expect to be a moderate interest rate increase over the next year (see our piece “Interest Rates: Moderate is the Word”), duration, a measure of interest rate sensitivity, also must be considered.4

Yld, Duration 12-30-15

The high yield bond market not only offers investors a yield more than double what is offered by the investment grade bond market, but also provides a lower duration, meaning it would face less interest rate risk as rates rise.

Given the historically high spreads currently offered in the high yield space and the lower interest rate risk per the lower duration, we believe investors should be considering an allocation to the high yield market as they assess their fixed income allocations.  We believe there is an opportunity cost to holding Treasuries or investment grade bonds in terms of the missed yield offered by high yield bonds.  Also keep in mind that if you expect interest rates to increase, for Treasuries that means that as rates/yields rise that translates to a price decline and we believe investment grade bonds also face outsized interest rate risk.

Of note, the yields and duration referenced above for the high yield market are for the index.  However, as an active manager, we can work to focus on value based on our fundamental analysis and credit selection, which has resulted in even higher yields and a lower duration in our portfolio, as we combine both high yield bonds and loans.  We believe that after the big repricing we have seen over the last year, today’s high yield debt market offers active investors attractive yield and value.

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, December 18, 2015, p. 29.
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, December 18, 2015, p. 30.
3 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, December 18, 2015, p. 30.
4 Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt. 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. Data as of 12/30/15 for the various Barclays indexes, source Barclays Capital, and 12/31/15 for the U.S. 5 Year Treasury Note. 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 is a modified adjusted duration for the various Barclays indexes and Bloomberg calculated duration to workout for 5-Year Treasury.
Posted in Peritus

High Yield vs. Equities—Is This the End of the Run for Equities?

The decline in credit has been well publicized over the last several weeks, though this decline began months ago. Since the summer, we have seen spreads, a measure of valuation for the high yield market, widen from 400bps to 760bps1 to levels we have not seen for the last four years. High yield bonds are often thought of as a leading indicator for equities, meaning this segment of the market is usually the first to recognize problems and decline and then the equity markets eventually catch up. But so far, we haven’t seen a material hit to equity valuations.

As the charts below picture, over the past four years we have seen high yield bond spreads come full circle, putting us back at valuations not seen since the 2011 European crisis2, all the while equities have moved in pretty much a straight line up from P/E’s of 14x to right around 22x3. Keep in mind generally the higher the spreads (a measure of the yield to worst relative to comparable maturity Treasuries), the cheaper we would view the high yield market, while the higher the P/E ratio, the more expensive we would view the equity market.

HY Spreads 4yr 12-22-15

SP 500 PE ratio 12-24-15

By historical valuations, equities are more expensive compared to historical averages, meaning you are having to pay more for given earnings4, while the high yield market is cheaper, meaning you are getting a higher spread for your bonds relative to the historical averages.5

 SP 500 PE ratio history 12-24-15

HY Spread History 12-22-15

Interesting, these high equity valuations are in the face of estimates for S&P 500 earnings to decline -4.4% for the fourth quarter, the first time we have seen three consecutive quarters of year-over-year declines in earnings since 2009.6 This poses the question, if earnings are going to be negative, what is going to drive P/E ratios higher and give investors a positive return in the months and quarters to come? We are seeing growth decline across the board globally and don’t see anything to cause that to change over the coming quarters and maybe even years. We struggle to see how equity investors can justify a further increase in valuations, thus we don’t see much upside from current levels, and potentially even downside.

However, with the high yield bond market already in correction mode, at multi-year highs in terms of spreads, and what we see as over-reaction to current market and economic conditions, we believe there is attractive value to be. Unlike equity investors, we don’t have to bet on earnings growth or valuations to increase to drive P/E ratios and returns. We instead need companies continue to pay their bills and plug along to maturity to realize that ultimate value and return, as barring a default, bonds mature at par value if not called prior to that above par. From a credit perspective, we believe that fundamentals remain relatively solid and that active investors that can focus on the bonds they see as undervalued are very well positioned to extract that value from today’s high yield bond market.

1 Data sourced from Credit Suisse, as of 12/22/15.  Spread referenced 7/01/2015, 12/22/2015.  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 12/22/15.  Historical spread data covers the period from 1/31/1986 to 12/22/2015.  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.
3 Based on S&P 500 PE Ratio as of 12/1/11 to 12/24/15, see http://www.multpl.com/.
4 Based on S&P 500 PE Ratio as of 4/1/1957 to 12/24/2015, see http://www.multpl.com/.
5 Data sourced from Credit Suisse, as of 12/22/15.  Historical spread data covers the period from 12/23/2015 to 12/22/2015.  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.
6 Butters, John, “FactSet Earnings Insight,” FactSet, December 11, 2015, p. 1.
Posted in Peritus

High Yield Bonds: The Energy Dilemma

Oil has once again broken the $40 level, and then swiftly broke $35.  This recent leg down in oil has taken a toll on the high yield market given that the energy sector accounts for 13-16% of the high yield market, depending on the index you look at.1  This means that funds that track these indexes would likely have a similar allocation.  While general default rates in the high yield market are expected to remain below their long term averages, this will not be the case for the energy and mining industries.

One of the top three ratings agencies recently gave their outlook on US high yield bond defaults, projecting energy related defaults to total 11% in 2016, while the non-energy and non-metals/mining sectors will face historically low default rates of 1.5%.  Similarly, J.P. Morgan is projecting a 10% default rate in energy and a 1.5% default rate excluding energy and metals/mining, well below the long term averages of 3.6%.2

We expect many energy companies, especially shale related producers, will not be able to make it through this cycle of low prices.  Many shale producers were not generating cash even when oil was more than double what it is today.  Additionally, these shale wells have massive decline curves of approximately 70% in their first year, meaning they require a large amount of capital to keep production flat, often resulting in a large cash bleed.  The high yield market is littered with these types of producers and also related service companies, thus we do expect oil and gas prices at these levels will certainly cause a spike in defaults related to the sector over the next year.  We are already seeing it happen with over 50% of defaults and distressed exchanges so far this year related to energy3, and as the hedges wear off in 2016 and the full effect of current oil prices are felt, we expect this energy related default activity to heat up.

Also related to energy, we see MLPs (master limited partnerships), which were high fliers and popular investment strategies not too long ago, as extremely vulnerable.   We had warned in the past for investors to be weary of return of capital versus return on capital.  The problem has been that these partnerships were providing a return of capital and now that access to capital (debt and equity) to continue to fund capital expenditures for growth and the dividend is drying up, resulting in dividend cuts.  We’ve recently seen some high profile companies cut their dividends, which is calling into question, rightfully so, the sustainability of dividends across the space.  There is likely more pain to come for MLP investors as the current lows on oil prices work through.

After it became apparent to us in early 2015 that lower oil prices were likely here to stay for the near-term, we significantly reduced our exposure to the energy space, maintaining an underweight to the sector relative to the various high yield indexes.  While we are intentionally underweight, we don’t believe the entire sector should be abandoned.  Certainly extreme caution and thorough understanding of the business fundamentals (including hedging activity, capital needs and cash flow generation/use) is warranted, but there are still a few selective opportunities we see in the space.  For instance, we are invested in a few exploration and production companies.  These are primarily Canadian-based conventional (not shale-related) producers in what we believe to be attractive geographies that get a margin benefit from incurring costs in a declining Canadian dollar and selling product in an appreciating U.S. dollar.  We focus on producers that have hedges in place for a portion of the production in 2016, minimal cash bleed after necessary capital expenditures and interest costs, relatively low leverage, ample liquidity, and that we believe can survive a prolonged downturn in prices, even if hedges roll off in 2016 and these low price points persist.

The concern about energy in the high yield market is appropriate for the index and products that track them as this is a large component of the indexes and, as noted above, there are a lot of energy related companies at risk as defaults increase in the sector, just as there are MLPs that investors should be weary of.  We expect there will be further losses and income disruptions.  But as an active manager, we have the flexibility to choose where we see value and believe there is compelling value to be had in many other sectors in today’s high yield market.  We are underweight the energy industry relative to the market, and the vast majority of our portfolio is diversely allocated to industries not related to energy.  As default rates in the non-energy sectors are expected to remain well below average, we believe we are positioned well and offering what we believe to be attractive, sustainable yield to investors.

1 For instance, energy is 14% of the J.P. Morgan 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, December 11, 2015, p. 39.
2  Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2016 High Yields Bond and Leveraged Loan Outlook,” J.P. Morgan North American High Yield Research,  December 9, 2015, p. 4.
3 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Default Monitor,” J.P. Morgan North American High Yield Research,  December 1, 2015, p. 1.
Posted in Peritus

Interest Rates: Moderate is the Word

In our recent piece “The High Yield Bond Market: Facing a Rising Rate Environment, Time to be Concerned?” we discussed why we don’t feel the high yield market is at major risk if rates rise. And as we look toward the likelihood of the first interest rate increase in nearly ten years this week, we felt it was appropriate to review our outlook on rates. In short, we are in the moderate camp; we don’t expect the Federal Reserve to be aggressive with rate increases. The Fed clearly wants to start raising rates, as we are eight years into this “recovery” and cycle, and frankly, they need to have some room down the road to ease if necessary. But the data isn’t there for this “data dependent” Fed to justify significant and quick increases. We’d expect a few sporadic rate increases over the next year for the Federal Funds Rate, the interbank lending rate that the Fed controls. We’d also expect that these Federal Funds Rate increases do not translate to massive spikes in the 5- and 10-year Treasury rates, the relevant rates for the high yield market.

We recently discussed in our piece “Making Sense of Markets” the primary reasons that we believe the Fed will be constrained in their ability to raise rates. In summary, here are the challenges we believe they face:

  • Growth: We are in a no growth world. China is clearly slowing, Europe continues to muddle along, and Japan is in a recession. Global conditions are having an impact here domestically, as evidenced by the latest earnings season and the projected 4.4% decline in Q4 earnings.1
  • Inflation: With oil and commodity prices yet again taking another leg down, we believe the Fed will be hard-pressed to reach their inflation target of 2% in the “medium term.”
  • Unemployment: While the headline unemployment number has improved, there is still a large contingency of underemployed and discouraged workers dropping out of the job hunt, and we know this is something the Fed monitors based on previous comments.
  • Consumer Spending: Approximately two-thirds of economic activity is consumer driven. With nearly 50% of Americans now on some form of government assistance and the massive number of people that have fallen out of the job market, there seems to be less spending power today than a decade ago. Many have said that the energy cost savings will spur consumer spending but that just isn’t playing out as money is being used to shore up other cost increases.
  • Dollar: The strong dollar continues to cut into corporate profits, manufacturing, and exports.

All of these factors we believe will keep the Fed constrained in the speed and magnitude as they increase rates. While the Fed impacts the Federal Funds Rate, there are a couple other factors that we believe will play into keeping 5- and 10-year Treasury rates from running up significantly from here.

  • Global Demographics: As we have written about before, we are facing ageing demographics globally. As people age, we’d expect them to focus more on income and capital preservation, meaning we’d expect to see the demand for bonds to increase and stocks decrease over time.
  • Global Rates: With the lack of inflation globally, 10-year sovereign bond rates across the globe are exceedingly low. The US is an outlier with our 10-year over 2%. Even countries that were on the precipice not too long ago, like Italy and Spain, have 10-year bond yields well below that of the US.Given these comparative rates globally, we’d expect there to be buyers of the higher yielding 5- and 10-year U.S. Treasuries, in turn constraining rates on these debt instruments.

Global Rates 12-15-15

Given that it seems a foregone conclusion that the Fed will be raising rates this week and markets are forward looking mechanisms, we believe the Treasury rates are already pricing in a rate hike. With that, over the past couple months we have seen the 10-year pretty range bound around 2.15-2.35%. Between the still tepid economic situation worldwide tempering the Fed’s hand and demographics and relative rates globally driving demand for US Treasuries, we don’t see relevant interest rates running significantly.

The Federal Reserve will likely start raising rates to get the ball rolling, and may move rates up a quarter of a point a few times over the next year, but we expect their move to be fairly minimal. Additionally, given how the high yield market has historically handled rate increases, we’d certainly not expect this moderate move to inflict great pain on this segment of the market as many seem to worry will happen.

1 Butters, John, “FactSet Earnings Insight,” FactSet, December, 11, p. 1.
2 Data as of 12/15/15, sourced from Bloomberg.
Posted in Peritus