US Financial Markets: Demographics and the Income Opportunity

We are in the midst of a global shift in demographics as the Baby Boom generation ages and faces retirement, causing a need for reduced volatility in their investments.  We believe this creates real issues for future money flows.  We have seen it reported that approximately 75% of global equity markets are owned by pension plans and retail investors, both of which are likely to dramatically reduce stock exposure going forward.  

Of this, pensions (which we have seen reported account for about 45% of global equities alone) are expected to increasingly focus on portfolio immunization, whereby they look to match the maturity of their assets and liabilities, which forces these plans to turn to credit versus equity.

On the retail side, as we have previously discussed in our piece “Of Elephant and Rates,” which was written two years ago, at the time, estimates were that nearly 75% of global retail assets would be owned either by those retired or near retirement within five years.1  This is a huge number, and as people in this demographic enter or near the retirement phase, they tend to focus on capital preservation and income generation, which we expect will cause investors to rotate out of equities into credit.

We believe that demographics are destiny.  As the population ages, they will no longer be focused on taking on risk to generate higher returns via equity markets, but rather turning to the income and lower volatility provided by fixed income.  While we expect this to prevent interest rates from significantly increasing as the demand for fixed income increases in the years and decades to come, we also expect it will result in less demand (or outright liquidations) and lower valuations for equities.

So while we believe that there will be little to drive further equity market valuation and price expansion over the next year and beyond (see our piece “US Financial Markets:  Fundamentals and the Outlook for Equities”), we do believe the high yield market can be part of the solution for investors focusing on income.

The high yield market offers a yield to worst of 8.4% and a yield to maturity of 8.6%, far surpassing the yields offered by various other fixed income options.  Additionally, high yield bonds have a lower duration, indicating less sensitivity to interest rate moves.2

FI yld, duration

While the high yield offered by these corporate bonds is commensurate with the higher perceived risk, if you look at actual performance, high yield bonds have also outperformed the other listed fixed income categories over the last quarter century.  High yield has posted a 25-year return of 8.3% versus the sub-7% return for corporate investment grade and municipal bonds and negative returns for the 5-year Treasury.3

FI 25 yr returns

Over the long term we think it is likely that equity valuations will begin to compress and stocks will begin to lose their long term appeal as both baby boomers and institutional investors continue to pursue yield and capital preservation strategies.  We believe that income focused investors should consider an allocation to high yield bonds, with its relatively high income generation, as an equity alternative to complement their fixed income allocation. To read more about our thoughts on the demographic changes ahead, our outlook for equities, and alternatively the opportunity we see in the high yield market, see our piece, “Zero Sum Game.”

1 See our piece “Of Elephants and Rates,” http://www.peritusasset.com/wp-content/uploads/2010/09/Of-Elephants-and-Rates-Final1.pdf, January 2014, p. 4-5.
2  The BofA Merrill Lynch US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market. The BofA Merrill Lynch US Municipal Securities Index tracks the performance of US dollar denominated investment grade tax-exempt debt publicly issued by US states and territories, and their political subdivisions, in the US domestic market. The BofA Merrill Lynch US High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market.  Data as of 3/31/16, sourced from Bloomberg.
3  Data for the period 3/31/1991 to 3/31/2016, sourced from Bloomberg.
Posted in Peritus

High Yield Bond Investing: Understanding Yield and Default Rates

We’ve always viewed default risk as one of the primary risks in high yield investing.  Unlike stocks, bonds have an end date and value via their maturity date and maturity price of par.  There may be a lot of price noise in a bond along the way, but over time the price would generally drift toward this maturity price as you get closer to the maturity date, or even higher toward a higher call price if an early call is expected.  However, a default (or distressed exchange) would be something that derails this end return.

Defaults certainly need to be considered as investors allocate money to the high yield market, or any fixed income security for that matter.  However, in assessing default risk, investors need to consider the potential default losses in the context of the yield being generated by the portfolio.  Yield can potentially go a long way in making up for default losses.  For instance, if the market as a whole is offering higher yields, investors can withstand a larger amount of default losses and may still generate what we would see as a decent return.  This is an important consideration as investors evaluate today’s high yield market, as we believe the yield currently offered by high yield bonds more than compensates investors for default risk.

Let’s evaluate some theoretical scenarios.  We’ll look at a high yield portfolio in which the underlying securities have an average price of $90 (90% of par), maturity of five years, coupon of 7.25%, and annual current or distribution yield of 8% for the initial year.  If we assume the portfolio appreciates in equal dollar annual installments to move from the $90 price (90% of par) on the underlying securities to a maturity price of $100 (100% of par) by the end of the five years and we assume all income is reinvested immediately, we get the following theoretical return scenarios:1

Return scenarios 4-14-16

Then if we factor in some sort of default assumptions on top of that, the theoretical returns are as follows:2

Default assumptions 4-18-16

So even in a very dire 10% default rate and 25% recovery per year for five years, a theoretical 1.5% annualized return is generated, and if that recovery on the 10% default rate per year moves toward historical levels of 40%, a theoretical 3.1% return is generated, which is twice what is currently offered by 5-year Treasury3.  Never in the history of the high yield market have we seen defaults stay at double digit levels for multiple years in a row.  Even during the financial crisis, we saw default rates hit all-time highs for about a year, but then quickly fall to historically low levels for many years to follow4, so by no means do we see this multiple years at a 10% default rate as a realistic scenario.

HY default rates 2-26-16

We’ve seen projections for US corporate default rates ranging from 4%-6% in 2016, depending on whose numbers you use.5  If we take the midpoint, in the scenario above, assuming a 5% default rate per year for the next five years and 40% recovery, the theoretical annual return would be around 6.4%.  This may well be too conservative given, again, we haven’t seen this many sustained years in a row of higher defaults and it doesn’t account for any early calls at premiums for the holdings, which is potential upside.

Furthermore, the projected default statistics of around 5% are looking at the corporate debt market as a whole.  Yet, energy and commodities are about 16.6% of the high yield indexes6 and defaults in these sectors are expected to see a huge spike, while the rest of the high yield market is expected to remain at below average default rates.  So if you are able to build a portfolio with much less commodity and energy exposure than the general market, then your default and loss rates may well be lower.

With the yields offered by today’s high yield market, we believe investors are more than compensated for the default risk ahead, especially for active managers who can reduce their allocations to the most vulnerable securities/sectors, namely in energy and commodities.  We believe investors have the potential to generate what we see as an attractive return in today’s high yield market even in the face of increasing default rates.

1  These calculations are hypothetical and are provided for illustration only. Actual results may be materially different. These calculations assume all holdings mature in exactly 5 years and do not account for the fact a portfolio would have debt securities with various maturities or early redemptions via call or otherwise may occur.  These calculations assume that the price appreciation is equally distributed per year over the entire five year period, moving the price on the underlying securities from $90 (90% of par) to $100 (100% of par), so assuming a $90 portfolio value, it would increase $2 per year to total a portfolio price value of $100 at the end of year five.  These calculations also assume that the 7.25% coupon on par remains constant on a percentage basis, while the current yield decreases as the portfolio price as a percentage of par increases.  Coupon income generated is assume to be immediately reinvested a the current portfolio price as a percentage of par.  These assumptions do not account for fees, expenses, price variations, and yield variations, among other factors, and assume that no companies default on their principal or interest obligations or that securities are bought or sold over the holding period.
2  These calculations are hypothetical and provided for illustration only. Actual results may be materially different. These calculations evaluate specifically the potential loss rate relative to the accreted portfolio value (moving from 90% to 100% of par in equal installments over five years, with the value adjusted for par loss rates) and do not consider any further portfolio factors or changes, such as the variability of prices and yields of non-defaulted and defaulted securities or the time frame for bankruptcy work out, among various other factors.  Default losses are assumed to occur at the end of the year for each annual period and are accounted for as a decline in portfolio value.  Loss rates not default rates are used as any recovered value in the default is assumed to be available for reinvestment.  Recoveries are assumed to be immediate.  These scenarios also include the same assumptions noted in footnote 1, with various adjustments made due to par loss rates and do not account for fees and expenses.
3  5-Year US Treasury rate as of 4/7/16.
4  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield and Leveraged Loan Research, February 26, 2016, p. 45.
5  For instance, Credit Suisse projects 5% (Fer Koch, Miranda Chen, James Esposito, and Amit Jain, “US Credit Strategy Outlook,” Credit Suisse Fixed Income Research, December 21, 2015, p.18), J.P Morgan projects 6% (Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” March 1, 2016, p. 5) and we’ve seen rating agency projections closer to 4%.
6 Based on the J.P. Morgan US High Yield Index.  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield and Leveraged Loan Research, March 18, 2016, p. 49.
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US Financial Markets: Fundamentals and the Outlook for Equities

The US dollar and bond markets will continue to benefit from a flight to quality trade keeping rates much lower than expected by many.  However, this is not because we see the US economy performing exceptionally well; rather, just less poorly than most.  We also see the beginning of the end of the bull market in stocks which began in 2009.  Importantly, we see a very negative long term trend for equities in general over the next decade.

Let’s begin with a look at some important historical data.  Stock returns over the long-term have averaged about 6.5% for US investors.  I believe that most investors would be very surprised at this number.  This takes into account the last 115 years.1

Real Stock Market Return

Note that the past ten and 20 year numbers are in line or slightly below the long term averages.  However, the past five years have shown a return significantly in excess of this historical average for the U.S.2

S

Another observation that is important for Canadian investors.  The past five and ten year periods encompass the highest average oil prices in history, yet equity investors have made almost no money investing in the Canadian stock market.  Is it any wonder that the best Canadian institutional investors have but token allocations to Canadian stocks and are instead turning to the US and other markets?

We believe regression to the mean is law in investing.  Turing back to US equity markets, on the back of the outperformance for the past five years, we believe that returns over the next few years are likely to be well below historical averages of 6.5%.  A brief look at beginning valuations tells us why we believe this to be the case.3

Shiller pe

We are now at valuation levels seen only twice before: once before the Great Depression in 1930 and the second spiking in 2000 after the internet bubble and then remaining elevated from there leading up to the financial crisis of 2008.  While valuations are key, we all understand that things can continue to be over-valued or become more over-valued for long periods of time, but at some point, markets will wake up to the reality, and often over-correct.  As we sit today, we believe that holding equities is not investing, but speculation.  What is well known by investors today is that both revenue and earnings growth is now effectively non-existent.  So much of the equity returns we have seen over this period have been nothing but increasing valuations based on money flow algorithms, which in turn were triggered by very low interest rates.  Interestingly, the valuation explosion has happened at a time when corporate profits as a percent of GDP have been at their all-time high.4

US Corp ProfitsWe have had a long run of productivity (jobs being replaced by machines or outsourced to low wage jurisdictions/countries) and had a huge dividend from lower interest rates (debt being refinanced at lower rates) but all good things come to an end.  We concur with recent research from Morgan Stanley that suggests labor will begin to take a larger share of the cost pie, hurting profitability going forward.  Labor forces are shrinking across the globe as population growth in both developed and key emerging economies slows.  Nowhere is this more evident than here in the U.S.5

Baby Boom

With unemployment rates falling below 5%, it is a matter of time before wage pressures begin to build.  And with the economy firmly pointed in the direction of services (i.e. healthcare), the ability to do more with less reaches its limits.  In summary, in the face of sky high valuations, we believe a lack of revenue growth and shrinking profit margins will all play a role on limiting future equity returns.

We believe US equity markets are ripe for a fall in 2016.  Valuations remain elevated in the face of no revenue or earnings growth.  Another factor at play will be profit margins (unsustainably high), which will likely suffer from increasing labor rates (including higher minimum wage rates) further pressuring earnings.  However, we believe the high yield market offers investors an attractive alternative to equities.

Outside of energy and commodities, we view the high yield debt market as undervalued given the fundamental backdrop relative to the yield and price discounts currently available.  Leverage ratios are stable and interest coverage ratios have been improving.  Additionally, defaults are expected to remain below historical averages outside of the energy and commodity sectors.6  We believe the high yield market, often a leading indicator, has already felt its pain due to the economic environment and is now starting to stabilize, offering what we see as a compelling opportunity.  However, we feel active management is essential in this market as investors need the ability to avoid certain securities/sectors and embrace others, rather than following a broad index. If you need any more evidence of the risks we see for these passive, index-tracking products, especially as it relates to energy, just look to iShares planning to launch a high yield ETF that excludes energy credits. We don’t think this sounds good for the hundreds of millions of dollars in existing high yield index-tracking products.  Active management matters.

We believe the high yield bond and loan market offers income focused investors a way to generate a steady income stream and the potential for capital appreciation to help drive long-term returns.  We see this as an attractive alternative to equities, where we expect the pain is in the beginning stages.  To read more about our thoughts on the outlook for equities, and alternatively the opportunity we see in the high yield market, see our piece, “Zero Sum Game.”

1 Inker, Ben, “Just How Bad Is Emerging, and How Good is the U.S.?”, GMO Quarterly Letter, Q3 2015, p. 9.  Copyright GMO.
2 Inker, Ben, “Just How Bad Is Emerging, and How Good is the U.S.?”, GMO Quarterly Letter, Q3 2015, p. 10.  Copyright GMO.
3 Source: Data sourced from http://www.multpl.com/shiller-pe/, as of March 7, 2016.
4 Inker, Ben, “Just How Bad Is Emerging, and How Good is the U.S.?”, GMO Quarterly Letter, Q3 2015, p. 15.  Copyright GMO.
5 Goodhart, Charles, Manoj Pradhan, and Pratyancha Pardeshi, “Could Demographics Reverse Three Multi-Decade Trends?”, Morgan Stanley Research, September 15, 2015, p. 24.
6 See the piece “Zero Sum Game” for full data and source details.
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Strategy Adjustments: Sell Discipline

As we noted last week, we have made some strategy adjustments as we work to help improve liquidity and dampen volatility.  Along those lines, we have implemented a sell discipline.  While as active managers we are always monitoring our holdings and evaluating our upside versus downside, we now are including an additional risk overlay that involves specifically re-evaluating our holdings once a $70 price is breached.

Through our many years of experience in the high yield market, we believe that $70 is the price point where bonds begin to be viewed as “stressed.”  Due to some of the regulatory changes, including the likes of Dodd Frank/Volcker among others, we have seen many securities gap down well below this price once it breached the $70 level, thus we believe re-evaluating at this point and potentially selling depending on our analysis may help reduce our portfolio volatility.  We will be highly sensitive to this $70 level going forward.

It should be noted that should we decide to sell a security for breaching this price point, these are often higher yielding/income generating names by the nature of the bonds at such a deep discount; thus, a potential sell and reinvesting in a lower yielding/more stable credit could result in lower income generation.   However, we see this process a tool to help us avoid future defaults and pricing downside, serving us well over the long run in terms of potential principal protection and reduced volatility.

We have been deep value investors through our history and have faced periods of volatility before, but given the new liquidity paradigm in which we are operating, bonds seem to gap down faster today than in the past and we are seeing many companies entering a restructuring preemptively while still holding large cash balances on their balance sheets.  We believe this is a notable paradigm shift in our sector and feel it is prudent to adjust accordingly.

Market environments are continually changing and investment strategies should have the flexibility to evolve through various markets.  We believe these efforts position us well to take advantage of the yield offered by the high yield debt market, while operating within the current market challenges as we actively work to protect principal and attempt to reduce volatility.

 

Posted in Peritus

Strategy Adjustments: New Issue Allocation

Investing is a dynamic process and managers must adjust to the market in which they find themselves.  We have done just that with some recent strategy adjustments.  To address the liquidity issues and concerns within the high yield market, we have instituted a strategic new issue allocation (see our piece “Liquidity Management” for further details), as our research has indicated that new issues tend to be very liquid and stable credits in the months following the issuance.

For a little bit of background on the liquidity issues, as we have discussed before, recent regulations have impacted and eliminated a great deal of market making support for the secondary high yield market.  The primary regulations that have an impact are the Basel accords and the Volcker Rule within the Dodd Frank bill:

  • Basel II+III—The banking provisions that increased capital and liquidity requirements to hold credit rated BB and lower.
  • Volcker Provision—The law inside Dodd-Frank that eliminated proprietary trading, which by its nebulous design has all but eliminated dealer market making.

The SEC has said an area of their focus pertains to secondary trading in bonds/loans and whether there was sufficient liquidity.  They are now looking at further ways to address the amount of “illiquid” bonds/loans within portfolios, but the challenge remains as to defining “illiquid” in a way that can be clearly quantified and monitored.  For instance, some of the big mutual funds and index tracking products have hundreds and upwards of 1000 holdings, and some trade rarely.  With Volcker and other regulations, we have seen added volatility, as we are at times seeing moves in bonds/loans from $2 – $20 or more in a day.

After completing our research and testing our thesis, we began implementing the new issue allocation in December, though it became a more significant allocation in more recent months due to market and economic dynamics.  Through our analysis, bonds seem to be very liquid in the days and months after issuance as the banks that brought the deal to market typically support their own deals, as well as other funds often add it to their portfolios thus helping keep a bid under the bonds.  Additionally, the company filings have been made in order to get the paper into the public markets, meaning they are generally well vetted upon issuance.  In today’s high yield primary market, by and large the higher quality new deals are the only ones getting done, which has resulted in lower coupon income for this allocation versus what we traditionally have generated (many of the coupons we have seen on the new issues are about 5-7.5%, with a select few outside of this range).  However, we believe this allocation provides the additional liquidity and price stability we intended and helps dampen portfolio volatility, so we believe a bit of yield sacrifice is worth it.  Part of this strategy is to continue to roll into more recent new issues, so we continue make efforts to sell previous new issues at premiums as we roll those proceeds into the newly issued bonds.  Along these lines, while we may have a shorter holding period, part of the goal with the strategy is to also have some capital gains potential as well over this holding period, providing what we see as an attractive total return.  The allocation to new issues will be determined by market dynamics and how big we feel it needs to be.

While the new issue allocation has resulted in some lower income generation, we believe it better positions us for the long term as we work to address liquidity concerns and provide more stability to the portfolio.  We feel we have taken steps to address some of the issues that face managers and investors of late, and continue to work to provide an investment strategy and process that fits the market environment.  Dynamic markets require dynamic, active investing.

Posted in Peritus

Zero Sum Game

As we close out the first quarter of 2016, investors reading the tea leaves should be concerned.  The price collapse in almost all commodities and the recent severe indigestion in US credit markets reject the notion that the global economy is going to grow at a rate greater than 3%.  With the weakness we are seeing globally and other developed nations focused on further quantitative easing, the idea that the US economy will be unaffected is not realistic.  Demographics remain the elephant in the room; this is no longer a future discussion but one that is now exerting its influence.  Final demand for many goods and services will continue to fall as the globe ages.  Importantly, demand for stocks by both institutional and individual investors looks to be rolling over.  With limited global growth and poor technicals, we believe it is likely we are beginning a secular trend that will compress equity valuations.  As demand moves from equities, we expect it to transfer to credit in this zero sum game.

Within this framework, we believe the high yield market offers investors an attractive alternative to equities and provides investors with the potential for higher yields/income than is available in various other fixed income options.  This market offers income focused investors a way to generate a steady income stream and the potential for capital appreciation to help drive long-term returns.  Click here to read more.

Posted in Peritus

High Yield Market Technicals

As we start to see the high yield market gain some footing, it is important to note the improved market technicals, mainly fund flows and primary market issuance. For the week ending March 16th, we saw high yield retail funds take in another $1.7bil, making it the fifth consecutive week of inflows.1

HY fund flows 3-17-18

Over that five weeks we have seen $11.2bil enter the asset class. This well reverses the negative inflows that we had seen through the first six weeks of the year, now putting us at a positive $6.1bil in inflows for the year. This is a significant reversal, given that for all of 2015, we saw $7.1bil leave the asset class.2 Clearly, money is starting to return to the asset class, which in turn has contributed to the price and return recovery we have seen over the last six weeks. Given what we see as attractive yields still being offered by the asset class, we could well see this trend of inflows continuing.

Another positive indicator is on the new issuance front, where dollar volume in the past week has increased to a 17-month high.3

New issuance 3-18-16

Again, we’d see this as a positive signal that interest is starting the re-emerge in the space and companies are able to undertake issuance for things like refinancing and M&A activity, though notably issuance so far has been focused on higher quality issuers, which we would expect to see before the market opens up to lower quality issuers.

Finally, there is one market technical investors, especially in index-based products, should be aware of. This is fallen angels—previously investment grade companies that have been downgrade by the ratings agencies to high yield. So far in 2016, we’ve seen a huge number of fallen angels.4

Rising Starts 3-18-16

We are looking at $140bil in fallen angels in less than three months, versus $143mm seen in all of 2015. This also clearly puts us on pace for the highest level of fallen angel volume that we have seen in the past 15 years, likely surpassing the $150bil in volume that we saw in 2009. While a high level of fallen angel volume does increase the size of the high yield market, here we believe it is important to note the breakdown of what is being downgraded and added to high yield.

The vast majority of these downgrades are in the energy space, with metals and mining making up virtually all of the non-energy downgrades (with just a few selective downgrades in other sectors). Energy currently makes up about 12.8% of the J.P. Morgan US High Yield Index and metals and mining 3.8%,5 but this will likely materially increase over the coming months as these fallen angels enter the index (of note, the fallen angels hit the index in about 90 days following the downgrade6). While we believe oil prices have likely hit their bottom back in February, we aren’t convinced that the volatility is over and remain skeptical that many companies will survive at current prices; thus, we caution investors to be very selective in their energy allocations. While there may be some selective opportunities in the space, we certainly do not believe it is time for a broad allocation to the sector and index-based investors should be aware that their allocation may well be increasing as these fallen angels hit.

As we look at the high yield market technicals, we believe that the increased retail fund flows and increased new issuance volume are positive indicators that interest is starting to re-emerge for the space as investors take advantage of what we see as largely an under-valued market, offering what we view as attractive yield. However, we continue to believe that investors should be taking advantage of the space via active management, focusing on credit selection. We believe this becomes even more relevant as we’ll see energy, metals, and mining make up more of the indexes due to the fallen angels hitting the market and indexes over the next few months.

1 Fuller, Matt, “US HY funds deliver 5th consecutive week of inflows,” March 17, 2016, S&P Capital IQ, LCD News.
2 Fuller, Matt, “US HY funds net big outflow, 2nd largest decline in market value,” January 21, 2016, S&P Capital IQ, LCD News.
3 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield and Leveraged Loan Research, March 18, 2016, p. 6.
4 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield and Leveraged Loan Research, March 18, 2016, p. 49.
5 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield and Leveraged Loan Research, March 18, 2016, p. 50.
6  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield and Leveraged Loan Research, March 18, 2016, p. 49.
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“Risk” in High Yield Relative to Equities

We’ve written about this topic before but feel it is worth revising given some of the rhetoric we hear by the financial pundits today as they discuss “risky” securities. Some seem to classify high yield bonds as “risky” but don’t seem to account for the risk inherent in equity investing as well. As we have discussed before, we believe there are a few important factors to consider when evaluating “risk” in high yield bonds versus equities.

Ratings

High yield bonds are classified as such by their ratings. The rating agencies assign investment grade versus non-investment grade (high yield) bond ratings based on their determination of credit quality. While we are skeptical of the ratings process given some of the limitations and backward looking nature of the process (see our piece “The Ratings Game = Opportunity“), there is no denying that this process is fundamental as to how we define the high yield market. Given the higher perceived risk of non-investment grade bonds versus investment grade bonds, these bonds generally carry higher yields to compensate the investor. But in looking at ratings, some seem to believe high yield bonds are too risky given the lower ratings, and then turn to equities instead. However, that sort of thinking doesn’t consider the fact that these bonds are in fact rated, while equities are not. So if you are considering ratings as you look at various investments, how are you to say a rated bond is more risky than an unrated equity?

Capital Structure

Along those lines, it is also important to understand where bonds and equities fall in a company’s capital structure. Debt (bonds and loans) ranks ahead of equities in the event of a default or bankruptcy. This means that within a company, they would pay their debt back first before there would be any meaningful recovery for equity holders. Defaults are a certainly a consideration, but in looking at specific company, if it were to default, the company’s bonds would fare considerably better than the equity the vast majority of the time.

Dividends/Interest

Income is an important component in high yield investing, as these bonds produce regular income via the coupon/interest rate on the bonds. Equities may produce income via dividends, but companies are not required to declare dividends. A company is contractually obligated to pay the coupon on their bonds per the bond indenture. On the flip side, a dividend on the equity is based on the discretion of the company’s board so a company can choose to not pay a dividend at all, or choose to cut or eliminate it at any point without violating any legal or contractual obligation to their stakeholders. Thus, income via bond interest payments is much steadier than dividend income.

Volatility

Finally, risk is often measured in terms of volatility (i.e., volatility of returns). Much has been made recently of the volatility in the high yield market. As we have noted, we have always seen periods of increased volatility in the high yield market when we see sell pressure, and that is currently be intensified some by the post financial crisis regulations that have limited market making activity by investment banks (see our piece “Understanding Market Liquidity”). However, in looking at the returns and volatility (as measured by the standard deviation of returns) over history, high yield bonds have historically performed relatively similarly to equities, but with nearly half the risk as measured by the volatility of returns.1

CS vs SPX 2-29-16

Even if you were to just look at that the past year, a period during which so many market commentators in the media seemed to focus on volatility within high yield, we saw similar results.2

CS vs SPX 1 yr 2-29-16

Again, over this period, during which we saw the high yield market lead the way in declining in response to the reality of the slow growth environment, we saw equities have more than twice the volatility of high yield bonds.

We’ve recently written about some of our concerns for the equity market from a valuation perspective and the challenges we feel this market faces going forward, as we believe the high yield market has already downwardly adjusted, and in our opinion over-corrected, in response to weakening market dynamics, while we believe the equity market has more room to fall (see our pieces “The Equity Alternative” and “High Yield vs. Equities—Is this the End of the Run for Equities”). We believe it is also important that investors frame the concept of “risk” in the proper light as they consider investing in high yield bonds and/or equities. Keep in mind that nearly two-thirds of high yield issuers in the Credit Suisse High Yield Index referenced above have public equity.3  Historically high yield bonds have outperformed equities (as measured by the S&P 500) on a risk adjusted basis (the return/risk metric in the chart above), helped by the consistent coupon/income generation and lower volatility.

1 Credit Suisse High Yield Index data from Credit Suisse. The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. S&P 500 numbers based on total returns. Period covered is 2/28/06 to 2/29/16 and 2/28/86 to 2/29/16. Calculations based on monthly returns and standard deviation is calculated by annualizing monthly returns. Return/risk is based on annualized total return/annualized standard deviation. Although information and analysis contained herein has been obtained from sources Peritus Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and other fixed income securities involves various risks and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.
2 Credit Suisse High Yield Index data from Credit Suisse. The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. S&P 500 numbers based on total returns. Period covered is 2/28/15 to 2/29/16 and 2/28/86 to 2/29/16. Calculations based on monthly returns and standard deviation is calculated by annualizing monthly returns.
3 Blau, Jonathan, James Esposito, and Amit Jain, “Description and Inclusion Rules of the Credit Suisse Leveraged Equity Index,” Credit Suisse Fixed Income Research, May 27, 2015, p. 1.
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Positive Signals

After a rough last couple months—or in actuality a rough past six months—we are starting to see some positive signs in the high yield market. After yields surpassed 10% in mid-February1, we are beginning to see investors come back into the asset class as energy prices somewhat stabilize and investors look to take advantage of the yield offered by this market. Notably, we’ve seen the outflows from exchange traded and mutual funds reverse over the last few weeks, with the inflow in the most recent week posting an all-time high at just under $5.0bil.2

HY fund flows 3-3-16

As we see investors start to embrace the asset class again, February posted the first month of positive returns since last October.3

HY monthly returns CS Feb 2016

If we include performance through the first few days of March, we actually see that high yield bonds have now fully recovered their 2016 loses.4

HY returns YTD 3-4-16

While energy and metals and mining defaults continue to accelerate, the default rate on the rest of the high yield market remains stable.5

Non energy default rate 3-4-16

The energy and commodity default rates have shot up and we expect them to continue to do so. We have seen a number of energy companies, including some very large ones, undertake bankruptcies over the past couple months because even though energy prices have somewhat stabilized, this $30ish level is not a level at which many of these players can survive.

We believe the strong negative sentiment toward the high yield market that we have seen over the past several month is starting to subside as investors once again begin to embrace the asset class. However, we believe active management and the flexibility to not invest in certain credits seen as vulnerable is essential as investors re-enter the space as defaults in the energy and commodity sectors are just starting to heat up and these sectors together remain around 15% of the index.6 Even though we have seen some upturn in the high yield market, we still believe it offers investors attractive value for both capital gains potential and yield and still has plenty of room to run given how low pricing and how high spreads had gotten.

1 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield and Leveraged Loan Research, February 26, 2016, p. 3. Yield referenced is the February 11, 2016 yield to worst of 10.44%.
2 Fuller, Matt, “Investors dump record $5B of retail cash into US HY funds,” S&P Capital IQ, March 3, 2016.
3 Koch, Fer, William Porter, Miranda Chen, James Esposito, Chiraag Somaia, and Amit Jain, “CS Credit Strategy Daily Comment,” Credit Suisse Fixed Income Research, March 4, 2016, p. 2.
4 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield and Leveraged Loan Research, February 26, 2016, p. 4.
5 Koch, Fer, William Porter, Miranda Chen, James Esposito, Chiraag Somaia, and Amit Jain, “CS Credit Strategy Daily Comment,” Credit Suisse Fixed Income Research, March 4, 2016, p. 5.
6 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield and Leveraged Loan Research, March 4, 2016, p. 38.
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A Negative 2015, but an Opportunity Ahead

The high yield bond market was down 4.6% for 2015, making this only the sixth time we have seen the market post a negative calendar year return in its nearly thirty years of existence and the third worst year on record.1

HY Annual Returns

 

Notably, we’ve never had two negative years in a row. Not only that, it is important to keep in mind that the negative years have generally been followed by strong years of performance.2

Returns following negative yrs

As we look back on 2015, the actual carnage in the high yield market was far worse than a -4.6% decline would indicate. As money flowed out of the market and there were a lack of buyers, we saw prices gap down, in some cases 10-20 points at a time, as reflected by the decline in average price for the index going from a high of $101.33 in February to a low of $87.82 in December.3

HY Avg price 2015

As 2016 has ensued, the pressure on the high yield market continued for the first six weeks, as financial markets around the world turned negative. However, over the last couple weeks, high yield has seemed to find a footing and we have started to see pricing stabilize and improve.4

HY Avg price Jan, Feb 2016

These gaps down in prices have created big discounts in many cases. As value investors, we are always on the lookout for price declines for wrong, temporary, and/or non-fundamental reasons. Bonds have built in call and maturity dates, so pricing gaps often cure themselves over time for the companies that can continue to pay their bills (including interest costs). We saw this in spades in the late 2008/early 2009 period when bond prices fell off a cliff in many companies out of fear in the market, even though profits and cash flows, while down a from what they were prior to the recession, were still more than ample for the company to service their debts and continue capital spending activity as needed.

As we sit today, we believe we are in the midst of one of the most compelling opportunities for active high yield investors since that 2009 time-period. Debt of fundamentally solid, cash flow generating companies now trades at big price discounts and large yields. With the world slowing, we will undoubtedly see this hit sales and possibly profits of a number of companies, but not enough to materially alter the fundamentals and the ability to service debt in many cases.

We do see this as one of the most compelling opportunities to purchase high yield in years, but that doesn’t mean investors should buy indiscriminately. The reality is a notable portion of the high yield market is directly tied to oil and commodities. Yes oil may well have found its bottom and could be stabilizing from here. That has helped investor psychology, but this stable level is in the $30s, which is certainly not a sustainable price for many producers and service providers. We are seeing the energy related bankruptcies start to hit, with some larger high yield issuers going that route in the last couple weeks, including the $3.5bil in debt from Sandridge Energy and nearly $3bil in debt from Energy XXI.5 We are even seeing some companies preemptively default, even when they have cash to continue for now but taking advantage of the market environment to clean up their balance sheet.

So with the attractive opportunity for investment also comes danger. Investing is rarely simple, nor do returns come easy. We’ve always believed that investing involves doing your homework on each credit and actively managing your portfolio. While indexing may work well during the boom times when it is a one way trade up, there are times in the cycle when indexing does not afford the flexibility to sell or avoid certain credits, such as we believe is necessary to navigate through the current environment. It isn’t the time to indiscriminately hold the high yield asset class, yet we see great opportunities for active investors who have flexibility in what they put or don’t put in a portfolio, can focus on fundamentals, and can look for the notable value we currently see in terms of price discounts and/or attractive yields.

1 Based on the Bank of America Merrill Lynch High Yield Index, data for 12/31/86 to 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.
2 Based on the Bank of America Merrill Lynch High Yield Index, data for 12/31/86 to 12/31/15. Data sourced from Bloomberg, based on par weighted price.
3 Based on the Bank of America Merrill Lynch High Yield Index, data for 12/31/14 to 12/31/15. Data sourced from Bloomberg, based on par weighted price.
4 Based on the Bank of America Merrill Lynch High Yield Index, data for 12/31/14 to 12/31/15. Data sourced from Bloomberg, based on par weighted price.
5 Based Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield and Leveraged Loan Research, February 26, 2016, p. 45.
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