The High Yield Market: Now’s the Time for Active Management

It is during volatile and uncertain times like this in the economic cycle that active management matters the most. When markets are in a one-way trade up, investors can ride the wave and indexing may work. But that doesn’t work for the entire economic cycle. Right now we are seeing a re-pricing of risk as well as weakening fundamentals in certain industries and companies, such as certain commodities, gaming, and energy names as oil prices decline and concerns about China slowing and global growth in general heat up.

Active management is essential for investors to determine where there is value and where there are bombs waiting to happen. For example, we have been vocal about our concerns with certain industries and companies in the energy space, namely the shale exploration and production companies and the companies that service them. Many of these companies weren’t generating cash flow after capital spending with oil at $100, and now that cash generation and profitability is even further constrained with oil at $50. And service companies that cater to the shale producers are facing pricing pressure and declines in drilling activity. Additionally, hedges are starting to roll off, meaning the impact of the current pricing oil environment will more fully be felt, and credit lines will likely be cut over the coming months as banks re-evaluate asset values based on current oil prices. This could lead to further liquidity constraints in the sector. While there are bombs that must be avoided in the energy space, there are selective credits in the sector that we believe offer investors long-term opportunities. Active management is essential for determining the difference. For instance in the energy space, our focus has been on Canadian producers who benefit from costs in the declining Canadian dollar and sell product in the appreciating US dollar. With the slower growth out of China having an impact on certain areas within the commodity and gaming industries, investors here must also parse out the hugely undervalued securities from the prospective defaults or companies that will face further pressure. What you don’t buy is as important as what you do buy.

In passive investing, fundamentals are not the primary focus in compiling the portfolio. It is only after a default that a security is removed from the index, and generally the passive products that follow it. Instead of staying ahead of the curve and trying to avoid defaults/questionable securities or position yourself in the more senior names in a capital structure, passive funds largely just hold what is part of the underlying index, irrespective of the credit fundamentals or prospects. If you see a train coming towards you, you’d get out of the way, but here, they can’t.

Active managers can deliberately position their portfolio for the current economic environment and outlook. Today, this becomes important as we consider interest rates. While we aren’t believers that we will see a huge increase in rates, duration is still important in times of rising rates and active investors are able to position their portfolio accordingly.

Active management is proactive not reactive. We are seeing some of the best opportunities in the high yield space that we have seen for years—when prices are down, your prospective return can increase—but it is essential to determine the real opportunities from the time bombs waiting to happen and position the portfolio for the environment we are in.

Posted in Peritus

Contrarian Opportunities in the High Yield Market

As an active manager, one of the core tenets of our investment philosophy is that we are contrarian investors. We are value-based investors looking for undervalued companies in which to make investments and in doing so, that means we are looking in areas other aren’t or embracing areas others are avoiding due to misinformation.  This doesn’t mean we are distressed investors by any means, but instead looking for the proverbial babies being thrown out with the bathwater.  Contrarian investing can take many forms. It involves looking for value in businesses and industries that we believe to be down for wrong or temporary reasons based on the company’s or industry’s fundamentals. Or it can involve having an understanding of market technicals, such as taking advantage of situations such as when new issues come to market at an inopportune time, forcing the securities to price wider/have a higher yield then they normally would.

Today we are seeing such opportunities in the high yield market for active, contrarian investors. For instance, on the new issue front, just last week we saw pricing in the primary market dramatically shift. All of a sudden, price talk just a few days prior dramatically changed and market participants demanded much higher yields, in some cases a couple percentage points higher, on the newly issued bonds, despite nothing changing on the company’s fundamentals over a few days. A few companies even pulled their deals. For an active investor who can assess the quality of the company and determine if the market’s repricing is unwarranted, this technical picture can create an excellent opportunity to acquire assets on the cheap. And in some prior periods when markets have gone through the same situation, shortly after issuance we have seen a notable move up in the prices of some of these securities, so this may create a very attractive opportunity for both yield and potential capital gains.

We are also seeing concerns about China and slowing global growth translating into entire industries being drug down. For instance, anything seemingly chemical or commodity related has taken a leg down. While some of these moves are justifiable given the specific company’s exposure to these geographies of slowing growth or certain output prices, not every company is in the same position. As a contrarian investor, we will sift through these beaten up companies and separate out the weak from the strong. As an example, on the commodity side, virtually everything is taking a hit, but we see good, long-term value in the gold space as a store of value. Some companies in the space even have more cash than debt. There are also chemical companies with strong liquidity that we believe will certainly weather the cycle given their product and customer mix, but their bonds are at massive discounts/yields.

Contrarian investing requires that you be a long-term investor, as it often takes some time for market sentiment to shift and the company’s underlying fundamentals to be realized. While there may be pricing noise in the near-term, bonds have set maturity and call prices, so as long as the company continues to pay their bills and performs (doesn’t default), the bond price will over time likely move toward that par maturity as you approach that maturity or call date. And by the nature of contrarian investing, it can result in some short-term underperformance. However, our focus is not on next week or next month but positioning our portfolios for generating long-term, total return value for our clients, whereby we can generate return from both the attractive yield offered by the undervalued securities we have identified and also potential for capital gains. Today’s high yield market is offering some of the best opportunities for investment that we have seen in years, ripe for active, contrarian investors willing to do the work.

Posted in Peritus

The High Yield Market: A Look at Past Recessions

The Fed interest rate decision came and went with relatively little market reaction. They pushed out an increase in rates, citing concerns about global economic conditions. Like many, we do share their concerns about the global economy, as we expect that it will result in muted growth here at home (and as we have noted in prior writings over the past several months, we’d expect that muted growth to ultimately result in a very moderate move in rates). But some market participants are voicing concerns that this global weakness will lead to a U.S. recession. That poses the question, are we headed for a recession, and if so, how is the high yield bond market positioned?

First, our opinion is that while top line demand growth will be constrained for corporate America given the slowdown in global growth (remember China’s growth has slowed, but is still growing), we don’t expect that to lead us into a recession. We have seen three notable recessions during the history of the high yield market: 1990/1991, 2001, and 2008/2009. Each of these was proceeded by major domestic events/issues. In 1990, we were in the midst of facing the Savings and Loan crisis, and the economic situation was further aggravated by the doubling of oil prices as Iraq invaded Kuwait. After a huge rise in the stock market toward the end of the millennium, in 2001 we saw the Internet and tech bubble burst, and that was then followed by the September 11th attacks. Then as we all remember, 2008/2009 saw the housing bubble burst, and subsequent sub-prime mortgage issues, as well as the impact of general over levering in the entire financial system, leading to bank failures/bailouts as the financial crisis ensued. Today, we don’t see any huge bubbles domestically that could weigh on markets as they burst, oil prices remain low, and we see don’t any systemic issues in the financial system, as the various regulations put in place and fear following the financial crisis have left us much less levered. The Fed may eventually start raising rates, but we expect them to be very moderate in their approach, and given their actions so far, they would certainly back off on any rate increase if there was a hint that it was sending us into a recession. So yes, there is global weakness but none of these broader issues to force a recession here at home.

While we don’t expect the current global economic conditions to cause a recession in the U.S., for the sake of argument, let’s look at how the high yield market has performed in past recessions. Looking at these three specific periods, we have noted how the high yield bond market (Credit Suisse High Yield Index) and equities (S&P 500 Index) have performed in the 6 months leading up to a recession (quarterly periods of negative growth), during the recession, and in the 6 months following a recession.1

HY in recessions 9-22-15

Excluding 2008/2009, which was certainly an outlier in terms of the severity of the market reaction and the duration of the recession, we have seen high yield bonds perform the worst leading up to a recession. So that then poses the question, if a recession is coming in near future, have we already seen the hit to high yield bonds from it? Of note, in the past six months, we have seen high yield bonds fall -2.9%, and down -4.1% in just the last three months.2 Once we finally got into the recession in both 1990/1991 and 2001 and the period immediately following, we saw the high yield bond market post positive returns. Also of note, in virtually every period, the high yield bond market has outperformed equities.

We are six years into the current economic cycle, but don’t expect that we are hitting the trough in the near term. As we look at the high yield market, we see it as significantly better positioned than we saw heading into 2008, as we haven’t seen massive LBOs and over-levering leading up to this point, we view the problem area in the high yield market—energy—as pretty well contained to those companies and not causing widespread fundamental issues into other industries, and spreads are at what we see as a very reasonable and attractive valuation currently, meaning our market is not near any sort of “bubble” level.

As J.P. Morgan recently noted in one of their reports, “…the broader fundamental outlook remains robust and we continue to expect the credit cycle to last at least a few years and maybe longer. We do believe concerns around oil, the Fed, and China will weigh less heavily with the passage of time, which should clear the way for a partial reversion.3 We agree and believe that with the currently attractive yield and income generation to be had in the high yield market and potential for spread compression, this market is positioned well. While we don’t expect to see a recession, even if we were to get a mild one on the back of these global concerns, we may well have already seen the return hit to the high yield market as history has shown that to be a leading indicator.

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.
2 Credit Suisse High Yield Index data from Credit Suisse. Based on month-end pricing/returns for the 6 month period 2/28/15 to 8/31/15 and 3 month period 5/31/15 to 8/31/15.
3 Acci avatti, 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, September 18, 2015, p. 4.
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Upcoming TV Appearance

Peritus’ Tim Gramatovich will be a guest on Business News Network today, September 17th, at 3pm ET to discuss the Fed’s decision on interest rates.

Posted in news

High Yield versus Equities: Assessing Risk

Some people seem to be under the perception that high yield bonds are very risky, much more risky than equities.  I’m sure the alternative name for high yield or non-investment grade bonds—junk bonds—doesn’t help.  But there are a few things investors should consider as they assess the risk in the high yield market.

First, we all know that high yield bonds are rated below investment grade, thus they are considered more “risky” than investment grade bonds.  However keep in mind these are still rated, unlike equities.  So how can someone say high yield bonds are more risky than equities because of the lower ratings, when you don’t have comparable ratings on equities?

Second, within a company’s capital structure, debt such as loans and bonds are ranked above the equity, which means that in the face of financial distress or bankruptcy, the bonds are paid back first before any sort of return is allocated to equities.  Additionally the interest obligation on bonds is a legal, contractual obligation—a company is required to pay this interest or can be forced to face a default.  Alternatively, dividends paid on equities are completely discretionary and can be cut at any time by the company’s board, as we are currently seeing in the case of many energy and commodity equities.  Also in some cases the ability for a company to pay a dividend can be dictated by the credit indenture or credit agreement on the debt, meaning there has to be enough funds to service the debt and/or leverage below a certain level before any dividend distribution can be considered for the equity holders.

Additionally, risk is often evaluated in terms of the volatility of returns (as measured by the standard deviation of returns).  Looking back over the 29 year history of the high yield market, high yield bonds have posted nearly half of the volatility of equities (here represented by the S&P 500 Index).1

CS vs SPX 8-31-15 29 yr

Not only has the volatility been significantly less, returns have been relatively similar, meaning that the high yield bond market has historically outperformed equities on a risk-adjusted basis.

Looking at the past three months, during a period of general market weakness where many people within the financial media have expressed heightened and well publicized concerns about liquidity, and resulting the volatility within the high yield market, we have seen more of the same.  Here we looked at daily volatility of returns to assess the risk and saw that the volatility in the high yield market was dramatically less than that of equities, and the bond returns were better over this period, thus high yield not only outperformed in this down market on a risk adjusted basis, but on a pure return basis.2

CS vs SPX 8-31-15 3mos

So it appears misguided for so much attention to focus on volatility in the high yield market, when we certainly see more volatility in the equity markets yet there seems to be little attention paid to that.

Another point to keep in mind when evaluating stocks versus bonds is the bonds and loans have maturity and call dates, so assuming no default, this provides a range of potential returns that can be expected over a certain time period. We see this as a big advantage versus equities, as with a portfolio of equities you have no idea if the market will realize the value in the security and price will go up—and since most equities don’t provide income like bonds do, you are heavily reliant on stock price appreciation to generate a return.

Investors who are led down the path that they need to be invested in equities to generate some sort of return or that high yield bonds are too risky, yet somehow equities aren’t, should reevaluate.  The high yield market can not only be viewed as an equity alternative in terms of what we see as the attractive long term, historical returns this market has generated relative to equities, but high yield bonds also carry lower risk on many fronts leading to this market’s historical risk adjusted outperformance versus equities.


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 8/31/86 to 8/31/15. Calculations based on monthly returns and standard deviation is calculated by annualizing monthly returns. Return/risk is based on annualized total return/annualized standard deviation. Although information and analysis contained herein has been obtained from sources Peritus Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and other fixed income securities involves various risks and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.
2 Credit Suisse High Yield Index data from Credit Suisse. S&P 500 numbers based on total returns. Calculations based on daily returns and standard deviation. Return listed is for the actual return for 5/31/15-8/31/15. Standard deviation is the annualized number based on the daily returns and an assumed 252 trading days per year. Return/risk is based on annualized total return/annualized standard deviation.


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The High Yield Summer Swoon, and the Opportunity Created

Over the past few months, we’ve discussed in many of our writings the opportunities we have seen created in the general high yield market this summer as the space has undergone a repricing.  High yield bond spreads have widened 136bps over the past three months, and the chart below outlines how that spread widening breaks down by industry.1

CS spread change by industry 8-26-15

We have certainly seen a massive widening in the energy and metals/minerals, which is fundamentally warranted given that oil prices have taken another leg down, as have various commodities, primarily due to concerns about Chinese demand.  But it is worth noting that we have seen spreads widen 80-130bps in all but four of the rest of the industries in the high yield market, when little has changed fundamentally for many of these companies.  We’d see this as a very attractive opportunity given that much of the rest of the high yield market, as we have pointed out before, is largely niche, domestic-focused companies that aren’t the huge multinationals like we see in the equity indexes, so factors like potential demand weakness out of China or Europe will have much less impact.

As investors look at the high yield market and the current valuations, the question must be asked, do we expect spreads to widen further across the board?  Is the timing right to enter the market now, or is there more pain to come?  We don’t see a further massive spread widening on the horizon.  During prior periods where we saw a big spike in spreads, that has been during times of recession and systemic issues.  While there are indications global demand is slowing and our own economic growth is moderate, we don’t expect that to lead to a recession here at home, nor do we see major systemic issues, such as the overlevering leading up to the 2008 crash.

While we don’t anticipate a recession, looking back at history, Credit Suisse recently published some research whereby they looked at the prior “pre-recession” selloffs in 1998 and 2007, and in both periods, market weakness was much more widespread versus confined to certain industries as we currently see.2  As we sit today, two thirds of the distressed sector is related to just the two industries of energy and metals/mining.3  We see this as further evidence of our take that a spike in the default activity will largely be contained to these industries and the broader high yield market will continue to have a well below average default rate.  For instance, J.P. Morgan is projecting a default rate in 2015 and 2016 of 1.5% excluding energy, well below the long term average default rate of 3.6%.4

Interest rates have been cited as another potential downside trigger in high yield, but we don’t see that as a cause of another leg down in this market.  We don’t expect the Fed to rapidly raise rates; we would need to see a pick-up in economic activity for that to happen, and stronger economic activity would certainly be a credit positive so we’d expect that would be an offset to rising rates.  Importantly, history has shown high yield bonds have actually performed well during years when we have seen rates rise5, so we don’t see some Fed activity on the rate front as justification for another leg down in the high yield market.

The recent market downturn has created a better valuation opportunity for active managers within the broad high yield market.  There is likely to be further pain in the energy and metals and mining sectors, but we believe that is contained and active managers can adjust their portfolios to minimize this downside risk.  The current high yield market lends itself very well to active managers who can look for value in companies that have seen minimal fundamental impact from recent global events.  Today’s high yield market offers what we see as attractive, tangible yield opportunities for investors that shouldn’t be ignored.

1 Blau, Jonathan, James Esposito, and Amit Jain, “U.S. Leveraged Finance Projections Update,” Credit Suisse Fixed Income Research, September 4, 2015, p. 4.
2 Blau, Jonathan, James Esposito, and Amit Jain, “U.S. Leveraged Finance Projections Update,” Credit Suisse Fixed Income Research, September 4, 2015, p. 4.
3 Blau, Jonathan, James Esposito, and Amit Jain, “U.S. Leveraged Finance Projections Update,” Credit Suisse Fixed Income Research, September 4, 2015, p. 4.
4 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Default Monitor,” J.P. Morgan North American High Yield Research, September 1, 2015, p. 4-5.
5 For full details on historic returns, see our piece “Strategies for Investing in a Rising Rate Environment.”


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Closed End Funds versus Exchange Traded Funds

There are currently a number of fund-based options available to investors looking for yield. In addition to traditional open-ended mutual funds, investors are also turning toward closed end funds (CEFs) and exchange traded funds (ETFs) to generate yield, including in the high yield bond market. Both CEFs and ETFs have continuous trading and pricing throughout the day, making them very liquid options for investors. While CEFs tend to be actively managed, there are both index-based options and actively managed options in the ETF space. However CEFs and ETFs have some dramatic differences that investors should consider when making a decision as to what structure is best for them.

Share Creation/Redemption

A closed end fund has a set number of shares, raising initial capital through an IPO. With this structure, shares are not created or redeemed based on market demand, but rather shares are purchased or sold within the market, and the fund’s share price reflects that demand. An ETF on the other hand, meets market demand with the creation and redemption of shares as needed so market demand can have less of an impact on trading price, though this means the number of shares and asset base is in fluctuation based on demand.

Fund Transparency

ETFs are fully transparent, with holdings disclosed on a daily basis. With CEFs, certain portfolio details, including holdings, are often only disclosed on a monthly, quarterly or semiannual basis.

Tax Efficiency

ETFs are generally considered tax efficient as the creation and redemption of shares between the market makers and the fund can be done “in-kind,” whereby no taxable gain or loss is generated for the shareholder. With closed end funds that do not have this creation and redemption option, capital gains generated within the fund have to be paid out at year-end, creating a tax obligation for shareholders.

NAV Premiums and Discounts

With the ability to create and redeem shares to address market demand, ETFs generally trade fairly close to their NAV. However, with CEFs, the value of the fund is based on demand. If investors are buying up and increasing the demand for shares, the fund price would be driven up and it may trade at a premium to the fund NAV. However, if there is sell pressure that may cause the fund to trade at a discount to NAV. In reality, most CEFs trade at discounts to their NAV, in many cases by 5-10%.  For instance, in Q2, the average CEF was trading at a -8.97% discount to NAV and taxable fixed income had an average discount of -10.43% at June 30th.1

Investors may look at these discounts to NAV and feel they are getting a deal—they are buying into a fund a price less than the underlying assets are worth. That may well be true, but it doesn’t necessarily mean that ultimately that value will be realized. Just like any stock with a fixed number of shares, market demand plays a huge part in the share price. So if there is not enough demand to drive the market forces to close the gap between the NAV and the market price, the fund may remain at that discount for an extended period, or the discount may even widen. We’d compare this to any sort of “value based” stock investment—investors are hoping that the market will ultimately realize the underlying value of the securities or the company and drive the share price up, but at the end of the day you are dependent on market forces. For instance, in some cases with high yield closed end funds we see discounts upwards of 10-15%. So when you are investing in some of these closed end funds that trade at large discounts to NAV, investors need to recognize that you are not only making a bet on the underlying assets but also that market forces will narrow the discount or at least hold it steady. Likewise, with ETFs, the discounts and premiums are dramatically narrower, thus investors or primarily making investment calls on the underlying assets.

Use of Leverage

Another thing to keep in mind when investing in closed end funds is that many of them use leverage, which can be upwards of a third of the total portfolio value. While leverage can be effective in increasing the distribution/dividend yield, leverage can also magnify fluctuations in the NAV and increase the underlying risk of the fund, as well as increase the cost of the fund. And another thing to keep in mind, if you expect interest rates to rise, that could well drive the cost of leverage higher and compress the ultimate net return and yield generated on the assets purchased with the borrowed funds. While some ETFs use leverage, it is only utilized in selective, leverage specific ETFs, not broadly used within the ETF space.


Fees in closed end funds not only include the basic management fees and fund expenses as you would see with ETFs, but also the cost of any leverage used, so this additional component must be included in assessing the total cost of the CEF.

Illiquid Securities

Many tout the ability for closed in funds to invest in illiquid securities as a benefit. By the Investment Company Act of 1940, open-end funds and ETFs are limited to 15% of the portfolio in “illiquid” securities, while closed-end funds do not face that same restriction and are able to invest a larger portion of the portfolio in illiquid securities. While some investors may see this as a positive, we doubt all investors will. Even if a CEF is not forced to sell securities to deal with redemptions, their holdings are still priced on a daily basis and the fund NAV is reported on a regular basis, so if there is a market downturn having an outsized impact on the security pricing of this higher portion of illiquid securities that would be reflected in fund NAV.

Return of Capital

Some closed end funds have managed distributions/dividends as a fixed percentage of assets, and if there is not enough income generated during the period, then the fund can make up the capital shortfall with a “return of capital” included in the distribution. While this return of capital is not taxable and instead lowers the cost basis for the investor, a return of capital would reduce the fund’s net asset value and future earnings power. ETFs do not have fixed distribution rates, thus payout income generated and don’t face the return of capital issue.

We view active management as the best option for investing within the high yield market and traditional open-end mutual funds, closed end funds, and ETFs all offer investors a way of accessing actively managed high yield portfolios.  However, each investment vehicle differs in terms of its structure, and investors need to understand the dynamics behind each structure.  And as with all fund investing, we caution investors to review the underlying holdings of the portfolio.  For instance, does a “high yield debt” portfolio include other assets, such as emerging market, government, or investment grade debt?

We see wise investors as those that take the time to understand what the own, be it the dynamics of the investment vehicle or the securities within it.  Most relevant in looking at ETFs versus CEFs, investors must understand the positives, negatives, and additional risks that can come with outsized discounts and the use of leverage for high yield funds.  For the high yield market, we view an active, unlevered ETF as a more straight-forward way to access the asset class.  With the additional fund transparency, potentially more tax efficiency and simplified distributions, and much narrower discounts to NAV (thus not relying on the additional element of the market narrowing or keeping stable the discount), we would favor ETFs.  Additionally, if an investor would like to lever up the assets, they can do that on their own rather than being forced to at the manager’s discretion within the portfolio.

1 Taggart, Mike, CFA, “CEF Market Overview,” Second Quarter 2015, Nuveen Investments, Inc., p. 1-2.
Posted in Peritus

No Bubble Here

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

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

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

S&P 500 PE 1957 8-27-15

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

Factset 8-5-15

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

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

CS HY Spreads 8-25-15

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

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

CS 4yr spreads 8-25-15

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

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

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

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

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

Posted in Peritus

Market Repricing: What Has Changed?

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

Energy/Commodity Markets

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

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

Interest Rates

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

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

Asset Valuations

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

CS 2mos spreads 8-25-15

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

CS HY Spreads 8-25-15

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

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

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


Posted in Peritus

What Value are Credit Ratings?

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

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

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

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

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

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

Posted in Peritus