Rates and the Curve

This past week the weaker economic data seemed to put more at ease that the next rate increase isn’t coming when the Fed meets on Wednesday, yet rate talk continues to dominate market conversations and markets will be waiting for what is said on Wednesday as to if a December increase is likely.  As rates do ultimately rise at some point, we would expect to see a larger move in the shorter rates, but don’t expect to see a huge spike in the medium to longer term rates (5 and 10-year Treasury rates)—in short, we’d expect a flatting of the yield curve.  Ever since the Fed began their tapering in 2013, we have started to see the yield curve beginning to flatten.1

Yield Curve 9-16-16

The Federal Funds Rate and rates and US Treasury debt are independent of each other.  Federal Reserve action changes the Federal Funds Rate, which is an interbank lending rate.  This in turn can impact market expectations for rates and market psychology, and market forces (investor demand) in turn “set” the rates on US Treasury debt.  For instance, if investor demand lessens for Treasuries and they all of a sudden require to get paid more to hold Treasuries, this causes Treasury yields (rates) to increase.  In our own high yield market, “spreads” are priced off of comparable maturity Treasury rates, so it is these 5- and 10-year rates that are in focus for us.

With the most recent Fed chatter, we have seen the 10-yr move about 30 bps up from its 2016 lows of 1.37 bps in early July to 1.7 bps today, with an almost 30bps move in the 5-year Treasuries over this period as well.2  Yes, this renewed rate talk does bring an immediate market reaction in US Treasury rates; however, we don’t expect to see a sustained and significant spike in the longer-end 5-, 10-and 30-year rates, even if/when the Fed takes further action in raising the Federal Funds Rate over the next year.  We would expect the shorter-end of the curve to be impacted by Fed action, but we’d expect the longer-end of the curve to continue to be constrained by a number of factors, including the following:

  • Global Growth: We are in the midst of a weak global demand outlook and a weak global economic environment.  China has been slowing, quantitative easing is still underway by the ECB hoping to get things going in Europe, and the Bank of Japan has been even more aggressive in their intervention.  Demand worldwide is tepid, impacting corporate profits and demand her at home.  Retail sales, industrial production, and GDP growth have been anything but robust here in the US.  In short, we certainly don’t have a strong economy that the Fed needs to temper and that the strong “data” the Fed looks to may be hard to come by in order to make much of a rising rate argument.  These longer dated Treasuries certainly take their cues from the data as well.
  • Global Rates: We expect that historically low, and in some cases negative, rates on sovereign debt throughout much of the developed world compared to our rates and economy will cause a continued demand for much higher yielding US Treasuries.  For instance, investors are in essence paying to have their money held for 10-years in Japan, Switzerland, and Germany.  Much of the rest of Europe has rates sub 0.5%, while the UK, even if the face of all of the Brexit uncertainty has rates under 1%.
  • Global Demographics: The population is aging and with that investors will become more and more focused on capital preservation and income generation causing them to rotate from equities into fixed income.  Additionally, as pensions focus more on liability driving investing (matching assets/income with upcoming liabilities/payouts), stability and calculated income will be key. We are already in the beginning stages of this and expect it to continue (see our pieces “Zero Sum Game” and “Of Elephant and Rates”), causing a demand for fixed income assets in the years and decades to come.

While we may see some continued near-term volatility in the 5- and 10-year rates on this resurgence of Fed-speak, we ultimately don’t expect the see a sustained upward swing in these yields.  We expect that the yield curve will flatten and in this low yield environment investors will continue to search for yield, and we believe that with the yields offered by high yield bonds, this remain an asset class investors should consider as they look for this yield.

1  Based on US Department of Treasury data, as of 12/31/13, 12/31/14, 12/31/15, and 9/16/16.
2  2016 low on 7/5/16 versus rate as of 9/16/16.
Posted in Peritus

What we Know

All eyes are on September 21st.  Just over a week or so ago, people seemed to feel a September rate hike was unlikely, now over the course of a week and a bit of hawkish Fed-speak, many now seem to believe September may actually be in the cards.  On Friday we saw security prices fall across the board, with both risk assets and Treasuries taking a hit.

Financial markets across the world have been taking their cues from central banks for years now, and last week was just another example.  Over the week, the ECB (European Central Bank) decided they would not take further easing measures at this time.  We know the Federal Reserve wants to at some point begin raising rates, thought timing uncertain.  What happens if the Federal Funds Rate increases 25bps or even 50bps over the next six months?  Do Treasuries all of a sudden spike?  For instance, could our 10-year move up 0.5% or even 1%, even in the face of rates for 10-year government bonds below zero to slightly above that in many other developed nations around the globe?

In 2013, we saw the “taper tantrum” as the Fed started tapering off their quantitative easing measures, with the 10-year yield/rate beginning its move up in May 2013 from around 2% to end 2013 at 3% only to see bond yields fall back to just over 2% by the end of 2014.  The move in 2013 was all in anticipation that the Fed would be lessening their easing measures over time and rates would eventually rise, though all of the “tapering” occurred during 2014 as Treasury rates were actually falling off their 2013 highs and that first actual Federal Funds Rate increase didn’t come until two years later.  In 2015, we saw the 10-year Treasury open the year around 2.2% and had lots of ups and downs, as anticipation about the first rate hike began to gain momentum, with yields peaking at just under 2.5% in June 2015 and staying above 2% until starting its steady decline in late December and into January 2016 after the Fed undertook their first increase on December 16th, 2015.  It would seem over the last few years, the anticipation has taken more of a toll on markets than the reality of a rate rise.  Will this time be the same?  Are we seeing a move up in Treasury yields in anticipation of some Fed action, only to see Treasury yields fall once they actually move?  It may well be given the global environment we are facing.

We know a few things that I believe should help us frame how we view a rate increase.  First, we know that this is a VERY measured Fed.  Given their past actions, I don’t think we would expect any aggressive action from them.  We know they want to raise rates to at least start somewhat on that path and give them some policy tools for the future should markets decline, but if they did take an increase and the market all of a sudden started tanking, we would expect they’d hold off on further increases until they saw market stabilization.  As recent history has shown, they certainly don’t have blinders on to market reactions to their policy moves.

We also know that rates across the globe are exceptionally low.  Yes, the German 10-year has moved back into positive yield over the past few days but still hovering around zero, while Japan and Switzerland remain negative.  And yields through much of the rest of the developed world are around 1% or below.  If US rates were to move up much, it seems likely to us that buyers from around the world would step in and buy our bonds on the back of our comparatively better economy—and we’d expect this buying activity would constrain the upward move in Treasury yields.

We also know that economic data has had its own fits and starts over the past several years; we haven’t seen a sustained strong and upward movement. And we know this Fed is “data dependent.”  If the data does take a clear path toward improvement and the Fed does see further room to raise rates above and beyond one or two rate increases over the next year or so, investors need to keep in mind that increase will be in the face of a clearly improving economy.  And an improving economy is generally good for markets, so that could provide an offset to higher rates.  Given how measured and slow to act today’s Fed is—for instance, even if we get a September rate increase, it would have been more than nine months since the previous hike—and the fact that global growth continues to stall and domestic data hasn’t shown consistent strength, we don’t think that the data will be there for a massive rate increase in the foreseeable future.

We will at some point need to come out of the environment of quantitative easing and low rates.  It took from 2008 to December 2015, so seven years, for the Fed to make their first move and it may well take years for them to move rates materially off these historical low levels, barring no further cyclical downturn in the meantime, at which point they may need to revert back.  We do expect any sort of move up to be slow and measured and think it is very likely in this economic environment that we may well be one and done for the time being.  Equities are trading at historically high valuations in the face of declining earnings, so we feel that a correction there is likely overdue and warranted, whether it be to a potential rate increase or something else.  In the high yield market, we continue to see valuations (spreads) still around historical median levels (see our piece “Looking for Yield?”) and if we look at history, high yield bonds have actually performed well during raising rate environments (see our piece “Strategies for Investing in a Rising Rate Environment”).

Posted in Peritus

Looking for Yield?

After a rough start to the year, following a negative 2015, the high yield bond market has reversed course and posted strong returns year-to-date, now up 15.0% through the end of August1.  This compares to a return of 7.8% for the S&P 500 index2.  Is the run over for high yield?  We certainly don’t think so.

A few things to keep in mind.  Yes, some of the strong return in the high yield index (and likely the S&P 500 too) has been energy induced.  As we have previously noted, energy and commodities are a notable portion of the high yield index and as energy recovered off the mid-February lows, we have also seen high yield recover.  However over the past few months we have seen oil prices range bound, though volatile within that range, and high yield still going up even when energy prices were going down (see our piece “Breaking the Correlation”).  Looking at just the last three months, the high yield market has still outperformed equities with the Barclays US High Yield Index up 5.8%3 and the S&P 500 up 4.1%4, all the while oil prices (WTI) were down nearly 9%5.  And looking at the YTD performance of high yield bonds of 15.0%, this market is still up 11.7% excluding commodities6.  So certainly energy prices aren’t the only driver of return for high yield.

One of the biggest current draws we see in high yield is the yield advantage we see it offering versus other areas of fixed income and equities.7

Yield Comps 9-6-16

As demand and prices for high yield bonds have increased so far this year, we have seen the yield come in; however, the yield offered by high yield bonds still far surpasses that offered by other asset classes—twice that offered by investment grade, three times the (dividend) yield offered by the S&P 500 and nearly four times what is offered by the 10-year Treasury.

For the naysayers and those that question whether there is more room for the high yield market to go higher from here, it is important to keep valuations in mind.   In terms of valuation, it is well known that equity valuations are currently high relative to history so don’t appear to be cheap by anyone’s measure, while high yield bond spreads are currently right about at the 20-year median levels.8  Also, on the default side of things, we are starting to see defaults decline in the most recent month after accelerating over the past year.  As we have noted in the past, default rates have increased this year by and large due to energy and other commodity related defaults.  Excluding these commodities, default rates are currently only 0.5% for the rest of the high yield market versus historical high yield default averages near 3.5-4%.9

Potential Fed action is an overhang on markets, but even if the Fed were to undertake another rate hike in the coming months, we don’t expect that to tangibly mean much for high yield bonds.  We would expect high yield bonds to weather an increase better than equities and we’d also expect any rate move to be very small.  The Federal Reserve is being anything but aggressive with their interest rate increases.  We saw the first rate increase in nearly a decade last December, and even if they were to do another rate hike in September, which seems doubtful, it would have been nine months since the last hike.  We all know they want to raise rates, but the economic data is forcing them to be extremely measured in doing so.  By their reading, they have seen some improving data, so maybe another rate increase in justified in their minds, but we don’t see much more beyond that in the near- to medium-term.  We remain in an environment of a weak global economy and negative yields through much of the rest of the developed world, which we believe will ultimately constrain domestic rates (Treasury yields) no matter what small movements the Fed makes in the Federal Fund Rate.  It’s these Treasury yields, primarily the 5- and 10-year, which are more relevant for high yield bond investors, not the Federal Funds Rate.  We think it is just as likely for the 10-year Treasury yield hit 1% as it is 2%…there are just so many global pressures that we wouldn’t be surprised to see the 10-year Treasury yield take another step down, no matter the “Fed speak.”

So as we enter September and investors look where to position themselves for the rest of the year, we believe the high yield market is an attractive area to consider.  Valuations appear reasonable in the face of low defaults in much of the market (outside of commodities) and yields double and triple some of those available from other asset classes.

1  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High-Yield Market Monitor,” J.P. Morgan North American Credit Research, September 1, 2016, p. 4, https://markets.jpmorgan.com.  Based on the J.P. Morgan U.S. High Yield Index, covering the period YTD through 8/31/16.
2  Data sourced from Bloomberg for the period 12/31/15-8/31/16.
3  Data from Barclays, based on the Barclays US High Yield Index as of 5/31/16-8/31/16.
4  Data sourced from Bloomberg for the period 5/31/16-8/31/16.
5  Data sourced from Bloomberg for West Texas Intermediate, for the period 5/31/16-8/31/16.
6  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High-Yield Market Monitor,” J.P. Morgan North American Credit Research, September 1, 2016, p. 4, https://markets.jpmorgan.com.  Based on the J.P. Morgan U.S. High Yield Index, covering the period YTD through 8/31/16.
7  Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). Barclays Corporate Investment Grade Index consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements (source Barclays Capital). U.S. 5 and 10 Year Treasury note yields sourced from the U.S. Department of Treasury as of 8/31/16. Yield used for the High Yield and Investment Grade Index is the Yield to Worst, which is the lowest, or worst, yield of the yield to various call dates or maturity date, data as of 8/31/16.  S&P 500 dividend yield sourced from http://www.multpl.com/s-p-500-dividend-yield/ as of 9/6/16.
8  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High-Yield Market Monitor,” J.P. Morgan North American Credit Research, September 1, 2016, p. 12, https://markets.jpmorgan.com.  Based on the J.P. Morgan U.S. High Yield Index, current spread of 564bps as of 8/31/16 versus 20-year median of 573bps.
9 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High-Yield Market Monitor,” J.P. Morgan North American Credit Research, September 1, 2016, p. 3, https://markets.jpmorgan.com.  Based on the J.P. Morgan U.S. High Yield Index.
Posted in Peritus

The High Yield Market: Market Size, Ownership, Funds, and Opportunities

The entire U.S. fixed income market (municipals, Treasuries, mortgages, corporates, federal agency bonds, money market, and asset back securities) totals over $41 trillion.1

FI Asset Class 3-31-16

Corporate credit (high grade, high yield bonds, and floating rate loans) is about $9.3 trillion of this pie. The high yield bond market is a growing piece of that corporate debt piece, now at $1.61 trillion.2

HY Market Growth 8-24-16

If you add in high yield floating rate loans, that includes another nearly $1 trillion and together high yield bonds and loans account for almost 30% of corporate debt.3

Leveraged Loan Market growth 8-24-16

The number above includes only institutional loans, but if you factor in other non-investment grade term loans and bank-held facilities, you get a broader loan market size of $2.3 trillion.4  One thing is clear, that the high yield debt market is a growing market, and one that cannot be ignored for fixed income investors.

As we look at just who owns high yield bonds, the three largest categories of owners are pension funds, insurance companies, and retail mutual funds, all of which have relatively similar size of ownership at just over a quarter of the market each.5

Who Owns HY 2015 8-24-16

With this we see both institutional and retail customers as active in the space. High yield ETFs account for about 13.5% of the total $271 billion “retail” high yield fund base6, which includes the much larger mutual fund counterpart, and ETFs account for about 2.8% of the broader high yield market and have been around the level for the last four years and loan ETFs less than 1% of that total market.7

ETF Ownership 2015 8-24-16

While a very small portion of the total market, the place of high yield ETFs within the broader high yield bond market has been a discussion point over the last year, with some critics speculating that some wider-spread selling in high yield ETFs could cause a collapse in high yield markets due to “liquidity” issues. We have previously explained how recent regulations post the financial crisis have led to less market making and lower dealer inventory of bonds, and the impact that has had on markets (see our piece “Understanding Market Liquidity”, “The Pricing Issue in High Yield“).

Flows in and out of these “retail” mutual and exchange traded funds (though we know that various institutions are buyers of mutual and ETFs as well) can be volatile week over week, but again, these flows pale in comparison to size of the total market.  For instance looking back over 2015, the largest weekly reported weekly retail (exchange traded and mutual fund) flow totaled around $3.8 billion8, and looking at fund flows over the past six months, which include both the largest and second largest weekly fund inflow on record, these flows were still sub $5 billion9, which compared to a $1.6 trillion market means it is about 0.3% of the total market, so seemingly miniscule.

Weekly Fund Flows 8-10-16

Over this period, the largest ETF-related flow was $2.3bil, so less than 0.015% of the total market.  Interestingly, with the increased difficultly in sourcing and buying bonds post the new regulations, we have seen situations recently where institutions turn to buying ETFs and then take the underlying bonds on redemption (in-kind redemption of security versus cash) as a way to quickly and easily gain exposure to the underlying bonds; rather than trying to build a portfolio on their own.

Not only do we see ETFs benefiting from their in-kind redemption mechanisms, in this environment of lower dealer inventory and heightened price volatility, we believe that high yield ETFs provide an advantage over mutual funds during more volatile times because ETFs trade/price intra-day, so we would argue provide a more accurate and true pricing mechanism for going in and out of the high yield market than mutual funds that only trade at the end of the day.

We see the high yield bond and loan market as an important part of the fixed income asset class, especially in this global low yield and high domestic equity valuation environment.  We believe that high yield ETFs provide investors great accessibility to the asset class. And while the recent regulations may add an element of volatility to the market, we would view this volatility as an opportunity for active managers like Peritus who have the ability to capitalize on discounts and can be intentional about the credits they invest in.  We have seen the high yield market stabilize over recent months but we believe that there are still attractive opportunities within the market.

1 From the publication “Outstanding U.S. Bond Market Debt” release by SIFMA, data as of 3/31/16.  Koch, Fer, Miranda Chen, and James Esposito.  “CS Credit Strategy Monthly,” Credit Suisse US Credit Strategy.  April 11, 2016, p.16, 42, https://research-and-analytics.csfb.com.
2 Koch, Fer, Miranda Chen, and James Esposito.  “CS Credit Strategy Monthly,” Credit Suisse US Credit Strategy.  April 11, 2016, p.16, 42, https://research-and-analytics.csfb.com.
3 Koch, Fer, Miranda Chen, and James Esposito.  “CS Credit Strategy Monthly,” Credit Suisse US Credit Strategy.  April 11, 2016, p.16, 42, https://research-and-analytics.csfb.com.
4 Koch, Fer, Miranda Chen, and James Esposito.  “CS Credit Strategy Monthly,” Credit Suisse US Credit Strategy.  April 11, 2016, p.41, https://research-and-analytics.csfb.com.
5 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2015 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 29, 2015, p. A152, https://markets.jpmorgan.com.
6 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2015 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 29, 2015, p. 125, https://markets.jpmorgan.com.
7 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2015 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 29, 2015, p. 130, https://markets.jpmorgan.com.
8 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2015 High-Yield Annual Review,” J.P. Morgan North American High Yield Research, December 29, 2015, p. 126, https://markets.jpmorgan.com.
9 Leverage Commentary and Data, www.lcdcomps.com.  Based on weekly reported fund flow information, including Jon Hemingway, “HY funds see $899M of inflows in latest week,” 8/18/16; Matt Fuller, “US HY fund flows turn negative with ETF-heavy outflow,” 5/26/16; Matt Fuller, “Investors dump record $5B of retail cash into US HY funds,” 3/3/16.
Posted in Peritus

Breaking the Correlation

Oil prices began their decline in late 2014 and accelerated over 2015 into early 2016.  As we got into 2015 and early 2016 we were see a dynamic whereby declining oil prices were causing contagion to the entire high yield market.  Here is what we wrote in January 2016 (from “The Pricing Issue in High Yield”):

As per what has caused and is causing high yield bonds and loans to fall in price, this dates back to 2014 when oil prices started to drop.   The various high yield indexes had somewhere between 15% and 18% of their holdings related to the oil industry at the time depending on what index you looked at.1  Investors began to worry and began to withdraw funds from this asset class as -$7.1B left bonds and -$16.4B left loans in 2015.2  With this, high yield managers had to provide liquidity to those investors that were exiting the asset class and this introduced another issue: liquidity.

With the implementation of the Dodd Frank regulations and the Volcker rule going into full effect in July, liquidity in the secondary market is not what it once was.  Mutual fund and exchange traded fund (ETF) managers,  authorized participants (APs) that handle the creation and redemption process for ETFs, hedge fund managers, institutional investors, and others managing and trading high yield debt had to work harder to find buyers for their bonds/loans.  To keep portfolios in balance during periods of withdraws, portfolio managers had to liquidate portions of securities across the board in some cases, even selling their best securities in their portfolios, thus pressuring the broader market and resulting in virtually the whole market being repriced lower. 

The situation we were facing at the time was that the energy fears were causing people to exit high yield in general, which in turn was dragging down the entire market.  Outside of energy and commodities, we were seeing prices gap down 5, 10, 15 or even more points on no change in fundamentals due to this selling pressure.  As oil began to stabilize and bounce back beginning in late February and March 2016, we started to see high yield bond prices also stabilize and improve.  In short from late 2014 through much of 2016 we have seen a strong correlation between high yield bond prices and oil prices.3

WTI vs HY Price 8-12-16

However, over the last few months, we are seeing this correlation breakdown, whereby high yield has continued to increase during a period when we saw oil prices falling.4

WTI vs HY Price 8-12-16, 3mos

Since the bottom in February 2016, we have seen a strong rebound in the prices of energy related bonds, but we have also seen many other bonds that went down due to then energy contagion bounce back up as well—in the case of the latter, down for no fundamental reason and now back up as fundamentals reassert themselves.  Fundamentals matter and investors are waking up to the attractive yield much of the high yield market offers, especially in the face of low, and in some cases negative, yields for much of the rest of the fixed income asset class.

Energy and commodities still remain a large portion of the high yield index and various sub-sectors of energy and commodities remain depressed, but those issues are now well telegraphed and are no longer gripping investors with fear and causing them to leave or avoid the high yield market entirely.  Bankruptcies in the energy and commodity sectors have increased dramatically and will likely continue, but it is becoming more and more clear which companies are able to handle the current pricing environment versus which ones are not, as we are now going on nearly two years of price declines.  All the while defaults in the rest of the high yield market remain well below historical averages.  Yes we may well continue to see volatile energy prices, but we don’t expect the entire high yield market to get drug down in the process as we saw last year.  There are names to avoid in energy as well as opportunities in the space, just as there are some credits that we see as overvalued or carrying too much risk relative to the yield in other industries, but there are also very attractive yielding opportunities within high yield.  We believe that an actively managed approach to high yield bonds and loans can position investors well for yield generation moving forward and we view this market as offering investors an attractive alternative to equities trading at high valuations in the face of no growth and to fixed income sectors that offer little in the way of yield.

1 For instance, energy was 16.6% of the J.P. Morgan High Yield Index as of December 2014. Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High Yield Market Monitor,” J.P. Morgan North American High Yield Research, January 5, 2015, p. 18, https://markets.jpmorgan.com.
2 Fuller, Matt, “US HY funds net small inflow to close 2015 after three big outflows,” January 4, 2016, S&P Capital IQ, LCD News. Fuller, Matt, “Outflows from loan funds stay heavy to close 2015,” January 4, 2016, S&P Capital IQ, LCD News, https://www.lcdcomps.com/.
3  Data sourced from Bloomberg and covers the period 6/30/14 to 8/12/16.  WTI is West Texas Intermediate closing price.  High Yield is represented by the Bank of America Merrill Lynch High Yield Index, with the average price on the underlying bonds used. The Bank of America Merrill Lynch High Yield Index monitors the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.
4  Data sourced from Bloomberg and covers the period 5/31/16 to 8/12/16.  WTI is West Texas Intermediate closing price.  High Yield is represented by the Bank of America Merrill Lynch High Yield Index, with the average price on the underlying bonds used.
Posted in Peritus

Loans: Understanding The Floating Rate

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

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

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

LIBIR rates 7-28-16

Treasury vs LIBOR 2.5yr 7-29-16

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

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

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

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

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

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

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

Breakdown of US FI 3-31-16

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

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

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

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

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

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

1  From the publication “Outstanding U.S. Bond Market Debt” release by SIFMA, data as of 3/31/16.  Koch, Fer, Miranda Chen, and James Esposito.  “CS Credit Strategy Monthly,” Credit Suisse US Credit Strategy.  April 11, 2016, p.16, 42.
2  Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Leveraged Loan Market Monitor,” J.P. Morgan North American Credit Research, August 1, 2016, p. 7, https://markets.jpmorgan.com/?#research.na.high_yield.
3  Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Leveraged Loan Market Monitor,” J.P. Morgan North American Credit Research, August 1, 2016, p. 7-8, https://markets.jpmorgan.com/?#research.na.high_yield.
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High Yield Bonds and Rates: Duration and Yield

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

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

FI yields 7-22-16

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

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

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

 Returns, Int Rates

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

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

1 Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). U.S. 5 Year Treasury Note is the on-the-run Treasury (source Bloomberg). Barclays Corporate Investment Grade Index consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements (source Barclays Capital). Barclays Municipal Bond Index covers the long-term, tax-exempt bond market (source Barclays Capital). Barclays data as of 7/22/16 and Treasury data as of 7/22/16. Yield to Worst is the lowest, or worst, yield of the yield to various call dates or maturity date. Duration is the change of a fixed income security that will result from a 1% change in interest rate. The duration calculation is based on the yield to worst date, using Macaulay duration for the various Barclays indexes and Bloomberg calculated duration to workout for 5-Year Treasury.
2 High yield and investment grade data sourced from: Acciavatti, Peter Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “2008 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 2008, p. 113; “High-Yield Market Monitor,” J.P. Morgan, January 4, 2016, p. 15. Treasury data sourced from Bloomberg (US Generic Govt 5 Yr). The J.P. Morgan High Yield bond index is designed to mirror the investible universe of US dollar high-yield corporate debt market, including domestic and international issues. The J.P. Morgan Investment Grade Corporate bond index represents the investment grade US dollar denominated corporate bond market, focusing on bullet maturities paying a non-zero coupon.  See https://markets.jpmorgan.com/?#research.na.high_yield.
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First Half Update

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

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

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

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

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

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

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

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

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

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