Upcoming Conference

Peritus’ Ron Heller and Rhondell Sawyer will be attending the INSITE™ 2015 conference in Orlando, Florida from June 3rd to the 5th. Be sure to visit them at booth #608 to learn more about Peritus’ strategy and products.

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Energy Markets: There Will be Winners and Losers

We are ardent believers that the recent decline in the price of oil is temporary given continued demand growth (which will likely only accelerate at lower prices) and our expectation that worldwide supply will decline at current prices; in short, we expect that the supply/demand balance will shift leading to higher pricing.

Much of the incremental worldwide supply growth that we have seen over the past several years has been tied to growth in U.S. production, predominantly the U.S. shale regions.  Looking at these shale producers, we’ve seen reported decline rates upwards of 70% in the first year for many of these companies.  For instance here’s a look at the legacy production of two major U.S. shale basins, Bakken and Eagle Ford, where we are not only seeing huge legacy declines, but current new production not keeping up with these declines.1

Bakken 5-15-15Eagle Ford 5-15-15

Capital had been readily flowing up until now to fund the treadmill of constant capital reinvestment needed to keep up production, but what happens when the capital inflow stalls and investors wake up to the fundamentals of the businesses?  We expect these dynamics will not only lead to a decline in U.S. production, but may ultimately lead to a number of producers who won’t be able to weather the storm.

With a larger and larger portion of U.S. oil production coming from shale producers who have these far greater decline rates than conventional oil producers, the total U.S. production decline rate has now more than doubled in the last five years, putting it at all-time highs.2

Oil decline rate 1

Oil decline rate 2

Production shortfall 2

This at a time when we are also seeing massive declines in rig counts.3

Oil Rig Count 5-26-15

So together we believe this has large implications for U.S. production going forward.  We will continue to see a record amount of production needing to be replaced over time due to these natural decline rates, all the while capital investment to replace this production will be stymied and rig counts, an indication of future production, have fallen off a cliff, leading to a meaningful drop in U.S. oil production.4

Production shortfall 1

Production shortfall 2

Where does that leave us?  If much of the incremental supply growth worldwide has come from the U.S., but that U.S. production will be declining, then the supply and demand balance will see a shift and thus we would expect to see a rebound in oil prices.  Though we caution investors this may well take several quarters to play out.

So at face value, this should mean that the energy sector is an attractive area to be positioned as we wait for that rebound—we may see some continued near-term volatility but in the longer-term, energy names are bound to go up, right?  Not so fast.  While we are long-term energy bulls, there were certainly be winners and losers as these dynamics play out.

As noted above, we have our concerns not only about the longevity of shale production, but to the viability of many of the companies themselves.  First of all, many of these shale producers did not generate free cash flow at oil prices nearly twice what they are today.  Oil and gas production is a capital intensive business, so with the severe decline rates and less capital now readily available to regain that production, as well as the lower prices received for what is produced, we expect this may well lead to the lack of funds available to service the debt loads of many of these companies. In sort, we expect these dynamics may lead to a spike in default rates.  And it isn’t only the shale producers that we see as vulnerable, but also the oil and gas service companies that will be hit as rig counts and production declines.

What does this mean for the general high yield market and investing within the space?  The overall energy sector comprises 16-18% of the high yield market5, depending on what index you use, making it the largest industry concentration in the high yield market.  So investors in the broad high yield market and index-based mutual and exchange traded funds likely have notable exposure to the sub-segments we see as most vulnerable.  The general high yield market has already taken a hit due to its energy exposure over the last couple of quarters, so we don’t expect a potential increase in shale or service-related defaults to lead to another leg down in the general high yield market; however we do expect it will cause pain to investors in these specific names and sub-segments.

So while we see shale producers and service providers as the losers as trends play out in the energy space, we do see other areas of opportunity to capitalize upon our expectations for a rise in energy prices.  For instance, we see opportunity in many of the Canadian oil producers.  Heavy oil from Canadian producers is in much shorter supply than light oil (which is produced by many shale basins) and is needed by certain refineries, and these Canadian producers have higher reserve lives and are more capital efficient (i.e., much lower decline rates).  Furthermore we expect that Canadian producers will benefit from the spread compression versus WTI (West Texas Intermediate)—in other words, the price for the Canadian grade of oil, WCS (Western Canadian Select), versus U.S. oil prices, WTI, is narrowing.  WCS has always been at a discount relative to WTI, but that discount has seen huge compression over the last couple years, going from as high as $42 to now under $10.6

WCS differential

This means Canadian producers are receiving a better relative price than the publicized WTI price would indicate.  Furthermore, oil is priced in U.S. dollars but costs for Canadian producers are in C$, so these producers benefit on the profitability side from a decline in C$.

We do expect that energy prices will rise, but that this rise may not be quick enough for many inefficient shale producers and services companies, thus we could see a pick-up in defaults for many of these energy companies.  Yet, certain other companies and sub-segments of the space will benefit at their expense, as there will be other companies that can weather the downturn and will profit from the rebound in prices on the other side.  Investors need to focus on the fundamentals of the businesses in which they invest and understand what they own, and be cautious of some exposures they may have when investing in the broader high yield market via passive mutual or exchange traded funds, where fundamental analysis is not the focus in determining holdings.  Again there will be winners and losers; there are opportunities to be had and companies to avoid.

1 Source: U.S. Energy Information Administration (May 2015).
2  Petrucci, Anthony, John Bereznicki, CFA, Dennis Fong, Sam Roach, CFA, Yassen Bogoev, CFA, Jeff Ebbern, Oliver Bailey, and Alexander Kohout, “Canadian Junior & Intermediate E&P,” Canaccord Genuity, May 25, 2015, p. 3.  Data sources include Canaccord Genuity estimates, IHS, EIA, DOE, and Bloomberg.
3  Baker Hughes U.S. Rotary Rig Count, as of 5/22/15, data sourced from Bloomberg.
4  Petrucci, Anthony, John Bereznicki, CFA, Dennis Fong, Sam Roach, CFA, Yassen Bogoev, CFA, Jeff Ebbern, Oliver Bailey, and Alexander Kohout, “Canadian Junior & Intermediate E&P,” Canaccord Genuity, May 25, 2015, p. 3.  Data sources include Canaccord Genuity estimates, IHS, EIA, DOE, and Bloomberg.
Posted in Peritus

Time to Go Active

Earlier this week we saw one of the major financial publications feature an article about how active management has outperformed passive management so far in 2015. While their article and data focused on equity funds, we believe that the same sort of opportunity for active fixed income managers exists over the balance of 2015. During times of a one-way trade up, passive management can benefit, but that is not the environment we have seen or expect for the remainder of 2015, in anticipation that we may see the biggest elephant in the room, the Federal Reserve, ultimately start to take some action.

Active management is about the human element and what you own versus what you don’t own. We have always been under the belief that what you don’t own or avoid is more important. As we look at today’s high yield market, there are certain areas that we are able to avoid as active managers. One area is the names that offer very little in the way of yield. As we look at the high yield market, we see a sizable portion of the market that offers yields of 3-5%. This not only means your portfolio is generating little in the way of income, but also means that you will most likely have a higher duration (a measure of interest rate sensitivity, a higher duration means higher interest rate sensitivity) given the lower yield. For instance, the Ba segment of the Barclays High Yield Index is trading at a yield to worst of 4.69% and a duration of 4.91 years.1 Broadly speaking we would not see this as an attractive yield and duration at which to put money to work. Yet as you get into the individual credits, there are some Ba names yielding 7% and some B names yielding 4%; the benefit of active management is that you can look for value to maximize yield and lessen your interest rate exposure (duration), and avoid the names where you don’t see value.

Another area that we have been vocal about avoiding is certain sub-segments of the energy space, specifically the US shale players. Energy is about 16.5% of the high yield index, by far the highest industry allocation2, so if you are invested in the broad high yield market passive strategies, you most likely have a sizable allocation to energy. Even with the rebound in oil prices that we have seen in the last couple months, moving closer to $60, we believe this still positions many US shale producers and energy service providers as vulnerable. As we have noted, shale production in many cases requires high prices and massive capital reinvestment. Cracks are already starting to emerge in the energy space and we do expect that to accelerate as rig counts declines ultimate work through the financials of service providers, revolver borrowing bases get reevaluated based on the current production value and outlook meaning likely reduced liquidity in some cases, and hedges come off. Investors in the energy space need to understand what they own and determine the prospects of their holdings, as in many cases an oil price recovery to $60 is not nearly enough. We have likened today’s high yield energy markets to the technology and telecom space in the early 2000s, which at that point was a large portion of the high yield indexes. We didn’t avoid the entire space then, but were selective about where we were positioned, investing only in the names that we saw as undervalued survivors in the space that would profit in the long term, and believe that same selectively is necessary in today’s energy market.

Passive-based investing can do well during times when we see broad uptrends in financial markets. However during times of uncertainty and volatility, we believe that provides opportunities for active managers to separate themselves, and we are seeing such opportunities today in a variety of financial markets, high yield included.

1 Source, Barclays capital as of May 18, 2015, using the 2% issuer constrained Ba sub-set. Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt. Duration quoted is the modified adjusted duration.
2 Based on the JP Morgan US High Yield Index. Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update.”  J.P. Morgan, North American Credit Research, May 15, 2015, p. 48.
Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. Information on this website is for informational purposes only. As with all investments, investing in high yield corporate bonds and loans and other fixed income, equity, and fund securities involves various risk and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.
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Upcoming TV Appearance

Peritus’ Chief Investment Officer, Tim Gramatovich, will be a guest on CNBC’s “Closing Bell” today, May 18th, at 3pm ET.

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Rates and Returns, 2013 versus 2015

Given the recent move in Treasury yields, with the 10-year U.S. Treasury yield up over 30bps in just the last 30 days, the concern about interest rate risk is heating up again.  As we have written about in the past, high yield bonds have historically done well during periods of rising rates (see our pieces “High Yield in a Rising Rate Environment” and “Strategies for Investing in a Rising Rate Environment“).

Interestingly, so far 2015 seems to be mirroring 2013, where the 10-year Treasury yield rose from 1.86% to 3.04%, with rates being fairly tame in the first five months of the year, and then started to spike in May.1

10 yr yield 2013, 2015 5-12-15

While the Fed will certainly be raising rates at some point, the timing and extent of the move we’ll see this year is anyone’s guess.  As rates ultimately rise, we would expect to see a larger move in the shorter bonds, but don’t expect to see a huge spike in the medium to longer term rates (5 and 10-year Treasury rates).  But what if we are wrong and see a repeat of 2013, where the 10-year Treasury rate almost doubled?  Just how did various asset classes perform during that period?

During 2013, high yield bonds and loans posted solidly positive returns versus other income-generating asset classes.2

 2013 total return

Over the course of 2013, high yield bonds and loans posted a return of 7.44% and 5.39%, respectively, versus -1.53% for investment grade corporates, -2.55% for municipal bonds, -0.17% for preferred stocks and 1.78% for real estate.

Looking specifically at the fixed income asset classes, duration is a measure of interest rate sensitivity.  As you can see, both back in the beginning of 2013 and the beginning of 2015, the high yield bond market had a significantly lower duration than both investment grade corporate and municipal bonds, while high yield loans have floating rates so are considered to have minimal interest rate sensitivity.

Duration Jan 2013, 2015

While of course past performance is no guarantee of future results, this does go to show how various asset classes have responded in recent history to a significant rise in rates.  Given the lower duration of the high yield bond market and higher starting yields, we would expect this asset class to weather a move in interest rates well, as it historically has.

1 Data sourced from the U.S. Department of the Treasury. 2013 10-year Treasury yields/rates cover the period of 1/2/13-12/31/13 and 2015 covers the period 1/2/15-5/12/15.
2 Barclays Capital U.S. High Yield Bond Index covers the universe of fixed rate, non-investment grade debt. Barclays U.S. High-Yield Loan Index, also known as the Bank Loan Index, provides metrics for the universe of syndicated term loans. 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. Barclays Municipal Bond Index covers the long-term, tax-exempt bond market. Performance (total return) data for the period 12/31/12-12/31/13 and modified adjusted duration provided as of the listed date, source Barclays Capital. The S&P U.S. Preferred Stock Index is designed to measure the performance of the U.S. preferred stock market, including stocks that pay dividends at a specific rate and receive preference over common stock. The Dow Jones U.S. Real Estate Industry Group Index is a subset of the Dow Jones U.S. Index and represents Real Estate Investment Trusts (REITs) and other companies that invest directly or indirectly in real estate through development, management or ownership, including property agencies. Preferred stock and Real Estate index data sourced from Bloomberg and performance covers the period 12/31/12-12/31/13.
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A Look at High Yield Bond and Equity Valuations

There has been talk in the media recently about high yield being overvalued at current levels. However, we feel that historical metrics indicate that we are nowhere near a point of overvaluation; rather, there is still value to be had in this market.

Looking at high yield bond spreads versus comparable maturity Treasuries is a primary way the “value” of the high yield market can be assessed. The chart below indicates a current spread to worst level of 513bps.1

CS HY Spread Chart TitleCS HY Spread Chart

This data goes back to 1/31/86, so nearly thirty years to the beginning of the high yield market, and over that time the average spread to worst level is 579bps.  This average level includes some points of massive spread widening during three periods (1990/1991, 2001/2002, and 2008/2009), which undoubtedly skew that number up, but even so, current spread levels don’t look historically tight relative to that 579bps average. The historical median spread to worst over this period is 520bps, so just about where current levels are.  To put this in a bit of perspective, at 513bps, historical spread levels have been below this level 49% of the time and have gotten as low as 271bps.  34% of the time, spread to worst levels have been below 450bps.2

J.P. Morgan looks at valuations in another way, as not only the spread to worst, but the premium to the 10-year Treasury, as pictured below.3

Premium to 10 yr Treas

Again, this metric clearly indicates that current high yield investors are getting a strong premium for holding high yield bonds relative to what they have historically received. So it certainly seems to us that we are around reasonable historical valuation levels for the high yield bond market and have room for further spread compression.

While we are on the subject of valuations, we think the real concern should lie with equity valuations. As the P/E chart below indicates, if we look back to the inception of the S&P 500 Index as we know it today, we are seeing a fairly wide disparity of a current S&P 500 PE valuation of 20.58 versus a median of 17.42.4

S&P 500 PE 1957

This disparity is even wider if we go back over 100 years to look at valuations of the index predecessors. Here, we see historical P/E median levels have been around 14.65 versus the current level near 20.6.5

S&P 500 PE 1900

So not only are we seeing signs of stretched valuations in equities, while we would argue high yield bonds are right around historical levels in terms of spread valuations, we have pointed out on numerous occasions that high yield bonds have historically performed better than equities on a risk adjusted basis (return/risk with risk measured as the annualized standard deviation of returns) and relatively similar returns on a pure return basis over 25 years.6

CS HY vs SPX 4-30-15

We continue to believe that high yield bonds have offered compelling historical risk adjusted returns and do continue offer value for investors today, especially in actively managed portfolios where managers can focus on the bonds offering the most value relative to risk in today’s market.

 

1. Blau, Jonathan, James Esposito, and Amit Jain, “Leveraged Finance Strategy Monthly,” Credit Suisse Fixed Income Research, May 5, 2015, p. 4.
2. Further spread breakdown and median based on the Credit Suisse High Yield Index for the period 1/31/1986 to 4/30/15.
3. Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update.”  J.P. Morgan, North American Credit Research, May 1, 2015, p. 41.
4. Data sourced from wwww.multpl.com, “S&P 500 PE Ratio” covering the period 4/1/1957-5/5/2015. Current PE is estimated from latest reported earnings and current market price.
5. Data sourced from wwww.multpl.com, “S&P 500 PE Ratio” covering the period 1/1/1900-5/5/2015. Current PE is estimated from latest reported earnings and current market price.
6. Credit Suisse High Yield Index data from Credit Suisse. S&P 500 numbers based on total returns. 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.
Posted in Peritus

Upcoming TV Appearance

Tim Gramatovich, Chief Investment Officer at Peritus, will be a guest on BNN’s “Business Day” on Wednesday, May 6th at 2:30pm ET.

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High Yield Bonds: A Legislative History and the Opportunity Created

Throughout history of the high yield market there have been various legislative acts that have created and continue to create the market dislocation that allows investors an opportunity to produce what we see as attractive risk-adjusted returns.  The Financial Institutions Reform Recovery and Enforcement Act (FIRREA), which passed in 1990, was the first piece of legislation that dramatically altered the landscape for high yield corporate bonds.  In the time leading up to this legislation, bank failures were everywhere and Wall Street lost junk bond pioneer Drexel Burnham Lambert.  Citibank was almost dead, more than 700 savings and loans/thrifts failed and the controversial California-based insurance company First Executive disappeared.  The government sponsored an agency that became known as the Resolution Trust Corporation (RTC) to deal with the savings and loan (S&L) failures.  Investments in junk bonds and junk loans to emerging market countries such as Mexico and Brazil were at the center of the storm and were the root cause of all the problems, according to the popular press.

Regardless of the blaming of Drexel and the junk-bond pirates, the real root of the problem developing in the 1980s was actually real estate. William Seidman, former head of both the Federal Deposit Insurance Corporation (FDIC) and the RTC, commented on the 1980s issues, stating:1

The critical catalyst causing the institutional disruption around the world can be almost uniformly described by three words: real estate loans. In the U .S., the problem was made even worse by allowing S&Ls to make commercial real estate loans in areas they knew little about. They were already in trouble because they borrowed “short” and lent “long” in financing the housing market.

How familiar does that sound?  Since 2008, we have been working off the biggest hangover in the history of residential real estate.

Apparently, we are slow learners or have selective amnesia.  Bill Seidman—one of the most respected regulators of our time—had come to the conclusion that real estate lending was at the core of the meltdown in the ‘90s. But Seidman’s claims were ignored. Instead, politicians decided that the answer was to make sure that going forward, thrifts were almost completely invested in real estate while forcing them to sell their high yield bonds at what was then the bottom of the market.  Below were two of the requirements that came out of this ridiculous piece of legislation (FIRREA):2

(7) Required savings and loans to meet a new “qualified thrift lender” test of the 70% of portfolio assets in residential mortgages or mortgage related securities.

(14) Required savings associations to divest their holdings in junk bonds by July 1, 1994, and generally follow the same investment guidelines as commercial banks. Junk bonds and direct investments of saving and loans must be held in separately capitalized subsidiaries.

Around the same time as all of this legislation was being passed, a group known as the Bank for International Settlements (BIS) was passing the first Basel Accord.  Known as Basel I, this accord set capital standards for global banks for a variety of very broad asset classes.  Corporate bonds and loans were set at 8%, meaning a bank had to have Tier 1 capital (equity capital and reserves) of 8 cents to back each dollar held in a corporate security.  Prior to this accord being passed in 1988, banks operated somewhat by the seat of their pants.  They reserved what they deemed appropriate for various asset categories and worked with regional or national regulators on these issues.

The ink was barely dry on Basel I when pressure from the various banks sowed the seeds of a monumental and ill-understood piece of legislation that led to the meltdown that began during the last quarter of 2008.  The argument sounded rational.  Why would a loan to General Electric require the same amount of capital as one to Joe’s Liquor Store?  So back to the drawing board we went, which led to the second Basel Accord, or Basel II.  At the heart of this proposal lies the notion of risk.  Regulators wanted to make sure that capital reserves were appropriate for the risk of the assets held by banks.  Sounds like good policy, but how does one measure risk? Well enter our friends the credit ratings agencies.  What Basel II effectively said was that credit ratings will determine risk and the amount of capital required.  Here is what was finalized:3

Claims on Corporates

To translate into simple English, if 8% was the base capital charge, then AAA to AA securities would require only 20% of this, or 1.6% capital backing for each dollar of securities held.  Anything below BB- would require 150% of 8%, or 12% capital. This led to banks focusing their attention on the highest-rated securities, which required limited capital and allowed for massive leverage.  Let’s do the math.  If a bank requires only 1.6% capital, the inverse of this is the amount of leverage they get, which is more than 60:1!  So once again, an arcane policy further restricts another group of major institutions from investing in lower-rated securities (regardless of their true investment quality).  Ironically, the chase for AAA securities was at the root of the 2008 financial crash as Wall Street created (and the rating agencies were relied upon to rate) many synthetic AAA bonds that turned D (defaulted).  In the end, the rating agencies ended up with more stature after proving they did not deserve it and the results were disastrous, as witnessed by the 2008 meltdown of the global markets.

More recently we have seen the impact of the Dodd-Frank Bill and Volker provision within it.  Post the financial crisis, various pieces of legislation, including Dodd-Frank and the Volker Rule were put into effect with the goal of reducing risk and increasing the stability of the banking system.  While these pieces of legislation may serve to stabilize the banks, they have created unintended consequences for financial markets, including what we see as less stability and higher volatility in fixed income markets.  For instance, the Volker Rule effectively limited the ability for banking institutions to engage in proprietary trading of securities for their own accounts.  As a result, traditional market makers and liquidity providers (such as the major investment banks) have pulled back on their lending and market making activities due to these regulations and a focus on risk reduction on their balance sheets.

Why is it important to understand such legislation? Mainly because it can shape who ends up owning certain asset classes.  In the cases of FIRREA and Basel II, banks became large sellers, creating opportunities for buyers.  In the case of Dodd-Frank, it has resulted in greater volatility in today’s high yield market, as many of the market makers that were previously in place to absorb some of the trading volume are no longer there.  Yet this volatility can create attractive entry points.  Great credit analysis—a pre-requisite for producing returns in this asset class—is aided by the opportunity-set itself, which is a function of the market and the lack of permanent investors created mainly by misinformation and poorly drafted legislation.  Over various points in history, we have seen this legislation create opportunity for high yield bond investors.

For more on the history and development of the high yield asset class, a discussion of the legislation and ratings methodologies that have created what we see as opportunities in the marketplace, and comparative historical risk adjusted returns with other asset classes, click here to read our updated piece, “The New Case for High Yield: A Guide to Understanding and Investing in the High Yield Market.”

1 “Panel Lessons of the Eighties: What Does the Evidence Show?”  History of the Eighties—Lessons for the Future.  Federal Deposit Insurance Corporation, 1997.  p. 58.
2 Friedman, Thomas.  Dictionary of Business Terms. Barron’s Educational Series, Inc., 2007.  “Financial Institution Reform, Recovery and Enforcement Act (FIRREA).”
3 “International Convergence of Capital Measurement and Capital Standards,”  Basel Committee on Banking Supervision. Bank for International Settlements June 2006.
Posted in Peritus

The Origin and Growth of the High Yield Market

Most investors place the origins of the high yield market in the late 1970s, which would not necessarily be wrong if by the high yield market we mean “original issue” high yield. Truthfully, high yield lending has been going on for centuries. Back in the 1700s, the Rothschild family was a dominant high yield lender (lending at higher interest rates/yields to more risky borrowers) but their focus was on countries rather than companies. Over the last two centuries, as commerce and the modern corporation developed, the bond market developed right along with them. However, for decades, the focus of both sides (issuer and investor) was on highly rated companies, aided by John Moody’s development in 1909 of the basic ratings system (Moody’s Rating Service), which is used today.

The earliest modern era data we have on the high yield market came in 1958, when W. Braddock Hickman, a researcher for the National Bureau of Economics Research, produced a seminal piece of work entitled Corporate Bond Quality and Investor Experience. As the title suggests, he reviewed the corporate bond market and investors’ experience with it from 1900-1943. Hickman used the terms “low grade” and “high grade” to differentiate what we now refer to as “high yield” and “investment grade.” His conclusions were as follows:1

On the average and over long periods, the life-span yields realized on high-grade bonds were below those on low-grade bonds, with the result that investors, in the aggregate, obtained better returns on the low grades.

The foregoing may be summarized as follows: (1) Investors, in the aggregate, paid lower prices for, and thus exacted higher promised yields on, the low-grade issues; (2) default rates on the low grades were higher than on the high grades; (3) loss rates, which take into account not only default losses but also capital gains, were higher on low-grade issues; (4) the higher promised returns exacted on the low grades at offering proved to be more than sufficient to offset the higher default losses; (5) in consequence, life-span yields realized on low grades were higher than on high grades. The results were quite typical within major industry groups. Similar results were obtained for most of the longer assumed chronological investment periods.

The finding that realized returns were higher on low-quality corporate bond issues than on high-quality issues has implications for investment theory as well as for practical investment policy.

Hickman’s findings turned everything about investing in fixed income on its head. His conclusion was unmistakable in that low-grade bonds outperformed high-grade bonds over this period. The increased default rates of low-grade paper were more than offset by higher-coupon income and recovery rates on the defaulted bonds. Apparently, this superb piece of work was ignored until the late 1970s, when Michael Milken—a graduate student at the Wharton School—dusted this script off and launched what became the original issue high yield market as we know it today. Michael Milken and Drexel Burnham Lambert ultimately became synonymous with high yield.

The high yield bond market as we know it today first started to really gain traction in the mid-1980s and has steadily grown since.2

Historic Gwth of High Yield Market

There were several distinct periods of growth that assist in understanding the development of this market. Prior to 1985, the market consisted almost entirely of securities that were once investment grade but had since been downgraded. These securities became known as “fallen angels.” It was in the 1980s that Drexel Burnham, and eventually all of Wall Street, began to embrace the concept of original issue high yield bonds to finance everything from leveraged buyouts to significant new industries, including modernizing Las Vegas (Caesars World, Circus Circus, Bally’s), creating cable networks (Turner Broadcasting-CNN) and ultimately even financing the beginning of the wireless age (MCI and McCaw Cellular). It is important to note both then and now that the high yield issuers are not start-up companies, but generally, mid-sized companies with well-established product lines or services looking for an alternative form of financing to sustain or grow their businesses.

The high yield market offered several important advantages to issuers. Prior to the original issue high yield market, companies would have to finance themselves with equity and/or traditional bank debt. The problem is that equity financing is often very expensive and massively dilutive to existing shareholders, while bank debt is short term, has amortization payments and comes with restrictive covenants. Bank financing would not be effective in building out the massive infrastructure required in many of these cases. Thus, the long-term nature and fixed coupon payments provided by high yield bonds allowed for the stability needed for these companies, and the market growth began.

However in 1990, the growth of the market stalled as the country entered a significant recession and default rates climbed. Given the limited size and breadth of the market at the time, many wondered whether this asset class would survive. But survive it did and as the country emerged from this period, the high yield market growth resumed. Yet the truly exponential growth in the market would not begin until 1996 and did not take another breather until the end of 2003.

Several factors led to this exponential growth in issuance. First, the asset class gained the attention of many institutional money management consultants as the return profile from 1990-1995 had been very attractive. This demand enabled more companies to raise money in the high yield space versus bank debt or other forms of financing. This was both good and bad. It did bring in many new players on the issuance side of the market, but as the demand grew so did the ability to raise money on fictional business plans, especially in the “TMT” (telecommunications, media and technology) space as the internet and technology bubble developed. Like in the equity market, billions of dollars were raised by companies with no revenues and only a plan for the future. This ultimately led to the second “nuclear winter” in high yield which occurred in 2002, culminating with the high profile defaults of Enron and Worldcom and the collapse of the technology and telecom markets. Once again, a period of healing and consolidation began as issuance subsided. But issuance once again picked up starting in 2006 and the market now stands at about $1.5 trillion and growing rapidly, with record issuance in 2013 and near record issuance in 2014. 3

Annual New Issuance

As we outlined in our recent writing (“Overview of the Fixed Income Market”), high yield bonds are now a sizable and growing piece of the fixed income space, worthy of investors’ attention. For more on the history and development of the high yield asset class, a discussion the legislation and ratings methodologies that have created what we see as opportunities in the marketplace, and comparative historical risk adjusted returns with other asset classes, click here to read our updated piece, “The New Case for High Yield: A Guide to Understanding and Investing in the High Yield Market.”

1 Hickman, W. Braddock, 1958. “Introduction and Summary of Findings.” Corporate Bond Quality and Investor Experience, partial text from pages 14-15. Princeton, NJ: Princeton University Press for National Bureau of Economic Research.
2 Blau, Jonathan, James Esposito, and Amit Jain. “Leveraged Finance Strategy Weekly,” Credit Suisse Global Leveraged Finance. January 9, 2015, p. 4.
3 Acciavatti, Peter D., Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li.. “Credit Strategy Weekly Update.” J.P. Morgan, North American High Yield and Leveraged Loan Research. January 9, 2015, p. 7.
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High Yield in a Rising Rate Environment

HY rate piece

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