The Election Impact on High Yield: Rates and Regulation, Interest Rates and the Economic Outlook

Now that Donald Trump has surprised virtually everyone with his Presidential victory, what does that mean for the high yield market?  For us, it looks like the most relevant impacts are interest rates, taxes, and regulations.

First, let’s look at interest rates.  The 10-year Treasury has gone from 1.83% on Monday, November 7th, the night before the election, to cross above 2.3% over the course of the next couple weeks.  Yes, this is a sizable move and has been primarily attributed to a couple of underlying factors, both of which we view as potential positives.  First is the expectation that the Trump/Republican initiatives, including infrastructure and other government spending, will drive economic growth. Second is the idea that with a Republican controlled House and Senate, tax cuts are very likely to get passed, and those tax cuts in turn could cause demand-pull inflation.  There have been promises of tax cuts on both the individual side, putting more money in the pockets of the consumer, and on the corporate side, allowing for greater profits which can in turn be invested in growth and capital spending.  Additionally there is the discussion of a corporate “tax holiday,” allowing corporations to repatriate cash held overseas, which they can then apply to things such as stock buybacks or debt reduction.  We know that consumer spending is nearly 70% of GDP and corporate spending another sizable piece of the pie, so whether it is tax cuts putting more money into the hand of the consumer and corporations or the infrastructure spending improving the job situation, we would see both as positives from an economic growth perspective.

Prices of high yield bonds have historically been much more linked to credit quality than to interest rates. The biggest cause of spread widening (price declines) over the years has been spikes (or anticipated spikes) in default rates.1

default-rate-vs-spreads-11-10-16

On the flip side, historically, interest rates are usually increasing during a strengthening economy and a strong economy is generally favorable for corporate credit and equities alike.  We believe investors should focus on default/credit risk when investing in the high yield sector, paying attention to the company’s fundamentals and credit prospects. When the economy is expanding, profitability, financial strength, and credit metrics generally improve.  Additionally, if corporations have more money in their pockets due to lower taxes and repatriation of cash that can allow for more money to service and pay down debt, further keeping default rates at bay.

After years of muted economic growth, during which the broad high yield market has still performed well, we would view a stronger economy as undoubtedly a positive from a credit perspective if it were to come.  Under this scenario, default rates (excluding energy/commodities) should continue their below average trend and we would expect high yield debt to be positioned well for yield generation and returns potential going forward.  For more on our thoughts on the economy, rates, regulations, and the outlook for the high yield market as a result of the recent election, see our piece “The Election Impact on High Yield: Rates and Regulation.”

1 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Default Monitor,” J.P. Morgan North American Credit Research, November 1, 2016, p. 7, https://markets.jpmorgan.com/?#research.na.high_yield.
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The Election Impact on the High Yield Market: Rates and Regulation

Now that Donald Trump has surprised virtually everyone with his Presidential victory, what does that mean for the high yield market? For us, it looks like the most relevant impacts are interest rates, taxes, and regulations.  We are already starting to see Treasury rates increase, and if that continues, what does that mean for the high yield market?  And since the moment Trump’s victory became certain, there has been incessant discussion of the various legislative and regulatory changes he may enact, so where does that leave us?  As we evaluate these various aspects, we do see some potential positives for the high yield market that may well come on the regulatory side.  However, we remain skeptical on a rapid rise in rates.  Yet either way, we believe the knee jerk reaction of investors to sell all “bonds” because rates are going to go up provides us with a very nice entry point across the high yield bond and loan asset class. Click here to read our recent writing, “The Election Impact on the High Yield Market: Rates and Regulation.”

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The Technical Piece of Active Management

Over the years we have spent a great deal of time discussing fundamental analysis and how important we believe it is in high yield investing.  Fundamental analysis—digging into a company, understanding what they do, and evaluating the future outlook for the business—is at the core of what we do as active managers.  However, market technicals also do have a place for us within our actively managed strategy.

Over the past few years, liquidity within the high yield market became an area of focus among investors and regulators alike.  In order to address liquidity within our investment strategy, nearly a year ago we proactively decided to allocate a portion of our portfolio to newly issued bonds.  Various market data and our own experience had, and has continued to, show that bonds tend to be most liquid immediately after issuance (see our pieces “Liquidity Management” and “Strategy Adjustments:  New Issue Allocation”).  Our goal with this strategy enhancement was to increase the liquidity as a whole and work to reduce volatility.

As we allocate money to these newly issued bonds, we pay close attention to market technicals.  We work to gain an understanding of the general primary market supply/demand conditions.  Are markets executing discipline in allocating money to newly issued bonds?  Are investors accepting lots of less favorable uses of proceeds (such as for M&A or dividend deals) causing leverage to increase to elevated levels, and or are underwriters getting more aggressive in their structuring, such as with PIK Toggle deals?  Do we see any red flags raised that warrant extra caution?  We also look at the supply/demand dynamics for the individual bond tranches we are evaluating for investment.  For instance, is there a strong demand, meaning there are likely many buyers after the deal prices and breaks for trading?

Within this new issue strategy, we have the ability to set coupon thresholds, not participating in the deals with very low coupons where we don’t believe investors are getting compensated for the risk.  We can also focus our attention on structures that we prefer, side-stepping PIK-toggles as that may put the investor at risk of receiving coupons in-kind instead of in cash.

As an active market participant, we are looking at both market and individual credit fundamentals and technicals as we execute on our investment strategy.  Not only do you need to understand what is going on at the company levels in terms of their earnings and outlook in the midst of the broader economic outlook, you also need to understand supply/demand conditions within the market, especially for bonds that are about to be issued.

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Bond versus Equity: Capital Structure Positioning Matters

In our writings, we have often posed high yield bonds as an equity alternative.  Over the last couple decades, these two asset classes have had similar return profiles.1

CS vs SPX 25yr 9-30-16

However, as we have often noted, high yield bonds have historically had less volatility/less risk relative to equities, leading to the high yield bond market’s historical risk adjusted outperformance (return/risk) versus equities (as measured by the S&P 500).

The lower risk profile for high yield bonds makes sense.  In a company’s capital structure, debt securities rank ahead of equity securities, so if a company were to run into trouble and can’t pay all of their obligations and/or the valuation of the company dramatically declines, the debt securities are paid back first and are the first to capture any remaining value in the company before anything is allocated to the equity (preferred and common) holders.

Another important fact to keep in mind about equity versus debt investing is the nature of the income they generate.  Coupon interest payments made by debt securities are contractual obligations—companies are required to make these payments in full to bond/loan holders, while dividend payments, when made on common stocks, are voluntary.  These payments are made at the discretion of the company’s Board of Directors, and can be cut back or entirely eliminated at any point.

This week we saw a clear example of why where you invest in a company’s capital structure is so important.  One of the companies we follow reported weaker than expected revenue and a need to spend money to invest in their sales force.  In order to conserve cash for this extra spending, they reduced their distribution/dividend on the equity by 50%.  In the day following the news, we saw the stock decline about 45% while the high yield bonds were down about 2%.  This company is an MLP (master limited partnership) and while not related to energy, we have seen these sorts of dividend cuts in numerous energy related MLPs over the past couple years.  While a sales miss is a negative for us, as bondholders, we ultimately see it to our benefit that the company is conserving cash and retaining it to invest in the business versus leaking it as dividends to the equity ranked below us in the capital structure.  The bonds were largely able to retain their value, while equity prices took a big hit as those equity investors that were depending on the income this security generated saw that income cut in half.

High yield bonds can generate steady coupon income over the life of the security and rank ahead of the company’s equity allowing for lower volatility.  We believe the high yield debt markets offer investors an attractive investment opportunity relative to 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, data sourced from Credit Suisse. S&P 500 numbers based on total returns, data sourced from Bloomberg. Period covered is 9/30/91 to 9/30/16. Calculations based on monthly returns and standard deviation is calculated by annualizing monthly returns. Return/risk is based on annualized total return/annualized standard deviation. Although information and analysis contained herein has been obtained from sources Peritus Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and other fixed income securities involves various risks and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.
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A Place for Active Management

Be it how hedge fund returns have been struggling over the past year or how index funds have been gaining some traction, there has seemed to be much in the financial media over the past few weeks about the challenges facing active management.  This certainly isn’t the first time we’ve seen people calling for the end of active management, only for those calls to be wrong.

Yes, we have seen passive strategies gain in certain sectors of the financial markets, but this only creates more opportunity for the active strategies that remain.  We certainly don’t envision us completely going to a model of all investments being held in index-based vehicles, or computer algorithms dictating how we allocate money.  There is a place for the human element, actual people looking into a security and doing fundamental work to see if there is value, as they compile a portfolio they expect will outperform the market.  We don’t believe that markets are completely efficient, nor are investors completely rational; rather, there are going to always be some dislocations and opportunities for active investors to capitalize upon, and as there are fewer people pursuing those dislocations, we would expect to see a better opportunity for gain.

Furthermore, we also believe some markets are better suited for active management than others.  Yes, there are certain areas of the large-cap equity market that are VERY widely followed and where lower cost passive strategies may make more sense.  However, in an area like high yield bond and loan trading, we believe this market lends itself much better to active management.  Keep in mind that high yield debt trading is more complex, and it can be harder to find and source product, which can give certain managers an advantage.

Additionally, not every name is widely followed.  For instance, many of the largest funds and institutional players focus more on larger issuers and the largest passive ETFs in the high yield bond market have size restrictions forcing them to primarily invest in securities over a certain tranche size, eliminating a large portion of high yield issuers.  Our experience over the years has been that we have often found some of the most attractive opportunities in this sector of the market often abandoned by many.  And keep in mind that if ETFs, mutual funds, insurance companies, and private funds weren’t stepping in to buy these companies that may not meet the index-criteria of certain products, there would be a large portion of the market that would not have the capital they need to run and grow their businesses.

Another area where we have seen market inefficiencies over the years is in bond ratings.  Many managers and investment vehicles invest according to ratings, and the entire high yield versus investment grade market is defined by ratings.  However, we believe such arbitrary restrictions limit investment opportunities.  All that we need to do is look to the 2008 subprime crisis to see that the rating agencies can get it very wrong.  Yet, much of the investment community still sees value in these ratings and uses them to make investment decisions—even though the agencies themselves say the ratings shouldn’t be relied upon to make investment decisions.  So while some investment vehicles may limit themselves to certain ratings categories, we believe there are opportunities in certain lower rated names where the ratings agencies may have it wrong…and vice versa, the ability to avoid certain higher rated names where we believe the rating agencies have it wrong and are ignoring important risks.

Above all, we believe that high yield debt investing necessitates active management because you don’t want to be trapped in a security, owning it just because it is part of an index.  We believe that the varying and dynamic risks involved in investing in the high yield asset class demand active management.  And as the risk return equation changes over time, investors need to change their portfolio positioning to maximize their return, lower risk, and take advantage of opportunities. With this, not only due to their ability to invest in these often overlooked securities, but also due to their ability to be more nimble in adjusting their portfolio to changing market dynamics and opportunities as well as their ability to focus on their best ideas, we believe that smaller investment managers and vehicles, what the investment community has often termed “emerging” managers, can be better positioned in this market.

Again, we don’t believe that markets are or will ever be completely efficient nor will investors be completely rational.  With the various dislocations, volatility, and opportunities we see in this market, we view the high yield debt market as one area of investing where active management will always have a place, offering investors an attractive alternative to passive vehicles.  Over our years of experience in this market, we have seen over and over again where risk is mispriced, creating opportunities for potential alpha generation.

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Is It Really that “Smart” or “Strategic”?

“Smart” or “strategic” beta.  The name sounds enticing; as an investor of course we all want to be smart and strategic.  In the ETF world, we’ve seen a number of “smart beta”/”strategic beta” funds recently launched.  These funds are positioned as a twist on the traditional indexing approach, a hybrid between passive and active management.  While they generally continue to follow an index, these funds have specific construction criteria that weed out securities that don’t fit their set “rules” or “factors.”  It could be something as simple as constructing an ETF with an equal-weight approach versus a market capitalization weight approach for an equity index, or screen for companies with dividend growth or low volatility.  Or some smart/strategic beta ETFs focus on more detailed screening that include a number of “factors” (thus making them “multi-factor” smart beta ETFs).

The premise behind passive/index-based products is that they offer broad exposure to a market at a lower cost, while the argument for active management is that the human element and focusing on individual security selection can allow for the ability to outperform an index.  These smart/strategic beta vehicles claim to be a means to enhance portfolio returns and reduce risk versus the index as they try to exploit market inefficiencies with their “factors” and offer a lower cost alternative to active investing.  Others say that this is just a means for those managers/issuers to charge a higher fee then they would for a pure index-based product.  The concept is relatively new, so only time will tell.  Additionally, we have seen some people question as to whether this sort of vehicle would result in much higher transaction costs given the monthly (or more frequent) rebalancing to fit the criteria.

While this vehicle type may work in some segments of investing, such as screening out for lower volatility securities within a broader equity index or changing the weight of a security from capitalization weighted to equal weighted, we aren’t convinced that this model really adds much to the high yield market.  For instance, there was a recently issued smart beta ETF that screens for liquidity and credit quality.  We haven’t seen the specifics as to what criteria they use, but generally speaking, we feel putting on arbitrary limitations within the high yield market isn’t wise.  What if you are screening for securities based on “credit quality” using credit ratings?  But in that case, who’s to say the credit ratings are accurate?  We believe the ratings agencies should not be relied upon to determine the true credit quality of a company—they are reactive not proactive, often exclude key factors (for instance, we’ve seen them exclude a company’s cash balance when assessing leverage and liquidity), and not to mention we have all certainly seen the ratings agencies get it wrong (the sub-prime crisis evidence alone).  Rather investors should look at the company’s fundamentals, understanding the outlook and other factors impacting the company as they determine the credit’s quality and prospects.  While not billed as a smart-beta ETF, some of the passive ETFs within the high yield market do have certain criteria that they use that narrows down the index, namely the size constraints. For instance, the two largest passive high yield ETFs have size constraints that limit their investments to primarily bonds that are over a $500mm tranche size in one case and over $400mm tranche size/$1bil in total debt issued by the company in another case.  Our experience has been that size doesn’t necessarily equate to liquidity (if that is the concern and the reason for the size focus) and we have always felt these sort of limitations put investors at a disadvantage as it eliminates a sizable portion of the high yield market and what we see as many attractive investment opportunities within that eliminated portion.

High yield debt investing is a dynamic process. We believe that true active management and fundamental analysis is necessary in this market, with someone looking at an issuing company, analyzing it as a whole (not just a few “factors”) and making an investment decision; computer models alone can’t paint the full picture nor can some rules-based criteria.  We believe that alpha comes from the individual credit decisions and the portfolio construction as a whole, and with that we believe the “smart” or “strategic” investing within the high yield bond and loan market is true active management.

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Investing by Duration

With all of the talk of the Federal Reserve taking action and raising rates in the next couple months, investors naturally are considering how they position their portfolios. Duration is one metric fixed income investors often pay attention to as they assess a potential interest rate impact.  Duration is a measure of interest rate sensitivity (the percentage change in the price of a bond for a 100 basis point move in rates), so the lower the duration the theoretically less sensitive that bond/portfolio is to interest rate movements.

By the nature of the shorter maturities and higher yields, the high yield bond market generally has a shorter duration than investment grade and municipal bonds, meaning high yield bonds are less sensitive to interest rate moves. Yet even within the high yield bond market we are seeing some products and vehicles with a lower duration than others.  Like most aspects of investing, you don’t want to consider duration in a vacuum, investing only according to what vehicle has the lowest duration. As noted above, duration measures a price change due to a rate move, but the price changed needs to be coupled with the portfolio’s yield to get a better idea of the expected return under various scenarios. Let’s look at some of scenarios to see how this plays out.

First, let’s hypothetically say you could achieve a portfolio with a duration of 2.25 years, so a 100 bps change in rates over 6mos would mean that the price of your portfolio would theoretically decline by 2.25%. If your starting current yield on the portfolio was 6.5%, meaning you theoretically generate 3.25% of income over that 6mos, then you are looking at a theoretical net gain of 1% (3.25% – 2.25%) over the period of rising rates. However, if you can build a portfolio in the high yield bond and loan market investing according to both maximizing yield and considering duration (keep in mind, loans are floating rate obligations so can serve to lower a portfolio’s duration), let’s say you can build a portfolio with a duration of 3.0 years and a current yield of around 8.5%. In this case, your theoretical sensitivity to a 100bps movement over 6mos would be a price change of 3.0%, but you would be theoretically generating 4.25% of income over the 6mos, so your net theoretical gain would be 1.25%. If that 100bps interest rate movement is over a year instead of 6 months, that yield benefit gets even larger, putting you at a theoretical net gain of 4.25% for the hypothetical short duration portfolio versus a theoretical gain of 5.5% for the higher yielding portfolio.1 And of course, if rates don’t move or even decline from current levels, then the higher yielding portfolio would not only benefit from the higher starting yield but potentially a theoretical positive price movement per the duration calculation.

Below we graphically depict a this and other scenarios that show how duration and yield would theoretically interplay during periods of rising rates for a variety of scenarios.2

Duration 10-6-16a

So we see this as compelling evidence that investing purely according to a short duration strategy and not factoring in yield is not necessarily the wisest way to approach this environment.  At the end of the day, yield matters.  A higher yield can go a long way in making up for relatively small differences in duration.  Thus we believe there are benefits to having the flexibility to build a portfolio that not only maximizes yield but also lowers duration as not only a better way to address interest rate risk, but can also provide less interest rate sensitivity relative to the broader high yield market and other products without this same flexibility.  Furthermore, even if rates do rise, it very well can take longer than many expect as we have seen over the last year, making the argument for the higher yielding portfolio versus the purely short duration portfolio even stronger.  For more, see our piece “Strategies for a Rising Rate Environment.”

1 The duration and price movement relationships are theoretical approximates and calculations are provided for illustration only. These calculations assume that credit spreads, among other factors, remain constant and do not factor in any fees or expenses or changes in price movements for other reasons, including security fundamentals, etc. Actual results may be materially different.
2 The duration and price movement relationships are theoretical approximates and calculations are provided for illustration only. These calculations assume that credit spreads, among other factors, remain constant and do not factor in any fees or expenses or changes in price movements for other reasons, including security fundamentals, etc. Actual results may be materially different. Barclays High Yield Index as of 10/7/16, with “duration” based on the Macaulay duration to worst and “yield” based on a current yield assumption of average portfolio coupon divided by the average portfolio price.
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High Yield in a Rising Rate Environment

HY rising rates 1pg 9-26-16b

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Volatility Within the High Yield Market

In our conversations with investors and advisors, we sometimes hear concerns about volatility within the high yield sector expressed.  People seem to be okay with equities but aren’t sure if the high yield market is too volatile for them—seemingly under the impression that high yield bonds are much more “risky” and volatile than equities.  However, the actual data shows that looking back over the last 25 year history, high yield bonds have shown to have significantly less volatility (as measured by annualized standard deviation of returns) than equities (here represented by the S&P 500 Index).1

CS vs SPX 25yr 9-30-16

In actuality high yield bonds have had nearly half of the volatility of equities but with similar returns; thus on a risk adjusted basis (using the annualized standard deviation as the measure of risk) high yield bonds have significantly outperformed equities, as noted with a return/risk of 1.08 for the high yield bond index versus a return/risk of 0.65 for the S&P 500 index over this 25 year history.

While this may be true for the last twenty five years, does recent history paint a different picture?  In our writings we have discussed how the post financial crisis Dodd-Frank Bill and Volcker provision have worked to curtail market making efforts by the investment banks and in turn has led to higher volatility within the high yield market.  However, even looking over the last one and three years, it has continued to hold that high yield bonds show less volatility then equities.2  While the drag from high yield’s exposure to energy and commodities has negatively impacted performance in late 2014 through early 2016, bringing down the entire high yield market’s performance during the past three years, we still saw risk adjusted outperformance (return/risk) for high yield over that period.

CS vs SPX 1,3yr 9-30-16

Yes, along with the higher return potential, high yield bonds are more volatile than some other areas in the fixed income space (such as investment grade bonds); however, history has demonstrated that high yield bonds are less volatile than equities.  We believe that given the historical return profile, high yield bonds can be viewed as an alternative to equities but with less volatility, as evidenced by the historical risk adjusted outperformance versus equities over various periods.

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, data sourced from Credit Suisse. S&P 500 numbers based on total returns, data sourced from Bloomberg. Period covered is 9/30/91 to 9/30/16. Calculations based on monthly returns and standard deviation is calculated by annualizing monthly returns. Return/risk is based on annualized total return/annualized standard deviation. Although information and analysis contained herein has been obtained from sources Peritus Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and other fixed income securities involves various risks and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.
2 Credit Suisse High Yield Index data from Credit Suisse. S&P 500 numbers based on total returns. Calculations based on daily returns and standard deviation. Return listed is for the actual return for 9/30/13-9/30/16. Standard deviation is the annualized number based on the daily returns and an assumed 250 (251 for 2016) trading days per year. Return/risk is based on annualized total return/annualized standard deviation.
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High Yield Market Conditions

As we all know, the Fed held rates steady last week and while they kept the door open for a December rate hike, they certainly didn’t indicate it is a foregone conclusion.  There are a number of important data points to watch over the coming months, not to mention an important election, which may well impact the outlook for markets and rates.  So just how is the high yield market positioned in this environment?

First, we believe that that high yield market remains an attractive area for investors looking for income and yield.  While we have seen strong performance for high yield so far this year and spreads come in from the 2016 lows, we still see value here and further room for spread tightening.  As we argued at the time, the decline in high yield that we saw in late 2015 and early 2016 was way overblown given the fundamentals of many of the credits in the high yield space.  Yes, at the time, energy and other commodity prices were in free fall and the entire high yield market seemed to be taking cues from that as selling pressure was widespread across industries.  In the months since the February lows in the market, we have seen stability in energy and other commodity prices and have seen investors begin to pay attention to fundamentals once again in non-commodity credits.  The issues in commodities are now well known and the impact from these prices on the companies is visible, while the stable fundamentals outside of commodities is also visible.  Commodity related defaults have been by and far the major source of the spike in defaults so far this year, and now seem to have peaked, as defaults have begun to decline in the most recent month.  All the while, default rates in non-energy/commodity credits remain near historic lows.

On the technical side, we believe we are seeing a healthy market in terms of retail fund flows.  It certainly hasn’t been a one-way trade in flows into exchange traded and mutual funds over the recent months, with money blindly flowing into the market.  Rather, we have seen many weeks of inflows, but also some weeks of outflows, in some cases large outflows—a give and take that you’d expect during normal, healthy market conditions.1

Weekly Fund Flows 9-23-16

Yet, interest remains strong in the primary market, as we have seen pretty steady new issuance over the past few months (of course excluding the seasonal end of summer slowdown).  This is allowing companies to lower interest rates and extend bond maturities, which we believe further positions the issuing companies well for the future.

The Fed action, as well as actions by central banks in Europe and Asia, indicate this low rate environment will continue for now.  In the midst of this, we believe that today’s high yield market is offering attractive yield, especially compared to many other asset classes out there, to investors given the fundamentals of the underlying credits.

1 Leverage Commentary and Data, www.lcdcomps.com.  Based on weekly reported fund flow information, including Jon Hemingway, “HY funds outflows moderate to $273.5M this week,” 9/22/16; 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.
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