Today’s Floating Rate Loan Market

Together the high yield bond and floating rate bank loan market total over $3 trillion.1 This has evolved into a significant, and growing asset class. With high yield bonds and loans now representing about 30% of corporate credit2, this market deserves not only our attention, but we also feel is ripe with opportunity for investors.

We recently have written on the current opportunity in the high yield bond market (see our commentaries, “The Opportunity in Volatility” and “Alpha Generation for Active Managers”), but now let’s turn our attention to the opportunity set we see in floating rate bank loans. Many often see this market as a duration play—a way to invest if you think rates will rise. Yes, loans benefit from the “floating” rate via the generally quarterly LIBOR-based interest rate reset. However, investors need to keep in mind that a large portion of these loans have LIBOR floors, often ranging from 1-1.5%. This means that we would need to see LIBOR move 0.75-1.25% off of current levels to move the rate realized by the investor. As a frame of reference, we’ve barely seen 3 month LIBOR move over the last few years.3

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So not only do you need to see a pretty significant move in interest rates to surpass that floor, and we don’t expect the Fed to take aggressive action by rapidly and sizably raising rates, but you would need to also see interest rate moves here at home impact LIBOR (the London Interbank Offered Rate), despite the quantitative easing we are seeing elsewhere in the world.

While there is certainly a duration benefit to a portfolio by investing in floating rate loans, we believe that investors embracing the loan market as a pure interest rate/duration play may well be disappointed. The more significant value that we see in this market is the expansive number of issuers and issues this market encompasses, allowing investors’ access to companies that may not issue high yield bonds and/or to secured securities in a company’s capital structure, expanding the opportunity set for yield-seeking investors.

As we ended 2013 and entered 2014, the clear consensus was that interest rates were rising and with that, investors poured money into the loan asset class. From mid-2012 to April of 2014 we saw a record 95 total weeks of consecutive mutual and exchange traded fund inflows into the floating rate loan asset class, totaling $81 billion.4 During that period, loan prices ran up and yields became compressed. As that higher rate expectation clearly didn’t play out as 2014 progressed, we saw a sharp reversal in the interest in the loan market. Since the spring of 2014 through mid-February we saw 42 of the last 44 weeks post fund outflows, for a total of $35 billion over this period.5

As we have seen investors leave this asset class, we have seen loan prices fall and yields increase. For instance we began 2014 with 84% of loans trading at a premium to par ($100). Yet we entered 2015 with only 19% of loans at a premium.6 We have seen a clear spread and yield widening in this asset class, which we view as an attractive opportunity for active investors that can look for those loans that offer the best value relative to risk. Keep in mind that loans are secured securities that are at the top of a company’s capital structure, ahead of unsecured bonds and equities, adding another potential layer of risk reduction for investors.

With what we see as attractive yields and discounts creating the potential for capital gains in many cases, today we see compelling value in both the high yield bond and floating rate bank loan markets for investors who have the flexibility to not only invest in both markets but also look for what they see as the best value within each market. Again, the high yield bond and floating rate bank loan markets are large and growing, and that along with the current opportunity we see in them warrants yield-seeking investors’ attention.

1 High yield bonds market size from Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update.”  J.P. Morgan, North American High Yield and Leveraged Loan Research, January 9, 2015, p. 40. Loan market size from Blau, Jonathan, James Esposito, and Amit Jain, “Leveraged Finance Strategy Monthly,” Fixed Income Research, January 6, 2015.
2 Source SIFMA as of 9/30/2014 for total corporate debt.
3 3-month LIBOR, data sourced from Bloomberg.
4 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Leveraged Loan Market Monitor.” J.P. Morgan, North American High Yield and Leveraged Loan Research. January 5, 2015, p. 7.
5 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update.” J.P. Morgan, North American High Yield and Leveraged Loan Research. February 13, 2015, p. 9.
6 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. 26.
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Peritus in the News

Peritus was mentioned in the article “ETF Chart of the Day: Return to Junk” by Paul Weisbruch of Street One Financial, on February 19, 2015.

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High Yield in a Rising Rate Environment: Duration and Yield

We began February with a yield on the 10-year Treasury of 1.68% and today sit at 2.14%.1 All the concerns and talk of maybe even no rate rise this year that we saw in January, have turned to frequent mention of a rate rise beginning in June. So what are bond investors to do? Is this finally the year of rising rates and what impact does that have?

Yes, it is well understood that the Federal Reserve will be raising the federal funds rate off of the 0.0-0.25% target that we have seen since the financial crisis. The timing is anyone’s guess, but at the end of the day markets are forward looking mechanisms and have/will price this move in long before it actually happens. Even if the Fed does start to raise rates this year, we don’t expect them to do so rapidly and we don’t expect their actions to have a dramatic impact on the 5- and 10-year Treasuries.

That being said, one thing we know over the last year is that interest rate moves have surprised nearly everyone. But what about investors that are concerned rates will make a sizable move up and with that, how various fixed income asset classes will perform in this environment? Let’s take a look at some data points.

One primary way to evaluate interest rate sensitivity is with duration, 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 decline in price. Below are the durations and yields for various fixed income asset classes.2

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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 just about 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 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. After a big run in 2014, municipals now 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 about 3%, while the broader high yield index offers a yield to worst of twice that, over 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 15 years that we have seen Treasury yield increases (rates rise) since 1980, the high yield bond market has posted an average return of 13.7% (or 10.4% if you exclude the massive performance in 2009). This compares to an average return of 4.5% (or 3.6% if you exclude 2009) for investment grade bonds over the same period.3

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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.

For all the chatter that bonds will get hit as rates rise and it is time to move to equities, this historical data would indicate that high yield bonds have certainly not suffered as rates rose in the past. While we currently have our concerns about longer duration asset classes, such as investment grade and municipal bonds, we believe that high yield bonds are positioned well for the rate uncertainty ahead. If rates don’t move much for the year, then you have a much higher starting yield for high yield bonds, and if rates do increase, the high yield asset class has a much lower duration.   Furthermore, also including floating rate bank loans in your portfolio can serve to further reduce your duration.

Right now we see many attractive opportunities for investments for active managers in the high yield bond and loan space. There remain over-valued credits and vulnerable credits (such as certain sub-sectors of the energy space) that we would recommend avoiding, but in the mix are also many bonds and loans that offer value for active managers who can select the securities they feel are positioned well for the environment ahead.

1 5-year Treasury rates as of 2/2/15 and 2/17/15.
2 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 2/13/15 and Treasury data as of 2/17/15. 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.
3 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 5, 2009, January 5, 2010, January 3, 2011, January 3, 2012, January 2, 2013, and January 2, 2014. 2008-2012 Treasury data sourced from Bloomberg (US Generic Govt 5 Yr), 2013 data from the Federal Reserve website. 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.
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Peritus in the News

Peritus was mentioned in the article “Potential Opportunities in Junk, High Yield Bond ETFs” by Max Chen of ETF Trends, February 17, 2015.

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Alpha Generation for Active Managers

As we discussed in our recent blog (see “The Opportunity in Volatility”), we are currently seeing a lot of attractive opportunities in the high yield market—discounts and yields that we haven’t seen in some time.  And while we have seen the yields in the high yield indexes and the products that track them increase over the last six months, they don’t really seem to reflect the true opportunity we are seeing in the market.    For instance, the yield to worst on the Barclays High Yield index is 6.46%1 and many of the large index-based products are reporting yields around 6%.  While this is certainly better than the index yields of sub-5% that we saw in mid-2014, this level at face value isn’t something we’d be really excited about.  So then why are we excited about today’s high yield market and see this as an attractive entry point?

Digging into what is held in the index, we see 33% of the issuers in index trade at a yield-to-worst of 5% or under.2  The large majority of this low-yielding contingency consists of quasi-investment grade bonds, rated Ba1 to Ba3.  Not only does this group provide a low starting yield, but would expose investors to more interest rate sensitivity if and when we do eventually see rates rise (given the lower starting yields).

On the flip side, 30% of the issuers in that index are trading at a yield-to-worst of 7.5% and above2, which in today’s low yielding environment, with the 5-year Treasury around 1.2%, seems pretty decent.   This group is certainly not dominated by the lowest rated of names and within this group, we are seeing an eclectic mix of businesses and industries.  Yes, there are segments of this group that we are not interested in.  For instance, we have been outspoken on our concerns for many of the domestic shale producers in the energy space given that we saw these as unsustainable business models when oil was near $100, and those issues will certainly be acerbated with oil at $50 as cash to mitigate the rapid well decline rates and to service heavy debt loads quickly runs out (see our writings “Intentional About Energy” or “Rome is Burning”).  But there are also what we see as great mix of business and industries that we would be interested in committing money to, especially at these levels.

This is where active management is especially important.  We view active management as about managing risk and finding value.  Yes, it is about managing credit risk (determining the underlying credit fundamentals and prospects of each investment you make—basically doing the fundamental analysis to justify an investment in a given security) and managing call risk (paying attention to the price you are paying for a security relative to the next call price to address the issue of negative convexity), as we have written about at length before (see our pieces “Peritus’ Investor’s Manual”).  Yet one risk factor that is often overlooked is that of purchase price.

By this we mean buying at an attractive price.  While it isn’t very intuitive, because it often seems that the risk is less when markets are on a roll and moving up, but really the lower the price you pay for a security, the lower the risk (you have less to lose because you put less in up front).  Jumping in on the popular trade certainly doesn’t reduce your risk profile.  Rather, you want to purchase a security for a price less than you think it is worth.

As we look at much of the secondary high yield market, especially many of the B and CCC names that have been out of favor over the past several months, we are seeing a more attractive buy-in for selective, active managers, which we believe lowers our risk.  And there remains a segment of “high yield” that isn’t at prices or yields that we would consider attractive, and we will avoid investments in those securities.  Alpha generation involves buying what we see as undervalued securities with the goal of generating excess yield and/or potential capital gains.  Today, we are seeing this opportunity for potential alpha generation for active managers.

1 Barclays Capital US High Yield Index yield to worst as of 1/30/15. Formerly the Lehman Brothers US High Yield Index, this is an unmanaged index considered representative of the universe of US fixed rate, non-investment grade debt.
2 Based on our analysis of the Barclays Capital High Yield index constituents as of 1/30/15.
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Peritus in the News

Peritus was mentioned in the article “Junk Bond ETFs Try to Shake Off Energy Pullback,” by Tom Lydon of ETF Trends, February 6, 2015.

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The Opportunity in Volatility

It seems the best way to sum up on the markets of late is with the word “volatile.”  We’ve seen surprise moves on the currency and interest rate front from the likes of Switzerland and Canada and the launch of quantitative easing in Europe.  Russian hostilities are once again heating up and talk of a Greek euro exit.  Oil continued to hit new multi-year lows during the month.  There have been many major earnings disappointments, as factors such as a strong dollar and weakening demand weigh on multinational corporations.  Q4 GDP came in weaker than expected.  Thus, in January, we saw the Dow Jones Industrial Average move more than 100bps on the majority of the trading days in the month and both the Dow and S&P 500 fall over 3% on the month.  We’ve seen the 10-year Treasury yield fall from 2.17% to 1.68% and the 30-year Treasury yield fall from 2.75% to 2.25%, a decline of a whopping 49bps and 50bps, respectively.

While volatility is generally viewed as a negative thing in investing—in fact, risk is often measured in terms of volatility of returns—it isn’t always necessarily negative.  In reality, we believe that volatility can create some compelling opportunities for investors, especially for those that are actively managing portfolios.  But its nature, volatility often leads to issues in specific securities or industries causing contagion to other areas of the market.  This in effect can create securities that have been hit purely by that contagion, and for no other fundamental reason.

We believe this is exactly what we are seeing right now in much of the high yield market.  Some of this contagion from weakness in the energy sector and in equities has bled over into the high yield space, creating what we believe to be compelling opportunities in many non-energy related names for which we have seen no change in the fundamentals of the businesses.  Many of the high yield issuers tend to be relatively small, niche, largely domestic focused companies.  Thus we would expect many of them to be much less impacted by currency factors hurting large multinationals that are pervasive in investment grade corporates and the large equity indexes.  While the US economy has had some hiccups, we certainly don’t expect to see a massive economic decline here.

As we look at today’s high yield investment landscape, we are excited about the current opportunities we see.  Since last June, yields for high yield bonds have increased 1.79% and spreads for the high yield market versus Treasuries have increased 188bps to nearly 600bps.1  Some of this is rightfully so in the energy names (see our recent writings on our concerns for US shale issues), but there is also much of the market that has been hit for what we see as no fundamental reason.  When we see prices decline and yields increase for what we view as no fundamental reason, we would view that as an attractive entry point.

To give the opportunity we currently see a little more tangibility, consider the statistics below:2

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So since last June, the month during which we saw the recent lows in spread levels, we have seen the percentage of the index at a discount to par move from a mere 11.5% to over 37% and the percentage of the index at a yield-to-worst level of 7.5% or higher move from about 11% to just under 30%. This means that today, there are over 830 individual bond issues that are priced sub $100 and nearly 700 individual issues that trade at a YTW of 7.5% or higher within the Barclays High Yield Index. So as we look at the landscape, there are plenty of names to evaluate and opportunities offering what we see as attractive yield and capital gains potentials. Furthermore, we see this opportunity as even more attractive given the expectations for a benign default environment to continue, excluding certain sectors of the energy space.3

 While 2014 was characterized largely by the lack of volatility for most the year, and active management suffered as a result, we see those tables turning in 2015 as we expect this volatility to continue.  As we sit today, we see an attractive entry point into the high yield market for active managers who can parse through the space to determine where there is value to be had, and where there are value-traps.

1 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, June 26, 2014, p. 33 and January 29, 2014, p. 33, as represented by the JPMorgan High Yield Bond Index, which consists of fixed income securities with a maximum credit rating of BB+ or Ba1. Referenced spread is “spread to worst” and referenced yield is “yield to worst.” The yield to worst is the lowest potential yield that can be received on a bond, without the issuer actually defaulting, and includes the various prepayment options such as call or sinking fund.  The spread is the spread to worst based on the yield to worst less the yield on Treasuries.
2 Based on our analysis of the Barclays Capital High Yield index constituents as of the indicated dates. Barclays Capital US High Yield Index. Formerly the Lehman Brothers US High Yield Index, this is an unmanaged index considered representative of the universe of US fixed rate, non-investment grade debt.
3 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. 14. See data in our piece “The Year Ahead: High Yield, Energy, and Interest Rates.”

 

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Upcoming TV Appearance

Ron Heller will be a guest on Fox Business Network’s “Countdown to the Closing Bell” on Tuesday, January 27th at 3:45pm ET.

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Upcoming TV Appearance

Tim Gramatovich will be a guest on Bloomberg’s “Market Makers” on Friday, January 30th, at 10am ET, to discuss the energy markets.

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Upcoming Conference

Ron Heller will be in attendance at the TD Ameritrade 2015 National Conference, in San Diego, CA from January 28th to January 30th. Stop by booth #S8 to learn more about Peritus’ strategy and products.

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