We have all witnessed a major move in Treasury rates over the last couple months, causing concern for many that we may well be in the early stages of a rising interest rate environment. The traditional thought is that as interest rates rise, bond prices fall. But looking at history, the high yield market has defied this widely held notion. Let’s examine the four main reasons why high yield bonds have historically performed well during times of rising interest rates. Click here to read more.
I have been an investor in the energy space for over 25 years. Outside of interest rates, I don’t believe there is anything that dominates the global economy more than oil prices. It is a product that touches every area of our lives. Like it or hate it, that is the reality. In my opinion, there is something dramatically wrong, as crude oil and gasoline prices are near all-time highs, yet the global economy remains stuck in neutral. I believe that we are being fed a bunch of nonsense with the rhetoric that the U.S. will be energy independent and that new technologies have released a torrent of new oil reserves. The price action is telling us something else entirely. Click here to read more.
We have just completed our most recent writing, “Certainty, Rates, and the Year Ahead.” Even after a strong showing for high yield bonds in 2012, we continue to believe that this asset class remains in the sweet spot for investors in 2013.1
- High yield bonds have a short duration and limited interest rate sensitivity, given the shorter maturities and higher coupons. We would expect to see higher rates in 2013, which will punish investors in high grade bonds that are more sensitive to rate changes.
- The primary risk for high yield investors is credit risk, which looks to be very tame and manageable over the coming years, as evidenced by the historically low default rates projected by J.P. Morgan and the conservative leverage metrics that we are seeing.
- While all the talk is about the leveraged loan market, we are not convinced. The default outlook for this market is even higher than that for high yield bonds, which would indicate the concept of “lower risk” is an illusion. Additionally, while higher rates would favor the lower duration/floating rate of leveraged loans, the higher interest cost would hurt the credit metrics of loan-heavy capital structures. We encourage investors to use the loan market to expand the number of opportunities to invest in, not to produce what could be illusionary portfolio math.
- While generally low rates and a risk-on mentality appear to favor equities, poor global growth patterns will likely put a cap on returns and will hamper earnings growth and multiple expansion.
We hope you take the time to read our full writing and we look forward to the year ahead.
1 See the paper for source references.
We see trouble developing and this has recently been supported by “more than a feeling.” Tangible signs of fundamental weakness are appearing everywhere, yet financial market participants are simply choosing to ignore these signs. Discipline is once again absent, and the consensus is that fundamentals simply don’t matter and “don’t fight the Fed” is the only thing you need to know. The challenge is navigating the weak fundamental picture with what we believe to be the beginning of a 15-20 year positive technical backdrop for fixed income, yield generating assets.
We see a technical shift underway that puts yield generating assets, such as high yield bonds, in the sweet spot. This not a “bond bubble,” but rather the beginning stages of the next cycle. With the lack of economic growth, valuation expansion, and dividend generation in equities, the yield trade is in full swing and we expect that with the favorable market technicals and demographics, this will continue. Ultimately, we expect that performance in the credit markets will be determined by pure alpha, which comes from the ability to select individual credits—the right credits—and to invest in areas others can’t or won’t.
Exchange Traded Funds (“ETFs”) for high yield bonds have become a bigger factor in today’s market. However, we believe that the passive, index-based funds have no ability to deal with risks in the current credit market. This involves credit risk, as well as call and pricing risks. The larger on the run names have become significantly over-valued as current market prices are way above their call price. We believe that this will lead to future principal losses, not from default but from these bonds being called well below current trading prices. Additionally, the passive funds hold numerous credits that in our mind are likely defaults and/or restructurings waiting to happen. By their passive nature, these funds do not sell or steer clear of these questionable securities or the over-valued bonds in today’s market. Furthermore, the largest high yield index based ETFs exclude a huge portion of the actual high yield market due to their issue size minimums.
Active management is essential in the high yield space; what you don’t buy is just as important as what you do buy. As an active manager, Peritus does not have the constraints these passive funds face and that flexibility gives us a dramatic advantage in today’s market.
Investors have come to recognize that there is a secular change occurring in financial markets. After the 2008 meltdown, we have watched equities stage an impressive rally off the bottom, only to peter out. There is no conviction and valuations are once again stretched given the lack of growth as the world economy remains on shaky ground. Unfortunately, there is another hard reality to deal with. The 30 year decline in interest rates is also coming to a bottom. Though we are not in the camp that yields necessarily have to rise dramatically from here, there is little room to fall a whole lot further. This means that most fixed income investors will likely at best earn the coupon on their securities and nothing more. This leaves the question: How do you generate some type of tangible return? Our answer is high yield bonds. High yield bonds produce the tangible yield investors need and desire and have become virtually the only place to turn to for yield in this prolonged low-rate environment. However, we believe the true opportunity for investors is the alpha available via active management. Playing the statistics of the high yield market through beta or indexing, or embracing some of the “strategies” based on ratings or maturity, we expect will ultimately be a loser’s approach to the space.
We believe it is time that investors and investment advisors wake up to the new realities of the world. The notion of equities magically compounding money at double digit rates should have been put to death over the past decade where the S&P 500 has effectively returned nothing. Amazingly hope springs eternal, as both pension accounting and many investment boards and consultants continue to spew the dribble that the next decade will be terrific for equity investors. We see limited growth for equities for the foreseeable future, and most other fixed income alternatives are currently offering very little in the way of yield. Yet the high yield bond market has not only proven to outperform equities (see document for data), but offers a much better yield than both equities and various other fixed income asset classes. We anticipate that investors have a limited window to allocate significant resources to the high yield market and lock in what we see as very attractive yields. We believe that this window will ultimately close as more people recognize the opportunity, which will reduce the yields available.
We have recent been asked first, is the timing right to commit money to the high yield asset class, and, second, how much of a client’s portfolio should be invested in high yield bonds. With the recent spread widening in the high yield market, we feel this space is now offering investors compelling value and history would indicate that spread levels such as we are seeing today provide an exceptionally attractive entry point.
As we look ahead, we see plenty to be concerned about—we are in the midst of a prolonged stagnant economy and Europe is facing mounting issues—however we believe the end result is a resetting of expectations and re-pricing of global equity markets rather than anything economically devastating. Corporate credit remains the port in the current storm for investors and we view an actively managed high yield bond portfolio as offering the best risk/return within this market.
The high yield market has had a significant run over the past couple years, no one can deny that, so is there value still to be had in the space? We think so. Based on current spread levels and benign default expectations for the next couple years, further spread compression is not unreasonable. There are still yield opportunities to be had for those that will take the time to scour the market for these values.
Concerns about inflation and rising interest rates abound right now. The traditional thought is that as interest rates rise, bond prices fall. But looking at history, the high yield market has defied this widely held notion; instead, high yield has historically performed well during a rising rate environment. We look at the four main reasons that explain the high yield market’s lack of sensitivity to interest rates.
ETFs are one of the fastest growing investment products due to their ease of accessibility and operational tax efficient structure. The benefits to investing in an ETF include access, broad exposure, liquidity, transparency, tax efficiency, and income. Additionally, there are benefits to active management within the ETF space.
As we have discussed over the last few quarters we believe that equity investors have been involved in the biggest head fake in history. The notion that nothing in the economy has been fixed is now coming to the forefront.
Our belief is that credit is either AAA or D (paying and expected to continue to pay or not paying and in default). So to us this company was in effect AAA, while one of the major rating agencies was telling us that these bonds “are likely in, or very near default.” There continues to remain a massive disconnect among investors about the corporate bond market, the ratings process and risk.