As we enter 2014, we see several themes. The economic consensus appears to believe that the “recovery” is in the beginning stages and the global all clear sirens have sounded. This does not pass our smell test. But even if one were to drink this flavor of economic Kool-Aid, you would ignore the fact that financial assets have dramatically outperformed the real world of earnings and economic growth. After five straight years of equity gains and excessive valuations, isn’t the good news already baked in, and then some? We think it is. We do not believe that equity indexes will reward investors in 2014.
Turning our attention to the fixed income markets, the consensus here appears to be Fed tapering will lead to higher interest rates across the board. While this may happen in the short run, demographics, liability driven investing, and a lack of global growth may surprise everyone and take interest rates nowhere. We see the high yield market as positioned well in the year ahead irrespective of rates and that in a trendless 2014, true active management in all asset classes will be required. Click here to view our year-end piece, “Of Elephants and Rates.”
Click here to view our most recent writing, “Tapping into Tapering.” It’s been quite a couple of weeks. So where to from here and what are investors to do? Our summary and conclusions are as follows:
- The high yield bond market has historically been negatively correlated with rising rates, offering investors the best of both worlds: protection against rising rates and excellent yield. We believe that it is simply the best risk-return asset class in fixed income.
- The enemy to the high yield investor is defaults, not rising interest rates. The default environment over the coming few years is likely to be significantly below the long term average. With high yield spreads now dramatically higher due to the contagion of the Treasury market, we view the value proposition for investors as superb.
- Investors should view with caution the idea that equities alone will be the place to be going forward. Recent action has shown that Fed-induced liquidity has blown plenty of bubbles, including the broad equity market. Economic data out of Europe and China shows a continuing contraction of economic activity and the domestic economy remains subdued at best, as evidenced by the recent 1.8% GDP number.
- Whether rates rise or not, we believe that the high yield bond market offers investors excellent tangible income and is among the shortest duration asset class in fixed income.
Regardless of where rates go from there, the recent knee jerk selling of everything has given investors what we see as a tremendous entry point to the high yield market, especially for value-oriented, active managers such as Peritus.
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.
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