In like a lamb, out like a lion seems to be an accurate description of the first half of 2015. As we sit in the second week of July, Greece and China have changed investor psychology (risk-off). The overall deflationary threat globally has likely changed the timing of Federal Reserve interest rate hikes as well. Oil has once again rolled over and is likely to test 2014/early 2015 lows.
Recent spread widening for high yield bonds and loans caused by events in Greece and China gives investors what we see as an outstanding entry point and we believe that these assets need to be bought aggressively. Outside of energy (domestic oil and gas exploration and production, and certain oil services companies), we expect default rates to remain well below average. In this environment, we believe that an active and thoughtful portfolio of high yield bonds and loans should continue to outperform various asset classes, including equities and investment grade corporates, for the rest of 2015, just as the high yield market has outperformed in the first half. For more of our thoughts and strategy for today’s market and outlook going forward, click here to read our “Mid-Year Update.”
2014 will go down as a year that was a “statistical champion” as both stocks (as measured by the S&P 500 and the Dow Industrials) and bonds (the more interest rate sensitive asset classes) had very good years. It was a year of duration over credit. What we mean is that interest rate sensitive sectors (Treasuries, mortgages and investment grade) dominated, while credit (high yield bonds and loans) were beaten down. At the beginning of 2014, we were one of the few firms calling for flat to lower rates, but even we did not see an 80 basis point move down in the 10-year Treasury.
So where does that leave us as we head into 2015? Stocks look extended. They are not cheap by any measure but the party continues until it doesn’t. How about bonds? Wholesale selling of the high yield asset class due to its large exposure to the energy industry has created what we see as attractive entry points into numerous names that have nothing to do with the energy markets. We did not see these types of discounts going into 2014. While we don’t expect interest rates to rise much in 2015, they are unlikely to fall and become a tailwind for longer duration asset classes, such as investment grade bonds. Read more of our piece, “The Year Ahead: High Yield, Energy, and Interest Rates,” click here.
The concurrent storms in energy and the secondary bond/loan markets have tested our mettle. However, we believe that both of these will pass as quickly as they came, but provide fantastic entry points for thoughtful investors as there is a hard cold reality every investor is facing: interest rates (yields) remain paltry and we expect will continue to for the foreseeable future. We ultimately expect the underlying fundamentals in certain segments of the energy sector will be realized and now are seeing yields and discounts (to par) in the broader high yield market that we have not seen for some time. This compares to an equity market where we expect valuations to struggle to move higher in a world of slowing growth. For more on our thoughts about financial markets and outlook, click here to see our latest piece, “Rome is Burning.”
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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Peritus I Asset Management Disclosure:
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. These reports are for informational purposes only. Any recommendation made in these report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and loans and other fixed income, equity, and fund securities involves various risks and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results. Historical performance statistics and associated disclosures available upon request.