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.
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.