First Half Update

After seeing prices indiscriminately marked down virtually across the board in the second half of 2015 and first couple months of 2016, general high yield market sentiment improved beginning in late February, helped by oil prices stabilizing and the realization any material change in interest rates is not on the near-term horizon.  We are now seeing a rebound in bond prices and returns throughout the high yield market for the various indexes, as the solid fundamentals for many credits outside of energy remain intact.

We now have a full six months under our belt with some of the recent strategy adjustments, primarily our new issue allocation that we began implementing last December.  As a reminder, with the banking regulation changes that went into effect in 2015 and liquidity concerns across the market, we implemented this strategy to proactively address these concerns.  Our research and experience had shown bonds tend to be the most liquid in the first several months after issuance as the institutions bringing the new debt to market are using their capital to support those deals in the secondary market and then in the months following you often see indexers and insurance companies adding exposure, providing another bid to these securities; thus we decided to strategically allocate a portion of our portfolio to new and newly issued bonds.  In the first six months of the implementation, we are seeing the intended benefits in terms of improved liquidity and lessened volatility.  We have and will continue to roll out of prior purchase every few months into the newest issued bonds, and so far we are finding we are also able to sell the majority of the positions we exit above par.  As we move forward, we see the ability to implement a strategy along these lines as a definite advantage of having a portfolio of actively managed bonds.

We also continue to allocate a portion of our portfolio to floating rate loans.  In many cases, the loans are at the top of the company’s capital structure and are less volatile, often providing stability.  We continue to see further opportunity in the loan space as we move forward, as many first lien loans have been sold off as investors have realized the floating rate aspect to those are not needed as rates are not going up any time soon; yet these are often companies with very low leverage that are trading at nice discounts, providing reasonable yields.

The remaining portion of our portfolio is our “alpha” bonds—our traditional fundamentally driven, value approach to credit investing whereby we are investing in bonds in which we see an attractive yield relative to the risk.  We are now seeing that  company fundamentals are being rewarded by the market.  By and large we are seeing generally stable revenues and earnings (which we measure by EBITDA, earnings before interest, taxes, depreciation, and amortization) outside of energy and commodities.  It should be noted that the high yield market consists largely of domestic (North American) focused companies, thus we have much less international exposure than we’d expect to see in many larger, multinational companies that are prominent in the equity indexes and issuers of investment grade corporate bonds.  We have had our concerns about the state of the global economy, as there is little in the way of catalysts to drive growth outside of the U.S., and apparently the IMF agrees, as they just lowered their global growth forecast, citing Brexit and the uncertainty it creates as one of the factors.

We believe that our active strategy fits well in today’s high yield market and as we move forward, as it affords us the ability to take advantage of what we see as the many attractive investment opportunities in both the bond and loan markets, all the while being able to work to address liquidity via smaller position sizes and the strategic new issue allocation.

1  Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update,” J.P. Morgan North American Credit Research, July 15, 2016, p. 1.
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