Topic Tags: Fixed Income - Below Investment Grade

Global Bonds and Negative Yields

This week’s chart examines the change in yield for global sovereign debt. While we have been in a low interest rate environment since 2008, over the last three years, we have seen negative yielding bonds move from 0% of the developed bond universe to 38%. A staggering number indeed, this has been the by-product of anemic global growth and aggressive monetary policies in Europe and Japan.

This week’s chart examines the change in yield for global sovereign debt. While we have been in a low interest rate environment since 2008, over the last three years, we have seen negative yielding bonds move from 0% of the developed bond universe to 38%. A staggering number indeed, this has been the by-product of anemic global growth and aggressive monetary policies in Europe and Japan.

One of the consequences of a negative rate environment is increased demand for higher yielding assets. Through the second quarter, U.S. high yield and emerging market debt have returned 9.1% and 10.3%, respectively. In addition to attractive yields, these asset classes have benefitted from stability in commodity prices and minimal exposure to the Brexit event. Should these conditions persist going forward, expect investor preference for credit and higher yielding bonds to continue, given this historically low interest rate environment.

A Bifurcation in High Yield Defaults

The price of oil recently rose over $50 per barrel following a dip near $30 only a few months ago. Despite this price recovery, many high yield energy issuers are still finding it difficult to make their debt payments, and default activity surged in May.

The price of oil recently rose over $50 per barrel following a dip near $30 only a few months ago. Despite this price recovery, many high yield energy issuers are still finding it difficult to make their debt payments, and default activity surged in May. These defaults are defined as missed coupon payments, missed principal payments, bankruptcy filings, or distressed exchanges. Notable May defaults include Linn Energy, SandRidge Energy, Midstates Petroleum, Breitburn Energy Partners, and Penn Virginia.

The default rate of the overall high yield index is now 5.2%, as shown by the blue line in this week’s chart. The default rate has recently risen due to more defaults in the high yield energy and metals/mining sectors. Defaults of issuers in that space now stand at 17.8%, as shown in the red line. Meanwhile, excluding energy and metals/mining, the default rate is at pre- and post-crisis lows, at 1.7% as shown in the green line. This bifurcation means that while the energy and metals/mining sectors have suffered from low oil and metals prices, the rest of the economy — healthcare, technology, financials, etc. — have performed as well as ever, at least in terms of how defaults can reflect performance.

The 5.2% overall high yield default rate and the 17.8% high yield energy and metals/mining issuer default rate confirm our previous paper about expected defaults for the year. Based on March-end spreads as a measure of the market’s expectation of defaults, the market was implying a default rate of 4.77%. The range we provided was 4% for the overall high yield default rate if the high yield energy and metals/mining issuer default rate reaches 10%, to 6.2% for the overall high yield default rate if the high yield energy and metals/mining issuer default rate reaches 30%, to 8.4% for the overall high yield default rate if the high yield energy and metals/mining issuer default rate reaches 50%. With the steady rise in the price of oil, we would be surprised to see the high yield energy and metals/mining issuer default rate reach as high as 50%, which should eliminate the worst case scenario for high yield investors. Of course, capital markets are dynamic and can change unpredictably, so we will continue to monitor this trend.

Is the High Yield Market Expecting a Rise in Defaults?

May 2016

Given the depressed oil prices earlier in the year coupled with the recent credit rally, we have gotten many questions from clients about the future direction of default rates, particularly for high yield bonds. In early February, the question was about how high default rates would rise as a result of low oil prices and their subsequent impact on high yield issuers, particularly those in the energy sector. Now, as credit has rallied, investors are wondering if expected default rates are too pessimistic in light of the rally and rise in oil prices. This newsletter contemplates the current implied default rate for high yield bonds and how successfully it has predicted actual default rates, all in an effort to further examine the state of the high yield market. Ultimately, the goal is to provide our clients with guidance on how current conditions in the market could impact their portfolios over both short and long term investment horizons.

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2016 Market Preview

January 2016

Similar to previous years, we offer our annual market preview newsletter. Each year presents new challenges to our clients, and 2016 is off to a volatile start with equity markets down significantly, oil dropping below $30, the Fed poised to further increase interest rates, and fears of a China slowdown rippling through the markets. However, other headlines will emerge as the year goes on, and it is critical to understand how asset classes will react to each new development and what such reactions will mean to investors. The following articles contain insightful analysis and key themes to monitor over the coming year, themes which will underlie the actual performance of the asset classes covered.

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High Yield: Where Do We Go From Here?

December 2015 Investment Perspectives

The recent sell-off in the high yield markets caught many investors by surprise, and has emerged as a primary concern as the year comes to an end. Given the magnitude of the sell-off, it is fair to ask if more bad news is to come from the high yield market and if investors should reduce their allocations to the asset class before year-end. The following newsletter examines the recent market drop and offers perspective on future prospects for the asset class as well as considerations for investors with allocations to high yield.

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What Happened to High Yield?

The recent sell-off in the U.S. High Yield market has caused concern among investors and many worry that the situation will worsen before improving; this is especially concerning because of its effects on portfolio values before calendar year-end. The Credit Suisse High Yield Index returned -1.08% on Friday December 11th and recorded another down day when the markets reopened on Monday with a return of -1.39%.

The recent sell-off in the U.S. high yield market has caused concern among investors and many worry that the situation will worsen before improving; this is especially concerning because of its effects on portfolio values before calendar year-end. The Credit Suisse High Yield Index returned -1.08% on Friday, December 11th and recorded another down day when the markets reopened on Monday with a return of -1.39%. Through December 14th, high yield has dropped 4.15% for the month and 6.11% for the year. As of December 14th, the yield for the index is 9.42% and the spread is 774bp.

The declines reflect liquidity concerns in the high yield market after the closure of a junk-bond mutual fund. Many investors took advantage of low bond prices after the financial crisis, betting that the U.S. economy would recover. While that thesis proved to be a profitable one, there has been a gradual change in sentiment, with significant outflows in high yield mutual funds over the last three years, including $10.5 billion this year. So what is driving this liquidity concern and subsequent sell-off?

Many would argue that the prolonged period of low oil and other commodity prices are the primary drivers of the sell-off, and are expected to drive default rates higher for the energy portion of the high yield index. As shown in the chart above, energy and metals/minerals constitute roughly 18% of the index. With commodity prices struggling and OPEC not willing to slow production in oil, the fear is that the underlying prices will continue to fall. A further fall in prices — particularly in the energy and metals/minerals industries — will lead to greater revenue losses and a higher likelihood of defaults. Although default rates for the other sectors of the index are expected to remain close to their long-term averages, high yield funds with a significant overweight to the energy and metals/minerals sectors may suffer above average losses over the coming year.

How to Position Fixed Income Portfolios for the Rate Hike

October 2015 Investment Perspectives

Much has been written and discussed in the media about when the rate hike will begin and the pace at which it will occur. Ultimately, the timing and pace are difficult to predict because they depend on many moving parts, including unemployment, inflation, and a host of unpredictable economic and political factors. The right question to ask is: How should an institutional investor position a fixed income portfolio for the rate hike, regardless of the associated timing and speed?

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High Yield: Don’t Throw the Babies Out With the Bathwater

This week’s Chart of the Week takes a look at the sell-off over the last month in risk credit as a direct result of global concern over China’s continued slowdown. Our chart shows the high yield bond spreads for each industry since the beginning of the year.

This week’s Chart of the Week takes a look at the sell-off over the last month in risk credit as a direct result of global concern over China’s continued slowdown.  Our chart shows the high yield bond spreads for each industry since the beginning of the year.

Not surprisingly, spreads for energy high yield issuers, shown in the purple, and spreads for metals/minerals high yield issuers, shown in the pink, have widened dramatically. In other words, their prices have depreciated significantly, as there is an inverse relationship between bond prices and their spreads.  This widening of energy and metals/minerals high yield bond spreads was due to the financial markets’ recognition of reduced Chinese demand for energy and metals/minerals.

However, all other sectors from chemicals, shown in the red, to utilities, shown in the orange, have seen their high yield spreads widen out as well. In our opinion, this is akin to throwing “the babies out with the bathwater.” In other words, the widening of spreads in all other industries except for energy and metals/minerals appears to be unjustifiably so.  The last two weeks have seen spread tightening across all industries as news of general stabilization has come out of China and Europe.  However, spreads for all other industries except for energy and metals/minerals remain elevated compared to where they were in the spring, suggesting some good value and opportunities in high yield within these industries.

Impact of Higher Interest Rates on High Yield Bonds

Under the Fed’s zero interest rate policy, high yield bonds have enjoyed a terrific run of performance. For the five year period ending June 30, 2014, the Barclays U.S. Corporate High Yield index produced an impressive annualized return of 14.0% per year. However, returns in this more speculative portion of the bond market have been disappointing since last summer, when the high yield spread over Treasuries reached a multi-decade low of 221 basis points.

Under the Fed’s zero interest rate policy, high yield bonds have enjoyed a terrific run of performance. For the five-year period ending June 30, 2014, the Barclays U.S. Corporate High Yield index produced an impressive annualized return of 14.0% per year. However, returns in this more speculative portion of the bond market have been disappointing since last summer, when the high yield spread over Treasuries reached a multi-decade low of 221 basis points. The index fell 0.4% in the twelve months ending June 30, 2015, and has continued to show weakness, falling another 1.9% through the middle of August.

This week’s chart examines the past relationship between high yield spreads and rate tightening cycles.1  Although there certainly isn’t a perfect correlation, tightening activity by the Fed has often caused high yield spreads to widen, significantly impacting total return potential. It is no secret that low and stable interest rates are good for speculative companies that are active in the debt markets. While a rake hike doesn’t spell impending doom for the entire high yield universe, some of the more speculative borrowers who have become accustomed to borrowing at ultra-low rates could be in trouble, particularly if the Fed embarks on a prolonged period of successive rate hikes. As we prepare for the first Fed rate hike — likely later this fall — it will be important to pay close attention to high yield exposure within investment portfolios as well as manager positioning within the high yield space.

1 Most recent rate tightening lines refer to the end of QE 1 and 2 and the start of the Fed’s tapering

Compelling Valuations for Energy Distressed Debt

Given the environment of record issuance and low yields, one is hard-pressed to find fixed income bargains. With the S&P 500 and P/E ratios at record peaks, bargains in equities are similarly few and far between. Energy distressed debt, however, is presenting extraordinary bargains.

Given the environment of record issuance and low yields, one is hard-pressed to find fixed income bargains. With the S&P 500 and P/E ratios at record peaks, bargains in equities are similarly few and far between. Energy distressed debt, however, is presenting extraordinary bargains. Since the energy dislocation began, an unprecedented amount of high yield energy bonds, especially those of shale fracturing E&P companies, have been trading in distressed/stressed territory. As shown in this week’s chart, the bars represent the par value of U.S. high yield energy bonds. The blue bars show the cross-section for May 2015, when $2.5 billion of bonds were priced at zero to 20 cents on the dollar, $2.1 billion were at 20 to 40 cents on the dollar, $7.0 billion were at 40 to 60 cents on the dollar and $19.9 billion were at 60 to 80 cents on the dollar. These values sum to $32 billion, or 15%, of bonds trading between zero and 80 cents on the dollar, which is known as distressed/stressed territory. Contrast this with June 2014, shown in the red bars, when only $0.8 billion, or less than 1%, were distressed/stressed. Clearly, this is an opportunity set that has emerged in the last twelve months and could pay off for investors.

There are two key channels through which investors can access this unprecedented opportunity. One is investing with an energy direct lender, which has two advantages. First, direct lenders can buy into a company’s debt at the top of the capital structure, above any existing bank loans and high yield bonds. This, in turn, gives the investor first-in-line access to the company’s assets in the event of a liquidation. Second, a direct lender can create further protection by negotiating heavy covenants, in contrast to the covenant-light bank loans and high yield bonds existing in the marketplace today.

The second approach is investing with a manager that specializes in buying distressed debt and working with the issuer through a restructuring to extract outsized value from the position. Because such managers would invest in existing covenant-light paper, it is beneficial to choose one that diversifies across oil and gas, coal, electric utilities, and alternative energy.

While distressed energy debt may not be appropriate for all institutional investors, it could also prove accretive to clients in the coming years. As we have seen many times in the past, buying at depressed prices often leads to outsized returns in subsequent years. Given the overall high valuations in the financial markets, we believe distressed energy offers a compelling valuation at this time and could help boost future portfolio returns.