Topic Tags: Fixed Income - Below Investment Grade

Has Oil Been Oversold?

Between June 2014 and the end of January 2015, oil experienced a precipitous fall from $107 per barrel to $45 as reduced demand and excessive supply combined to drive its price significantly lower. During that time, the Credit Suisse High Yield benchmark experienced a -3% total return, as 15% of the index is comprised of energy issuers. In February, oil recovered to $52 and the high yield benchmark rebounded by 3%. Given the wide dispersion of projected oil prices, we attempt to gauge how fairly priced both oil and high yield energy bonds currently are, based on the Baker Hughes North America Rotary Rig Count.

Between June 2014 and the end of January 2015, oil experienced a precipitous fall from $1071 per barrel to $45 as reduced demand and excessive supply combined to drive its price significantly lower. During that time, the Credit Suisse High Yield benchmark experienced a -3% total return, as 15% of the index is comprised of energy issuers. In February, oil recovered to $52 and the high yield benchmark rebounded by 3%. Given the wide dispersion of projected oil prices, we attempt to gauge how fairly priced both oil and high yield energy bonds currently are, based on the Baker Hughes North America Rotary Rig Count.

The Baker Hughes North America Rotary Rig Count is an important business barometer for the oil and gas industry because it tracks active oil drilling rigs and serves as a leading indicator for the demand for oil and gas products and services. The rig count nosedived from 1,931 at the end of September 2014 to 1,267 at the end of February 2015, a period of just five months.

This week’s chart divides the price of oil by the rig count. By doing this, we can see how overpriced or underpriced oil is in the context of active rigs. The blue line shows that oil was generally overpriced over the last six years and is now somewhat cheaply priced as it falls below its average shown by the dotted blue line; the significant reduction in rig count has helped to improve this ratio. The green line shows the spread of energy bonds in the Credit Suisse High Yield benchmark divided by the same rig count. It currently sits above its average, suggesting that perhaps energy high yield bonds have been oversold, and may offer a buying opportunity for value-driven investors.

1As measured by West Texas Intermediate crude, the benchmark for oil prices in the United States.

2015 Market Preview

January 2015

Similar to previous years, we offer our annual market preview newsletter. Each year presents new challenges to our clients, and 2015 is no different: U.S. equities are at all-time highs, uncertainty reigns for international equities, and to everyone’s surprise, interest rates fell dramatically in 2014…but are poised to rise from historic lows over the next year. In the alternative space, real estate remains a solid contributor to portfolio returns, and private equity delivered on return expectations, though dry powder is on the rise. Hedge fund results were mixed, but have shown to add value in past rising interest rate environments. Further macroeconomic items that bear watching for their potential impact on capital markets include the precipitous fall in oil prices, the strengthening U.S. dollar, job growth, and international conflicts.

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The Fed Is Adding Repos to Its Toolbox

A repurchase agreement (“repo”) is a transaction in which a dealer sells securities to an investor and agrees to repurchase the securities at a future date. Typically, the dealer sells the securities at a discount to the repurchase price.  The repo market is relevant because it is a critical mechanism for the U.S. financial system to facilitate short-term lending between major financial institutions, money market vehicles, and the Federal Reserve.

A repurchase agreement (“repo”) is a transaction in which a dealer sells securities to an investor and agrees to repurchase the securities at a future date. Typically, the dealer sells the securities at a discount to the repurchase price. Effectively, the arrangement is akin to a collateralized loan with the difference between the sales price and repurchase price equating to an interest payment and the securities serving as collateral in the event of default (i.e., failure to repurchase).

The repo market is relevant because it is a critical mechanism for the U.S. financial system to facilitate short-term lending between major financial institutions, money market vehicles, and the Federal Reserve. The credit crisis in 2008 was preceded by heightened leverage in the repo market. When the fragile state of banking institutions’ balance sheets became apparent, money market funds and private lenders collectively barred access to capital for borrowers perceived to be weak. Due to a general lack of transparency as well as market fear, access to capital from the repo market dried up and sealed the fate of the likes of Lehman Brothers and Bear, Stearns & Co. who depended on it as a source of borrowing. Since then, the Federal Reserve has been aware of the need for reforms to reduce reliance on private banks and money market funds for liquidity in the repo market during times of stress.

This week’s chart shows evidence of the Fed’s intervention in the U.S. repo market to manage liquidity in lending markets and promote the stability of the financial system. In 2008, the Fed acted as a lender of cash, increasing its position in repurchase agreements, attempting to supply much needed capital to the banking system. More recently, the Fed has done the opposite. On September 23, 2013, the Fed began testing its reverse repurchase agreement program. As part of the new program, the Fed has been increasing its position in reverse repurchase agreements which means it absorbs cash from private institutions, thus acting as a borrower. While some believe this is simply a measure of monetary tightening, a more compelling argument is that the Fed is maintaining its role as a provider of liquidity despite taking the other side of the trade. In the face of high demand for U.S. Treasury securities as collateral for private institutions and money market funds, the Fed is using reverse repos to increase the availability of those securities in the market by drawing them from its own balance sheet. Meanwhile, the New York Fed is monitoring the weighted average maturity of banks’ borrowings in the repo market to identify vulnerable institutions with an overreliance on borrowing. Though the program has not yet been permanently instituted, it seems probable that the Fed hopes to use this new tool to stabilize bond markets ad infinitum.

High Yield Primary Market Indicative of Credit Cycle

Recent events have raised investors’ concerns about how much runway we have left for a risk-on fixed income portfolio. This week’s chart explores high yield bond issuance ratings and use of proceeds as indicators of where we are in the credit cycle.

Recent events have raised investors’ concerns about how much runway we have left for a risk-on fixed income portfolio. First, the ECB made an unprecedented move towards negative deposit rates for banks to deposit funds with the central bank, thereby incentivizing more lending with the aim of further stimulating Europe’s economy and containing the risk of deflation. Second, while the Fed maintains its dovish stance, swaps indicate that the market anticipates Yellen to raise rates by July 2015. Third, the TXU bankruptcy’s $20 billion in defaulted loans increased the bank loan default rate to 4.64%, but it is expected to drop back to the 1% to 2% average next quarter. Lastly, as of May 2014, 2nd lien bank loans were 4.58% of all bank loans outstanding, which for the first time since the housing bubble is above the long-term average (since January 2004) of 4.51%.

This week’s chart explores high yield bond issuance ratings and use of proceeds as indicators of where we are in the credit cycle.

The lowest quality bonds, CCC-rated, reached a peak of 32.9% as a percentage of all high yield issues in 2007, just before the housing bubble burst. For the first quarter of 2014, this figure was only 15.2%, roughly at 2004 levels. This segment of the capital-raising pipeline is very telling because it shows whether there is an atypical amount of the most speculative rated companies accessing capital to meet the demand of investors reaching for yield, which was the case in 2007. Based on the current data, this trend does not appear to be resurfacing.

Another key insight can be gleaned from how the proceeds of newly issued high yield bonds are used. More specifically, the greater the amount of proceeds used for LBOs (as opposed to less risky actions such as refinancing debt or repurchasing equity), the more heated the market. LBOs as a percentage of new high yield issues reached a peak of 33.7% in 2007, just before the housing bubble burst. However, the same data point was only 2.6% for the first quarter of 2014, which equates to 2003 levels.

Collectively, these two metrics peaked before spreads blew out during the 2008 credit crisis and deserve careful observation as the credit rally continues. Fortunately, based on current levels, they indicate that we have perhaps another few years to go before another major market correction.

High Yield, Bank Loans, and Non-Agency RMBS for 2014-2015

The following paper analyzes current valuation levels as well as future return prospects over the next few years for High Yield, Bank Loans and Non-Agency RMBS.

Given the ongoing low interest rate environment, fixed income investors continue their unprecedented quests for yield. With the persistent slow growth in the U.S., necessary monetary easing in Europe and Japan, and the sustained slowdown in China, U.S. rates that were previously expected to rise moderately in 2014 and 2015 are now projected to rise at a much slower pace, if not remain range-bound. As a result, we expect continued strong interest in the fixed income sectors that have offered the most appealing yields and returns over the last five years: high yield, bank loans, and non-agency residential mortgage backed securities. The following paper analyzes current valuation levels as well as future return prospects over the next few years.

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Lower Debt Costs in Eurozone

This week’s chart examines the improving financial conditions in the Eurozone’s peripheral countries. Italy, Spain, and Portugal have recently seen their borrowing costs reach significant lows as investors’ confidence strengthens.

This week’s chart examines the improving financial conditions in the Eurozone’s peripheral countries. Italy, Spain, and Portugal have recently seen their borrowing costs reach significant lows as investors’ confidence strengthens. Italian and Spanish 10-Year bond yields fell to 3.1% in late April, the lowest since 1999 for Italy and 2005 for Spain. After its first regular debt auction since a 2011 bailout, Portugal saw its yields drop to 3.7% marking a new post-2009 low.

More than two years removed from the European debt crisis, investor sentiment has improved as economic growth (though small) has returned to the region with participation from the peripherals. The Eurozone’s purchasing managers composite index (PMI) has been in expansion territory for nine consecutive months and hit a post-crisis high of 54 in April. While the Eurozone certainly remains in a fragile state with only a tepid level of growth, investors are encouraged by the improving conditions as well as the commitment of additional support from the European Central Bank if needed.

Time to Bail on Bank Loans?

With record net inflows, compressed spreads, rising levels of corporate debt and a dramatic increase in covenant-light loans, bank loan investors have become concerned about their investments. While there are many ways to assess future prospects for the asset class, one key indicator to examine is the amount of 2nd lien bank loans compared to the total bank loan market.

With record net inflows, compressed spreads, rising levels of corporate debt, and a dramatic increase in covenant-light loans, bank loan investors have become concerned about their investments. While there are many ways to assess future prospects for the asset class, one key indicator to examine is the amount of 2nd lien bank loans compared to the total bank loan market. 2nd lien loans outstanding as a percentage of the market is a useful gauge because it shows the level of risk investors are willing to take just to hold senior secured debt that is subordinate to 1st lien holders in the event of a bankruptcy and/or liquidation. A primary concern about the amount of 2nd lien loans is that as the market heats up and investors reach more and more for yield or, as in the case of 2007, become enamored with the illusion of safety and superior yield offered by subordinated paper, companies will issue more and more 2nd lien loans to meet that demand, as was seen throughout 2006 and 2007.

The good news is that we are not yet in such an environment. As shown in the chart above, 2nd lien bank loans outstanding as a percentage of all bank loans outstanding is currently at 3.9%, well below the peak of 6.8% reached in 2007. While it has risen from its recent trough of 2.7% in March 2013, it is still below the 10-year average of 4.5%. Although yields on bank loans have compressed over the last several years, the asset class still remains one of the most compelling fixed income investments available to institutional investors, especially relative to the much lower yields found in other sectors. Going forward, it is critical to keep a pulse on inflows, leverage, cov-lite issuance, and 2nd lien loans as a means to monitor the health of the bank loan market. However, at the present time, investors should remain in bank loans and maintain their allocations until 2nd lien loans outstanding as a portion of the whole rise well above their long-term average.

A Challenging Year for Core Bonds

This week’s chart depicts the challenging environment core fixed income investors faced in 2013. The ten-year Treasury rate jumped causing significant price depreciation while the coupons failed to cover the losses.

This week’s chart depicts the challenging environment core fixed income investors faced in 2013. The ten-year Treasury rate jumped causing significant price depreciation while the coupons failed to cover the losses. The Barclays Agg index declined 2.0% in 2013, the first negative calendar year return since 1999. This performance was made up of a -4.6% price return and a 2.6% coupon return.

Facing the prospects of low income and prices losses, many investors transitioned away from traditional core bonds in favor of higher yields and/or lower interest rate risk. It should be noted that this allocation change generally accompanies an increase in credit risk as there is no free lunch. While the bull market in fixed income is likely over and return expectations have been lowered, traditional bonds still serve an important role as an anchor to diversified portfolios, providing a steady source of income and principal repayment to investors.

Fixed Income Repositioning

This week’s Chart of the Week examines the estimated net mutual fund flows that occurred within fixed income from January 2013 through November 2013. Notable fund flow trends during this time included investors diversifying away from more traditional bond categories such as intermediate-term, municipal, government, inflation-protected bonds, and money markets.

This week’s Chart of the Week examines the estimated net mutual fund flows that occurred within fixed income from January 2013 through November 2013. Notable fund flow trends during this time included investors diversifying away from more traditional bond categories such as intermediate-term, municipal, government, inflation-protected bonds, and money markets. With generally low yield levels across fixed income asset classes and the expectation of a rising interest rate environment, investors added to categories such as bank loans, nontraditional bonds (which include unconstrained and opportunistic categories), world bonds, and short-term bonds.

Favored bond categories in 2013 tended to carry less interest rate risk such as bank loans and shorter maturity securities. Tactical investments like nontraditional bond and world bond categories where the investment manager typically has more control over interest rate or credit exposures taken at any given time also drew investment dollars. Short and ultra-short bonds were favored as a substitute for money market funds in the current low yield environment.

As investors reposition their fixed income portfolios for an expected low growth and rising interest rate environment, strategies with low interest rate risk or an emphasis on tactical flexibility within their mandates will likely continue to see net positive fund flows.

Defaults Set to Rise?

As shown in the graph above, 2013 has been a tremendous year for both investment grade and below-investment grade companies to issue debt. Given the near record low levels of both interest rates and credit spreads, the amount of issuance has not been surprising.

As shown in the graph above, 2013 has been a tremendous year for both investment grade and below-investment grade companies to issue debt. Given the near-record low levels of both interest rates and credit spreads, the amount of issuance has not been surprising. However, one of these very metrics which has driven this supply serves as a key risk metric to watch in the coming year: credit spreads. Over the last 18 months, the option adjusted spreads (“OAS”) for investment grade debt rated AA, A, and BBB has fallen; the decline in the OAS for high yield is even more remarkable.

Certainly, these declines have benefitted credit investors, but their current low levels coupled with low default rates hints that there is only one direction for defaults and subsequent credit spread levels to go: up. While we have not yet seen alarm bells ringing for either of these items, they bear watching over the coming year.