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Question of the Week

Question of the Week - December 14, 2015

Guest Post - Monday, December 14, 2015

What’s going on with the high yield bond market?

The short answer: nothing we haven’t already known, but it’s reminder about how niche markets such as high yield work. For perspective’s sake, the market is just over $1 trillion in size, which is a fraction of the $70 tril. global equity market footprint, so conditions can get stranger here and more quickly.

It’s important to remember that while bond managers care about earnings, they don’t obsess to the same degree equity managers do. They don’t need to. As long as bond issuers create sufficient earnings, or cash flows more specifically, to honor coupon payments and retain certain ratios of earnings-to-interest payments among others as buffers for harder times, bondholders are happy. It’s not about explosive growth, it’s about being paid back on time and avoiding defaults (and downgrades, whenever possible). This is why credit research is critical in this space.

Currently, 80-90% of the high yield market has been described by active managers we’ve both spoken with and reviewed commentary from, to be in decent shape from a fundamental standpoint—this includes a fairly broad swath of consumer companies, health care as well as industrials. To no surprise, this reflects the situation with equity markets, where the bulk of sectors have experienced positive earnings growth over the past year. By contrast, 10-20% of the high yield market is pressured or distressed, and has been priced as such, in fact with pricing already assuming defaults in the most distressed areas. These areas include the problematic energy, materials and mining companies, which have been under the microscope for the larger part of a year. While the composition of the S&P 500 is just over 10% in these troublesome sectors, they represent about double that proportion of the overall high yield market.

The decline in oil prices over the past year has been dramatic, and while larger integrated global oil companies such Exxon Mobil, Chevron and the like, are diversified enough and use more sophisticated tools to hedge against a variety of oil price uncertainties (their biggest risk), smaller exploration and production-only firms are generally much less complex. To no surprise, these smaller ‘high-beta’ firms perform best in periods of strong and rising oil prices where market pricing significantly exceeds marginal costs of extraction/production.

However, when oil prices fall dramatically, and more importantly, stay at low levels for extended periods, higher-cost drilling projects that once made sense under high oil prices don’t pencil out at lower levels. At the same time, it’s hard to flip a switch overnight and turn projects on/off considering the high levels of capital expenditure invested and fickleness of prices in the short term. This has been part of the problem. While domestic production capacity has finally leveled off somewhat and rig counts are lower from capacity being taken off-line, the more efficient wells are still pumping at high levels. So, these firms that are generally highly-leveraged anyway are experiencing cash-flow concerns, again based on how long this low price environment lasts. Of course, this isn’t a surprise development, and represents one of the biggest risks in energy sector investing (for bonds or stocks). It’s also one of the reasons why we tend to believe active management makes very good sense, particularly in some market segments like high yield debt. We can see the results over the past week, where popular exchange-traded fund HYG has fallen by some -2% in line with the index, where several higher-quality focused open-end mutual funds have suffered significantly less—due to much lower weightings to the energy/materials complex, for example, where these problems had been spotted very early on. (Although some firms have been spotting interesting, potentially oversold opportunities here.)

At the same time, that doesn’t stop the scary headlines. Word came out Friday of a well-known ‘focused credit’ mutual fund closing its doors, putting ‘gates’ in place for fund shareholder redemptions and an eventual fund liquidation. Why the scare? Unfortunately, liquidity has a price, and this might be a reminder of how certain strategies that can make sense in endowments/foundations or separate accounts don’t always work with daily NAV products and shareholders who can demand their money back on a same-day basis. Most of the bond market, and particularly the lower-rated market, doesn’t trade by the millisecond like the stock market does. Some bonds trade infrequently, if at all, and often the best investment results occur when managers can buy distressed paper at very cheap levels, hold onto it for several years, clipping a very high coupon in the meantime, and wait for maturity. Shareholder redemptions create a bump in this path as managers are required to sell paper at current market prices at any given time, which may not be ideal (considering retail investors’ success rates in calling market tops and bottoms, it more than likely the opposite). So, this makes operating such a vehicle difficult when markets hit speed bumps, especially a concentrated offering with much less liquid holdings than average. This isn’t a surprise, but could have been a bad product idea from the beginning.

Could this happen in a larger fund? Perhaps, but larger asset bases, diversification, and ‘strata’ of different types of bonds (some liquid, some not so much) helps buffer the impact of shareholder redemptions. Could it happen in an ETF? ETF’s only own the index, so there’s no manager oversight regarding sector or company choices, so it’s possible that shareholder redemptions could result in less discriminate selling of assets (although active high yield managers are often standing at the sidelines looking for good buys when this happens, and it seems to be happening right now). So, really, investors have to blame themselves for these things happening.

The high yield market is not homogeneous. There are higher-quality ‘5 B’ (rated BBB by one issuer/BB by another) issuers that could almost be in the investment-grade camp (and very well could be at some point), fallen angels that used to be investment-grade but no longer are due to large debt levels or poor prospects, as well as some truly risky companies that are highly-leveraged, offer uncertain growth profiles and likely deserve a low credit rating—and, accordingly, have to pay bondholders a very high interest rate as compensation for that risk. This is the way it’s always been. This price inefficiency at times has also created good and even great opportunities for investors willing to take on this trade-off.

Read our Weekly Review for December 14, 2015.

Read the previous Question of the Week for November 30, 2015.

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