High Yield Market Fundamentals
By Tim Gramatovich, DFA, CIO and Heather Rupp, CFA, Director of Communications and Research Analyst for Peritus Asset Management, Sub-Advisor of the AdvisorShares Peritus High Yield ETF (NYSE Arca: HYLD)
As we look at the high yield market, we see decent market fundamentals. While it would be a normal occurrence to see companies re-lever themselves after six years into a cycle, we have seen little of this type of bad behavior with total leverage metrics near historic lows. Interest coverage has also remained on the high side (meaning more cash flow to service debt) as companies have been able to refinance at lower rates.1
So while we have had diatribes about Armageddon in the high yield space from Jeff Gundlach and Carl Icahn earlier this year, we believe they are silly and unsupported outside of the oil and gas industry. Note the following funds flow chart which shows significant outflows from high yield bond mutual funds over the past three years.2 This hardly supports the notion of an overbought or popular asset class, as many of the pundits have seemed to claim in the early part of 2016.
The loan market is no different. The basic difference between loans and bonds is that loans are floating rate, while bonds have fixed rate coupons. After a massive inflow in 2013 (based on taper tantrums and the notion that interest rates were going significantly higher), the last two years have seen very significant outflows.3 This has caused much of the loan market to trade at a hefty discount to par, thus giving investors the opportunity for potential capital appreciation in addition to the coupon interest.
Broader loan market activity and issuance relies significantly on collateralized loan obligation (CLO) issuance. Thus, the loan market has been further pressured by proposed “risk-retention” rules that require CLO managers to own 5% of the total value of their structures. Only a handful of large managers have the ability to do so today.
As we have discussed in our recent piece, “Zero Sum Game,” legislatively and technically the markets for loans and bonds are broken. Yet we believe this has created a very compelling opportunity for investment as the price decline and spread expansion we have seen in these markets over the last year is largely driven by these technical factors not fundamental weakness (outside of commodities). After hitting multi-year high spread and yield levels in mid-February, we have started to see buyers come back into the high yield bond market as they recognize the value to be had. With this, we believe we are past the worst in the high yield market, yet we still see many bonds trading at notable discounts and with what we see as attractive yields. The high yield market has started to stabilize and we believe still offers attractive value for investors, and as an active manager, we are positioned to take advantage of the opportunities in this market. See our recent piece, “Zero Sum Game,” to read more about our take on financial markets and the opportunity we see in high yield debt.
1 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2015 High Yield Annual Review,” J.P. Morgan North American High Yield Research, December 30, 2015, p. 152,154. Leverage ratio is the company’s debt divided by earnings before interest taxes depreciation amortization (EBITDA). Coverage ratio is EBITDA divided by the company’s interest expense.
2 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2015 High Yield Annual Review,” J.P. Morgan North American High Yield Research, December 30, 2015, p. 127.