Alpha Generation for Active Managers
By: Heather Rupp, CFA, Director of Research for Peritus Asset Management, the sub-advisory firm of the AdvisorShares Peritus High Yield ETF (HYLD)
As we discussed in our recent blog (see “The Opportunity in Volatility”), we are currently seeing a lot of attractive opportunities in the high yield market—discounts and yields that we haven’t seen in some time. And while we have seen the yields in the high yield indexes and the products that track them increase over the last six months, they don’t really seem to reflect the true opportunity we are seeing in the market. For instance, the yield to worst on the Barclays High Yield index is 6.46%1 and many of the large index-based products are reporting yields around 6%. While this is certainly better than the index yields of sub-5% that we saw in mid-2014, this level at face value isn’t something we’d be really excited about. So then why are we excited about today’s high yield market and see this as an attractive entry point?
Digging into what is held in the index, we see 33% of the issuers in index trade at a yield-to-worst of 5% or under.2 The large majority of this low-yielding contingency consists of quasi-investment grade bonds, rated Ba1 to Ba3. Not only does this group provide a low starting yield, but would expose investors to more interest rate sensitivity if and when we do eventually see rates rise (given the lower starting yields).
On the flip side, 30% of the issuers in that index are trading at a yield-to-worst of 7.5% and above2, which in today’s low yielding environment, with the 5-year Treasury around 1.2%, seems pretty decent. This group is certainly not dominated by the lowest rated of names and within this group, we are seeing an eclectic mix of businesses and industries. Yes, there are segments of this group that we are not interested in. For instance, we have been outspoken on our concerns for many of the domestic shale producers in the energy space given that we saw these as unsustainable business models when oil was near $100, and those issues will certainly be acerbated with oil at $50 as cash to mitigate the rapid well decline rates and to service heavy debt loads quickly runs out. But there are also what we see as great mix of business and industries that we would be interested in committing money to, especially at these levels.
This is where active management is especially important. We view active management as about managing risk and finding value. Yes, it is about managing credit risk (determining the underlying credit fundamentals and prospects of each investment you make—basically doing the fundamental analysis to justify an investment in a given security) and managing call risk (paying attention to the price you are paying for a security relative to the next call price to address the issue of negative convexity), as we have written about at length before. Yet one risk factor that is often overlooked is that of purchase price.
By this we mean buying at an attractive price. While it isn’t very intuitive, because it often seems that the risk is less when markets are on a roll and moving up, but really the lower the price you pay for a security, the lower the risk (you have less to lose because you put less in up front). Jumping in on the popular trade certainly doesn’t reduce your risk profile. Rather, you want to purchase a security for a price less than you think it is worth.
As we look at much of the secondary high yield market, especially many of the B and CCC names that have been out of favor over the past several months, we are seeing a more attractive buy-in for selective, active managers, which we believe lowers our risk. And there remains a segment of “high yield” that isn’t at prices or yields that we would consider attractive, and we will avoid investments in those securities. Alpha generation involves buying what we see as undervalued securities with the goal of generating excess yield and/or potential capital gains. Today, we are seeing this opportunity for potential alpha generation for active managers.
1 Barclays Capital US High Yield Index yield to worst as of 1/30/15. Formerly the Lehman Brothers US High Yield Index, this is an unmanaged index considered representative of the universe of US fixed rate, non-investment grade debt.
2 Based on our analysis of the Barclays Capital High Yield index constituents as of 1/30/15.