The Opportunity in Volatility
By: Heather Rupp, CFA, Director of Research for Peritus Asset Management, the sub-advisory firm of the AdvisorShares Peritus High Yield ETF (HYLD)
It seems the best way to sum up on the markets of late is with the word “volatile.” We’ve seen surprise moves on the currency and interest rate front from the likes of Switzerland and Canada and the launch of quantitative easing in Europe. Russian hostilities are once again heating up and talk of a Greek euro exit. Oil continued to hit new multi-year lows during the month. There have been many major earnings disappointments, as factors such as a strong dollar and weakening demand weigh on multinational corporations. Q4 GDP came in weaker than expected. Thus, in January, we saw the Dow Jones Industrial Average move more than 100bps on the majority of the trading days in the month and both the Dow and S&P 500 fall over 3% on the month. We’ve seen the 10-year Treasury yield fall from 2.17% to 1.68% and the 30-year Treasury yield fall from 2.75% to 2.25%, a decline of a whopping 49bps and 50bps, respectively.
While volatility is generally viewed as a negative thing in investing—in fact, risk is often measured in terms of volatility of returns—it isn’t always necessarily negative. In reality, we believe that volatility can create some compelling opportunities for investors, especially for those that are actively managing portfolios. But its nature, volatility often leads to issues in specific securities or industries causing contagion to other areas of the market. This in effect can create securities that have been hit purely by that contagion, and for no other fundamental reason.
We believe this is exactly what we are seeing right now in much of the high yield market. Some of this contagion from weakness in the energy sector and in equities has bled over into the high yield space, creating what we believe to be compelling opportunities in many non-energy related names for which we have seen no change in the fundamentals of the businesses. Many of the high yield issuers tend to be relatively small, niche, largely domestic focused companies. Thus we would expect many of them to be much less impacted by currency factors hurting large multinationals that are pervasive in investment grade corporates and the large equity indexes. While the US economy has had some hiccups, we certainly don’t expect to see a massive economic decline here.
As we look at today’s high yield investment landscape, we are excited about the current opportunities we see. Since last June, yields for high yield bonds have increased 1.79% and spreads for the high yield market versus Treasuries have increased 188bps to nearly 600bps.1 Some of this is rightfully so in the energy names (see our recent writings on our concerns for US shale issues), but there is also much of the market that has been hit for what we see as no fundamental reason. When we see prices decline and yields increase for what we view as no fundamental reason, we would view that as an attractive entry point.
To give the opportunity we currently see a little more tangibility, consider the statistics below:2
So since last June, the month during which we saw the recent lows in spread levels, we have seen the percentage of the index at a discount to par move from a mere 11.5% to over 37% and the percentage of the index at a yield-to-worst level of 7.5% or higher move from about 11% to just under 30%. This means that today, there are over 830 individual bond issues that are priced sub $100 and nearly 700 individual issues that trade at a YTW of 7.5% or higher within the Barclays High Yield Index. So as we look at the landscape, there are plenty of names to evaluate and opportunities offering what we see as attractive yield and capital gains potentials. Furthermore, we see this opportunity as even more attractive given the expectations for a benign default environment to continue, excluding certain sectors of the energy space.3
While 2014 was characterized largely by the lack of volatility for most the year, and active management suffered as a result, we see those tables turning in 2015 as we expect this volatility to continue. As we sit today, we see an attractive entry point into the high yield market for active managers who can parse through the space to determine where there is value to be had, and where there are value-traps.
1 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, June 26, 2014, p. 33 and January 29, 2014, p. 33, as represented by the JPMorgan High Yield Bond Index, which consists of fixed income securities with a maximum credit rating of BB+ or Ba1. Referenced spread is “spread to worst” and referenced yield is “yield to worst.” The yield to worst is the lowest potential yield that can be received on a bond, without the issuer actually defaulting, and includes the various prepayment options such as call or sinking fund. The spread is the spread to worst based on the yield to worst less the yield on Treasuries.
2 Based on our analysis of the Barclays Capital High Yield index constituents as of the indicated dates. Barclays Capital US High Yield Index. 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.
3 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. 14. See data in our piece “The Year Ahead: High Yield, Energy, and Interest Rates.”