The True Opportunity in Today’s High Yield Market
By: Heather Rupp, CFA, Director of Research for Peritus Asset Management, the sub-advisor to the AdvisorShares Peritus High Yield ETF (HYLD)
There has been talk recently about the yield of the high yield market, as represented by the various indexes, and if there is return left to be had. While the high yield indexes are representative of the high yield “market,” we do not believe they are representative of the true opportunity in the high yield space.
Let’s breakdown a couple of the widely quoted high yield indexes. The quoted yield-to-worst, generally what people are quoting when they talk about “yield” on the high yield market, on the Barclays High Yield Index is 4.94%. This index consists of 2,162 issues and $1.33 trillion in market value, with a par weighted dollar price of $105.78. Of that $1.33 trillion in market value, nearly 60% of it trades at a yield-to-worst of 5% or less.1 Similarly, the Bank of America Merrill Lynch US High Index reports a yield-to-worst of 4.98%, with 2,245 individual issues, $1.35 trillion in market value represented, and a par weighted dollar price of $105.72. Here, over 60% of the market value is from bonds that trade at yield-to-worsts of 5% or less.2 With such a large portion of the market at low yields, this is certainly skewing the “average yield” numbers.
Why are yields on such a large portion of the market so low? As we have discussed in the past, due to a wide open new issue market and historically low rates over the past several years, it seems to become a give-in that most the issues will be called at the nearest call price, meaning many often trade at or above this price. As a consequence this leads to low yields, in some cases VERY low yields if the company is current callable. As noted above, with a par weighted average dollar price of $105.78 on the Barclays High Yield Index and $105.72 on the Bank of America Merrill Lynch US High Yield Index3, it is evident that a large part of the market is trading at a premium to call prices.
Above and beyond this, we have seen lots of interest in the high yield market over the past five years, and with that we believe that many investors have become complacent, running up bonds prices and not demanding to get paid commensurate with risk (for an example, see our blog “Avoiding Complacency”). Our experience has been that this is often more evident with the large, most liquid on-the-run names.
So while there is a portion of the market at these historically low yields, as reflected by the “average yields” presented by the indexes, there is also a sizable portion of the market that still offers what we view as attractive yields in good companies. In some cases these can be tranches that are smaller than the $1 billion issuer/$400mm issue or $500 million tranche size that is required to be included by some of the index-based products, or tranches/issuers that are overlooked by investors that rely on Street research on the widely covered names to make investment decisions. Or there may be names that are misunderstood by the market for wrong or temporary reasons.
Furthermore, when discussing yields it is also important to understand that in many cases the stated yield-to-worst isn’t necessarily the yield an investor would expect to realize from their investment. For instance, when we look at a credit we certainly look at the yield-to-worst but we also determine our own expectations for the credit given the company’s fundamentals and potential catalysts—an “expected yield,” which in some cases may be higher than the yield-to-worst.
Capturing capital gains is also an important piece of realizing an expected yield. In the current market environment where we are seeing bond prices run well above call prices, active managers have the ability to lock in these premiums and reinvest proceeds into situations with a lower dollar price and a better expected yield going forward. For example, in a security now trading at $110, and active manager would be able to sell at the price and buy a new security closer to $100; whereas an index-based, passive product would instead ride a security to $110 and then stay in it until the security is called, typically between $101 to $105, or possibly until the security matures at $100 (depending on the vehicle’s mandate), potentially capturing a lower expected yield for the life of the holding. We believe that the ability to sell is important in realizing capital gains and potentially increase your expected return.
It’s worth repeating: while the high yield indexes are considered representative of the high yield market, we do not feel they are representative of the true opportunity we see today in the high yield market. This is a market where we believe that generating decent yields requires hard work: active managers digging to find names and then doing the research on the names to determine the best opportunity for return given the risk component. For managers and investors willing to do the work necessary, we continue to believe there are plenty of opportunities for attractive yield in the high yield space, and this is over a $1.3 trillion market, so there is plenty to work with. Furthermore, as active managers, we have the additional flexibility to invest in loans, bonds, and dividend paying equities which can enable us to drastically increase the available market size far beyond that for bond-only or loan-only index-based products.
1 The Barclays High Yield Index is an unmanaged index considered representative of the universe of U.S. fixed rate, non investment grade debt. One cannot invest directly in an index. Data as of 6/9/14.
2The Bank of America Merrill Lynch High Yield Index monitors the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market. Index data sourced from Bloomberg. Data as of 6/9/14.
3The Barclays High Yield Index is an unmanaged index considered representative of the universe of U.S. fixed rate, non investment grade debt. One cannot invest directly in an index. Data as of 6/9/14. The Bank of America Merrill Lynch High Yield Index monitors the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market. Index data sourced from Bloomberg. Data as of 6/9/14.