The Year of Active Management
By 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)
The Bank of America Merrill Lynch US High Yield Index currently carries a weighted average yield to worst of 5.9%, a yield to maturity of 6.3%, a spread to worst of 423 bps, an average coupon of 6.5%, and average price of $100.40.1 The Bloomberg Barclays High Yield index is virtually the same, currently also carrying a weighted average yield to worst of 5.9%, a yield to maturity of 6.3%, a spread to worst of 423 bps, an average coupon of 6.5%, and average price of $100.65.2 While you can’t technically “buy” an index, they do provide a snapshot of what the broad high yield market looks like. However, digging down into the individual index constituents is even more telling of what sort of value is available in today’s market.
If we look at the nearly 2,000 individual bond tranches in the Bank of America Merrill Lynch US High Yield Index, nearly 74% of the index is over par ($100), 62% of the index $102 or above, and over 40% of the index $104 or above. Nearly 50% of the index is trading at a current yield of 6% or under, while over 65% of the index is at a yield-to-worst of 6% or under and nearly 50% of the index is at a yield-to-worst under 5%.3
As we look through many of the individual securities available in the high yield market, we see a number of securities that we aren’t interested in as value-investors. We see cases of very thin yields relative to the risk—again nearly 50% of the index is providing a yield-to-worst of under 5%, with many of those yielding 3-4%, which even in this low rate environment isn’t the sort of yield we are looking for as investors. On the other end of the spectrum, we see weaker and highly levered credits that have caught a bid up in this market euphoria, but still carry extreme credit risk from our perspective—again putting yields in a place where we don’t see investors properly getting compensated and securities that we would avoid.
But all of that is not to say the entire market is overvalued. We still see a number of credits in both the high yield bond and loan space where yields are attractive relative to the risk being assumed—we continue to see the opportunity to build a portfolio with what we see as attractive yield/income metrics without having to take on undue risk. As noted, there are nearly 2,000 individual tranches and nearly $1.4 trillion in market value in this high yield bond index alone4, so plenty of merchandise to choose from for selective investors to build a well-diversified portfolio.
We are eight years into the cycle and while we do see a number of reasons that this market can continue to run (i.e., spread levels are still far from historic lows and the lows we often see before the cycle turns, credit fundamentals are still reasonable, market technicals remains strong, default rates are expected to be well below historical averages, real economic improvement could finally begin this year in turn benefiting credit, etc.), we also believe that there is enough uncertainty and we are far enough into this cycle that investors should execute a degree of caution. We don’t want to ignore the high yield debt market altogether, as we do continue to see it as a source of attractive tangible yield/income for investors and the added potential for capital gains, but again, caution and selectivity are warranted. As we look over the next few years, we believe the one-way, broad high yield debt market trade up has ended and what you own in terms of individual securities will matter much more than it has over the last year. The high yield indexes and passive products that track those indexes don’t put credit analysis, from both a fundamental and technical side, at the forefront of their criteria for security inclusion, however we believe this analysis will become all the more important in the years ahead. Many market commentators have said this will be the year of active management in the equity market, and we believe that rings just as true in the high yield debt market.
1 1 Data as of 1/12/17, sourced from Bloomberg. The Bank of America Merrill Lynch US High Yield Index monitors the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.
2 Data as of 1/12/17, sourced from Barclays Capital. The Bloomberg Barclays US High Yield Index covers the universe of fixed rate, non-investment grade debt.
3 Based on the individual bond tranches in the Bank of America Merrill Lynch US High Yield Index, using the January 2017 universe. Data as of 1/12/17, sourced from Bloomberg. Percentages based on the sum of total weights for each individual security in the category.
4 Data for the Bank of America Merrill Lynch US High Yield Index as of 1/12/17, sourced from Bloomberg.