It has been a long quiet period in credit but volatility has returned with a vengeance. I have had an opportunity to discuss this with a number of our institutional clients in recent days, but there are a few factors that are exacerbating the recent price declines in the high yield bond market. To cut to the chase, most importantly for investors, we see this as representing a fantastic opportunity to buy this market aggressively on the cheap and capture a liquidity premium created by the law of unintended consequences. With over thirty years of experience in this market, I do not see it as a value trap or a fool’s errand. Nobody is making the case that a huge default cycle is about to begin in either the high yield or loan market, so from our perspective the fundamental fears are fairly non-existent. It does not mean that we won’t see defaults. We certainly will, as evidenced by the biggest failure of all Texas Utilities (aka Energy Future Holdings). But these remain a very, very small percentage of the overall high yield market which is now approaching $1.7 trillion. We have the Fed (Yellen and Fisher) barking at the moon, talking about risk in the high yield market. My best guess here is that they are trying to warn the market of impending rate increases. They surely cannot be talking about fundamentals of corporate high yield debt issuers, which they would have no idea about. My advice is for them is to talk with the investment grade corporate and mortgage community which have much more significant exposure to higher rates. Our asset class is among the lowest duration among the major fixed income sub-groups.1 We have written chapter and verse on why we see rates going nowhere so let’s leave that alone for now.
Let’s turn our attention back to the law of unintended consequences. Post the 2008 carnage, governments across the globe have been working overtime to “reduce” systemic risk in the financial system. What they have done is created a series of regulatory mechanisms (Basel III, Dodd-Frank and Volcker) that has penalized any type of risk taking. This includes market making activities for all the major banks/broker dealers. So what we have is very thin secondary markets. What has happened recently is that significant selling has been met with low-ball bids or none at all. The bonds in many cases have to experience “price discovery,” whereby investors such as Peritus and others become the market. Said another way, there are brokers but no dealers.
This is not really a surprise to anyone, but this is one of the first stress tests in bondland since the new regulations have taken hold. While there is short term pain involved, we see the potential ability to capture sizable liquidity premiums and buy discounted bonds as incredibly attractive and very timely. Attractive because we don’t believe that anything fundamentally has changed. With the recent and substantial widening of spreads, we believe it is simply a matter of time before institutional investors re-allocate monies to our asset class and the liquidity premium and overall spreads tightens back to much lower levels.
1 See our blog “High Yield Bonds and Interest Rates” for actual comparisons of durations of investment grade, municipal, and high yield markets.
Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and other fixed income or equity securities involves various risks and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.
This article was written by Tim Gramatovich, CFA, CIO for Peritus Asset Management, the sub-advisory firm of the AdvisorShares Peritus High Yield ETF (HYLD).