Earlier this week we saw one of the major financial publications feature an article about how active management has outperformed passive management so far in 2015. While their article and data focused on equity funds, we believe that the same sort of opportunity for active fixed income managers exists over the balance of 2015. During times of a one-way trade up, passive management can benefit, but that is not the environment we have seen or expect for the remainder of 2015, in anticipation that we may see the biggest elephant in the room, the Federal Reserve, ultimately start to take some action.
Active management is about the human element and what you own versus what you don’t own. We have always been under the belief that what you don’t own or avoid is more important. As we look at today’s high yield market, there are certain areas that we are able to avoid as active managers. One areas is the names that offer very little in the way of yield. As we look at the high yield market, we see a sizable portion of the market that offers yields of 3-5%. This not only means your portfolio is generating little in the way of income, but also means that you will most likely have a higher duration (a measure of interest rate sensitivity, a higher duration means higher interest rate sensitivity) given the lower yield. For instance, the Ba segment of the Barclays High Yield Index is trading at a yield to worst of 4.69% and a duration of 4.91 years.1 Broadly speaking we would not see this as an attractive yield and duration at which to put money to work. Yet as you get into the individual credits, there are some Ba names yielding 7% and some B names yielding 4%; the benefit of active management is that you can look for value to maximize yield and lessen your interest rate exposure (duration), and avoid the names where you don’t see value.
Another area that we have been vocal about avoiding is certain sub-segments of the energy space, specifically the US shale players. Energy is about 16.5% of the high yield index, by far the highest industry allocation2, so if you are invested in the broad high yield market passive strategies, you most likely have a sizable allocation to energy. Even with the rebound in oil prices that we have seen in the last couple months, moving closer to $60, we believe this still positions many US shale producers and energy service providers as vulnerable. As we have noted, shale production in many cases requires high prices and massive capital reinvestment. Cracks are already starting to emerge in the energy space and we do expect that to accelerate as rig counts declines ultimate work through the financials of service providers, revolver borrowing bases get reevaluated based on the current production value and outlook meaning likely reduced liquidity in some cases, and hedges come off. Investors in the energy space need to understand what they own and determine the prospects of their holdings, as in many cases an oil price recovery to $60 is not nearly enough. We have likened today’s high yield energy markets to the technology and telecom space in the early 2000s, which at that point was a large portion of the high yield indexes. We didn’t avoid the entire space then, but were selective about where we were positioned and believe that same selectively is necessary today.
Passive-based investing can do well during times when we see broad uptrends in financial markets. However during times of uncertainty and volatility, we believe that provides opportunities for active managers to separate themselves, and we are seeing such opportunities today in a variety of financial markets, high yield included.