While default rates as a whole are expected to remain below average for the next couple years, expectations are for a meaningful increase in defaults in certain sectors, namely energy and commodities. For instance J.P. Morgan expects total default rates of 1.5% this year and to remain at 1.5% next year excluding energy, but 3% for the entire market on the back of a 10% default rate for energy,2 compared to historical average default rates around 4% for the high yield market. This projection seems pretty reasonable to us. Energy makes up about 13-15% of the high yield indexes, depending on which index you use, and metals and mining about 3-4%.3 So together, we are looking at about 16-19% of the total high yield indexes as extremely vulnerable to default given today’s oil and various other commodity prices. We are in the midst of the shale boom bursting and there will be casualties. In looking at the 21 companies that have defaulted year-to-date, all but four of them relate to energy or metals and mining. On a par basis, 86% of defaults have been related to these sectors so far this year.4 And we think this is just the beginning.

We believe this will pose a problem for the index based products. Again, these sectors combined make up about 16-19% of the indexes, leaving notable exposure for the passive products tracking the indexes. This exposure that can’t be avoided as these products don’t base investment decisions on fundamentals, but rather primarily on what is held in the underlying index. And given that the energy and commodity sectors are such a big portion of the market, we don’t see the “diversification” benefit that many cite in index-based investing as posing much of a help.

Right now, investors in the high yield market have to walk a tight balance between opportunity and default risk. For the vast majority of the market, we see great value and believe that investors are being overcompensated for the risk they are taking on (see our piece, “Making Sense of Markets” for our further thoughts). Yet there are problem areas to be avoided. We believe this is the time in the cycle when the “one of everything” approach by the index-based, passive products won’t work; rather, investors need to be digging into the fundamentals behind their investments to selectively and deliberately choose where they want to put their investment dollars. We believe this plays right into the hands of active investors; we believe active management is essential in today’s high yield market as investors look to avoid certain sectors and embrace the value to be had in the vast majority of the rest of the high yield debt market.

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