High yield bonds have come under particularly acute pressure since the widely publicized closing of a distressed debt fund in mid-December. The decision by the fund’s managers to limit redemptions by shareholders exacerbated an already jittery market that had been battered by the decline in energy prices. This came less than a week after OPEC decided to maintain current production levels, despite clear evidence of an oversupply in global oil markets. Year-end tax loss selling and concerns over an impending interest rate hike by the Fed stoked additional fears among high yield investors.
For 2015, the broad high yield market, as measured by the Barclays U.S. Corporate High Yield Index, declined 4.5%, with most of that decline (-2.5%) occurring in December. However, it is important to note that the performance of the Barclays Index is skewed significantly by price changes in three commodity-intensive industries: independent energy companies (down 35.6% in 2015), oil field services companies (down 20.9%), and metals/mining companies (down 23.7%). By contrast, the total decline on the remaining 89% of the high yield universe was 1.5% for 2015.
Widening high yield spreads (the extra income high yield investors earn over Treasuries for taking credit risk) have led some investors to question whether the credit cycle is turning from an expansionary phase into a downturn. The answer for some industries is yes, but that is not the case for the majority of the high yield market. While problems in the energy and metals/mining sectors are evident, much of the remaining market continues to exhibit fairly stable credit metrics. As an example, one important credit metric we monitor is interest expense coverage. This indicator is simply earnings (EBITDA) divided by interest expense and is a measure of a company’s financial strength (higher is better). For context, this metric reached a low of 3.5x in the third quarter of 2009. Except energy, interest expense coverage was 4.6x for the third quarter of 2015 (up from 4.3x in the third quarter of 2014). Although this is only one metric, improving interest expense coverage ratios do not suggest a broad-based downturn in the credit cycle. Other metrics we watch are consistent with this. The divergence between commodity-centric and non-commodity issuers provides ample opportunity for skilled active managers to add value to client portfolios.
The relative stability of non-commodity investment grade corporate spreads suggests that high yield market pressures are more related to flows and fund redemptions than broader economic concerns. If corporate bond investors expected broad economic and corporate credit weakness, investment grade spreads should also widen materially. To date, that has not been the case.
One historically reliable indicator of the health of the economy is the slope of the U.S. Treasury yield curve. An inverted yield curve (short rates higher than long rates) has preceded every recession in the U.S. except one since the 1960s. Currently, the slope is reasonably steep (+120 bps as of January 4, 2016) and does not suggest a pending recessionary slowdown.
At City National Rochdale, we believe in diversified exposure to a number of below investment grade fixed income securities, including bank loans, high yield bonds, and global debt. We continue to monitor each of these areas closely and are comfortable with our current exposures.
All returns cited are total returns including price returns and interest income.
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There are inherent risks with equity investing. These risks include, but are not limited to, stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices. Investing in international markets carries risks such as currency fluctuation, regulatory risks, economic and political instability. Emerging markets involve heightened risks related to the same factors as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks, and less developed legal and accounting systems than developed markets.
There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT) and taxable gains are also possible. Investments in below-investment-grade debt securities and unrated securities of similar credit quality, commonly known as “junk bonds” or “high-yield securities,” may be subject to increased interest, credit, and liquidity risks.
Investments in emerging markets bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more developed foreign markets. Emerging markets bonds can have greater custodial and operational risks, and less developed legal and accounting systems than developed markets.
Investments in Master Limited Partnerships (MLP) are susceptible to concentration risk, illiquidity, exposure to potential volatility, tax reporting complexity, fiscal policy and market risk. Investors of MLPs are subject to increased tax reporting requirements. MLP investors typically receive a complicated Schedule K-1 form rather than Form 1099. MLPs may not be appropriate investments for tax-advantaged accounts because of potential negative tax consequences (Unrelated Business Tax Income).
As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.
Returns include the reinvestment of interest and dividends.
Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk.
Past performance is no guarantee of future performance.
The Standard and Poor’s 500 Index (S&P 500) is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
The Dow Jones Industrial Average Index is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the NASDAQ.
The MSCI Emerging Markets (EM) Latin America Index captures large and mid-cap representation across five Emerging Markets (EM) countries* in Latin America. With 119 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
*EM Latin America countries include: Brazil, Chile, Colombia, Mexico, and Peru.
The Barclays U.S. Corporate High Yield Bond Index is a market value-weighted index which covers the U.S. non-investment grade fixed-rate debt market. The index is composed of U.S. dollar-denominated corporate debt in Industrial, Utility, and Finance sectors with a minimum $150 million par amount outstanding and a maturity greater than one year. The index includes reinvestment of income.
The NASDAQ is a global electronic marketplace for buying and selling securities, as well as the benchmark index for U.S. technology stocks. NASDAQ was created by the National Association of Securities Dealers (NASD) to enable investors to trade securities on a computerized, speedy, and transparent system. The term “NASDAQ” is also used to refer to the NASDAQ Composite, an index of more than 3,000 stocks listed on the NASDAQ exchange that includes the world’s foremost technology and biotech companies.
The STOXX Europe 600 Index is derived from the STOXX Europe Total Market Index (TMI) and is a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represents large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom.
The Bloomberg Commodity Index (BCOM) is calculated on an excess return basis and reflects commodity futures price movements. The index rebalances annually weighted 2/3 by trading volume and 1/3 by world production and weight-caps are applied at the commodity, sector and group level for diversification. Roll period typically occurs from 6th-10th business day based on the roll schedule.
Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.