William Miller, CFA
Managing Director, Senior Portfolio Manager
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 Third Avenue Focused Credit Fund’s managers to limit redemptions from fund shareholders exacerbated what was already a very nervous market 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 from the Fed stoked additional fears of high yield investors.
Through December 15, the broad high yield market, as measured by the Barclays U.S. Corporate High Yield Index, has returned -5.04% in 2015, with the majority of the decline occurring in December (-3.10%). It is important to note that the year-to-date index performance is significantly skewed by three commodity-intensive industries: independent energy companies (-31.55%), oil field services companies (-20.38%), and metals/mining companies (-24.39%). The total year-to-date return on the remaining 89% of the high yield universe was -2.21%.
Some investors have been wondering if widening high yield spreads (the extra income high yield investors earn over Treasuries for taking credit risk) are signaling weaker economic conditions that would precede a material increase in defaults. Outside of energy and metals, we do not believe this is the case. Job growth has been strong, inflation and interest rates remain low, and although the Fed just increased the federal funds rate for the first time in nine years, the future rate of increases is likely to be gradual. Although defaults will likely increase over the coming year, much of that increase should be concentrated in the commodity sectors most exposed to declining energy and metal prices.
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 financial market 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 for one since the 1960s. Currently, the slope is reasonably steep (+130 bps, as of December 15) 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, to include bank loans, high yield bonds, and global debt. We continue to monitor each of these areas closely and are comfortable with our current exposures.
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The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein.
Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.
Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.
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.
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 commodities can be very volatile and direct investment in these markets can be very risky, especially for inexperienced investors.
As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money.
Investing involves risk, including the potential loss of principal. Past performance is no guarantee of future results.
The Barclays U.S. Corporate High Yield Index: covers the U.S.-dollar denominated, non-investment grade, fixed-rate, taxable corporate bond market and includes securities with ratings by Moody’s, Fitch and S&P of Ba1/BB+/BB+ or below.
The U.S. Corporate Investment Grade Index: publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered.
The Barclays U.S. High Yield Index: covers the universe of fixed rate, non-investment grade debt. Eurobonds and debt issues from countries designated as emerging markets (sovereign rating of Baa1/BBB+/BBB+ and below using the middle of Moody’s, S&P, and Fitch) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind bonds (PIKs, as of October 1, 2009) are also included.
Indices are unmanaged and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.