Considering today’s low interest rates, high yield stands out as an asset class with potentially attractive returns. Even after a strong rally from their mid-February lows, high yield spreads are only slightly lower than where they were at year-end and are historically high for non-recessionary periods.
Of course, high yield’s returns in 2015 were unattractive, particularly in the energy- and commodity-sensitive US region. We think the high spread level will be more than sufficient to compensate for the coming defaults, which we expect to be primarily concentrated in the Energy and Metals & Mining sectors as the effect of low commodity prices moves through the market. These two sectors were large inputs into 2015’s weak performance, with commodity price weakness from a slowing China also depressing global risk appetite.
Looking more deeply within 2015’s returns, we also saw high yield investors express a strong preference to be overweight bonds that would be relatively easy to trade. Banks have dramatically decreased the amount of capital they use in market making activities, and are now only looking to position bonds with high trading volumes. Correspondingly, high yield managers have preferred to hold bonds with the traits that make bonds easy to trade, such as strong credit quality, large issue size, from well-known public companies and have avoided bonds lacking these traits.
Not surprisingly, the relatively liquid bonds have become very expensive compared to their less liquid cousins. The less liquid issues are often smaller, are somewhat riskier due to higher leverage or are from private companies with harder-to-get financial information; yields on these less liquid issues are sometimes more than double that of their more liquid counterparts. We believe that, although liquidity conditions are unlikely to improve any time soon, taking advantage of the yield premium available in the less liquid issues as part of a full spectrum approach to high yield will be the winning strategy. Strong security selection is essential in high yield, and bonds from smaller issuers can be an important contributor to portfolio return.
How should investors look to capture the opportunity that the less liquid end of high yield presents? In our opinion, if one chooses to buy high yield bonds directly, buying less liquid issues could create volatile returns, particularly if some issuers encounter credit stress. If purchasing bonds directly, a focus on strong, larger issuers appears appropriate. Building a diverse portfolio is critical, and transaction expenses can hurt performance, especially for smaller sized trades.
Another possibility is to use an Exchange Traded Fund (“ETF”), sometimes referred to as index funds or trackers. As ETFs are bought and sold on stock exchanges, it is easy and quick to gain exposure to the broader market this way. However, ETF returns over short periods are heavily influenced by the premium or discount to Net Asset Value at which the shares are traded. Over the longer term, the fact that the ETF underlying securities are drawn from the largest and most liquid issues in the market means that these instruments will not gather the liquidity premium offered by less liquid high yield bonds, and that the ETF will be forced to own these names regardless of the manager’s view of underlying credit fundamentals. For institutional investors, a similar dynamic exists in the available credit derivative index products, such as the iTraxx XO and Markit CDX, as these instruments usually reference bonds from larger and more traded issuers that often trade at lower yields than the broad indices.
In our view, mutual funds remain the best vehicle to capture the attractive spreads found in less liquid high yield bonds. When considering a mutual fund, it makes sense for an investor to check that the fund is benchmarked against one of the broad market indices, and not a subset of more liquid issues. The fund manager should have a strong credit research focus, and have the expertise to capitalize on the opportunities found in mispricings prevalent in the high yield market.
However, our view is that the mutual fund should not be too avidly focused on gaining return from less liquid issues. Considering the possibility of fund redemptions, the fund should be managed with an eye on liquidity, with only a modest overweight to CCC-rated securities, as BBs and Bs are easier to sell in falling markets; the fund also needs to be diversified to avoid concentration risk. The fund should also hold cash or easy to liquidate securities in order to meet potential redemptions and control the overall risk level.
If the market continues to rally, we see less liquid bonds performing better than their more liquid counterparts. However, at some point this opportunity will transition from the combination of higher carry and capital gains to solely higher carry; we think that the market has plenty of room to run before that occurs.
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