September High Yield Corporate Bond Review

Babies and Bathwater

with Randy Masel, Managing Director (October 2, 2014)

Well, it could have been worse. A huge ninth inning rally on September 30th helped the high yield market turn in a 2.1% loss in September, changing a truly awful month into one that was merely really bad. By comparison, the S&P index was down 1.4% for the month and investment grade bonds were down 1.2% (bond data courtesy of Bank America Merrill Lynch). A myriad of reasons have been suggested for the sell-off in high yield: increased new issuance, a bump up in interest rates, fears of Fed rate hikes, the sell-off in equities and commodities, etc. Certainly risk came off across asset classes in September and high yield was in the cross-hairs.

After ten straight months of steady gains, the high yield market has turned more volatile and been trading in a sharp saw-toothed fashion: straight down in July, straight up in August, straight down again in September. Prices have perked up the last two days but certainly recent history shows that two days does not make a trend make.  Markets in general, and high yield in particular are likely to remain choppy for a while as investors agonize over the Fed and grapple with geopolitical issues in Hong Kong, Ukraine, Scotland, Catalonia, the Mideast, etc. (did I leave any place out?).

Volatility can present opportunities for the patient investor, however. Over the past month, I heard more than one trader say that “babies were being thrown out with the bathwater”.  A lot of what seems to be indiscriminate selling may be attributed to ETF redemptions. For ETFs that track to an index, it is all bathwater- what is bought and sold reflects the index and is not based on fundamentals or even bond technicals.

As of this writing, the high yield market’s yield to the worst call date is 6.1%, about 50 basis points greater than where we started the year. The corresponding spread over Treasuries is 459 basis points, 45 basis points higher on the year. With default rates under 2%, high yield investors are being well rewarded for the credit risk they are taking. Interest rate risk, as we have discussed in previous monthly reviews, is the boogey man that has caused bond investors to sleep with one eye open but has failed to materialize. The Treasury curve has flattened meaningfully during 2014 and is likely to flatten further once the Fed hikes rates in mid-2015. Rate hikes will be most immediately felt on the shorter end of the curve and the benefit of rolling down the curve, which we have discussed previously, will be more muted. Nonetheless, we remain sanguine about the direction of interest rates over the next six to nine months. Volatility does not appear to be going back into its box any time soon, however. We are out looking for cute babies. For investors with patience and the willingness to hang on to positions in what may be a bumpy market, we think the current sell-off is presenting attractive opportunities to buy high yield bonds.


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