with Randy Masel, Managing Director (January 6, 2015)
“Prediction is very difficult, especially about the future.” Niels Bohr, Nobel Prize Winner, Physics
Back in February of last year, in my inaugural review, I wrote that “the high yield market is likely to generate returns in the 5%-7% range in 2014”. Clearly, I was a bit too optimistic. The Bank of America High Yield II index posted a 2.5% return in 2014 as 6.6% of coupon income was offset by 4.1 points of price loss. By comparison, the S&P 500 generated a 13.68% total return in 2014.
A year ago just about everyone with at least $5 in the markets was preoccupied with the direction of interest rates as the Federal Reserve began tapering its bond purchases. There was near unanimity amongst economists that rates would rise significantly. Economists surveyed by The Wall Street Journal predicted that the ten year Treasury would yield 3.52% at the end of 2014, up from 3.03% at 2013 year-end. Of course, high levels of market consensus usually mean the consensus will be proved wrong. The ten year ended 2014 yielding 2.17%.
It is not quite fair to say economists got it dead wrong about rates in 2014. Interest rates did rise in the short end of the Treasury curve- the two year Treasury moved from .38% to .66%, for example. The shape of the Treasury curve flattened considerably in 2014 as falling inflation expectations pushed down the long end of the curve while concerns over prospective rate hikes pushed up the shorter end, with the five year Treasury more or less the pivot point. As a result the spread between 30 year Treasuries and 2 year Treasuries narrowed a sizeable 150 basis points.
A Tale of Two Halves
My base case for last year was that rates would rise a modest 25 basis points or so in the five to ten year part of the Treasury curve and that this move would be offset by high yield spreads narrowing given low defaults and a solid economic backdrop. Things looked pretty good for a while. High yield chugged along over the first half of 2014, notching gains every month and generating a 5.56% return through June. The tide turned in July, triggered by a confluence of factors: continued concern about the future course of interest rates, jawboning by the Fed and Janet Yellen about high yield valuations, geopolitical tensions, and one large tactical allocation out of high yield and into REITs by an ETF allocator. Selling begat selling; high yield mutual fund net outflows totaled $7.5 billion in July. The heavy selling finally tested the “new normal” of more limited liquidity in the over the counter debt markets. Banks and dealers, hamstrung by new regulations, have been dedicating less capital to the credit markets for some time. The implications of this reduced market-making were masked while the high yield market was banging out steady returns; in July it became evident. In the second half of 2014, high yield posted a loss of just under 3%.
Perception Becomes Reality
The irony in all of this is that interest rates, the boogey man that so frightened the high yield market, have been more or less flat to down (depending on maturity) since high yield peaked on June 23rd. Perception became reality, however, as the threat of higher rates caused selling, illiquidity, and lower prices. The vulnerability of high yield to higher rates was “proved” even though rates did not move. In reality, high yield was undone by two factors: the more limited liquidity previously mentioned, and the precipitous drop in oil prices. The energy sector is disproportionally weighted in high yield, representing roughly 15% of the market but only a little over 8% of the S&P 500. Liquidity is unlikely to improve any time soon given the current regulatory regime. Risk premiums, in the form of higher spreads over Treasuries, should and have adapted. The question going forward is have spreads moved enough and what strategies need to be implemented to adjust to the new paradigm.
The Bank of America High Yield Master II index yielded 6.65% to the worst call on Dec 31, 2014. That is a spread of 513 basis points above comparable Treasuries- a cool 95 basis points more than where spreads started the year. Spreads have averaged +585 bp over the last 18 years but this includes two periods of extreme volatility: the NASDAQ /Enron/Worldcom/9-11 crash in the early 2000’s and the Great Recession of 2008-2009. Excluding 2001-2002 and 2008-2009, spreads have averaged +477 since the end of 1996. At the same time that spreads are quite healthy, current default rates are historically low at approximately 1.6% versus the long-term average of 4.5%.
Default rates are likely to bump up if oil prices stay at current levels ($50.95 for WTI as of this writing). I don’t think anyone anticipated a year ago that oil prices would be trading where they are today, and I am not going to prognosticate on where they will be a year from today. I would point out an interesting report done by Morgan Stanley indicating that the peak supply-demand gap is expected to occur in the second quarter of 2015 at 1.3 million barrels a day. That sounds like a lot but it is just 1.6% of global production. According to Morgan Stanley, lower prices are expected to trigger demand growth of 300,000 barrels a day and capital spending cutbacks are projected to lower supply by 450,000 barrels a day. A relatively small amount of supply disruptions caused by political risk (e.g., Libya, Iraq) or production cutbacks resulting from economic distress or OPEC actions could put the oil market much closer to equilibrium. It is also worth noting that many high yield E&P companies have hedged out a good chunk of their 2015 production at higher oil prices and the amount of high yield energy bonds maturing in 2015 is minimal. In any event, current spreads appear to have plenty of room built in to cushion against the prospects of higher defaults in 2015.
“It’s déjà vu all over again” Yogi Berra
Once again as we start the new year it appears that interest rates are poised to rise. The Federal Reserve has indicated that it is likely to raise its targeted funds rates sometime in the middle of 2015. The forward Treasury curve is indicating that the five year Treasury (which has the approximate duration of the high yield market) will be 1.97% a year from now, or a half a percent more than where it is sitting today. A 45 basis point rise in yields due to higher Treasury rates would imply a 2 point drop in price for high yield, far from fatal given an average coupon of 6.9%. Of course, interest rates tend to rise in strengthening economic environments. High yield companies, given their higher leverage, tend to perform better financially in such environments. As a result, high yield risk premiums (spreads above comparable Treasuries) historically have decreased as interest rates rise. Barclays has concluded that historically U.S. high yield bond spreads had a beta of -1.0 to five year Treasury changes. In other words, a 100 basis point increase in 5 year Treasury rates was offset by a 100 basis point tightening in high yield spreads. All else being constant, this implies prices would be unchanged despite the rise in interest rates. Is this probable in 2015? It would be nice if it was that simple and there were no additional knock-on effects from rising rates (equity sell-off, e.g.). The key takeaway is to recognize that historical data suggest that a rise in interest rates does not spell doom for high yield.
Things That Go Bump in the Night
With spreads sitting north of 500 basis points and a yield to worst of 6.65%, it is not unreasonable to assume (again) that high yield can generate 5% to 7% returns in 2015. The economic backdrop in the U.S. remains supportive, interest rate increases can be absorbed by generous spreads, and even with lower oil prices defaults should be contained. All that being said, and maybe because credit guys tend to take a “half empty” view of the world, it does appear that we enter this year with more things to worry about at night than in recent years. Some of the things worth keeping an eye out for are, in no particular order:
Once again, Greece, with a population smaller than Ohio’s, threatens the stability of Europe. Elections in January bring along with them the prospects of a new government that may reject austerity measures and the existing bail-out program. In a worst case scenario, Greece could end up ditching the euro, sowing the seeds of contagion to other “peripheral” countries such as Portugal and Italy. More likely than not Greek voters will come to their senses (as the Scots did last year) and will vote against major regime change. If they don’t, the potential outcomes are too varied to contemplate. Given the very low yields of other peripheral debt currently (Portugal five year bonds are yielding 1.3%), it appears at least for now that the markets are discriminating and contagion will be limited.
- Ripple Effect of Lower Oil Prices
Lower oil prices will benefit many. However, they will be very damaging to some. The risk is that the major damage to the few will outweigh the more limited benefit to the many. For example, in high yield, the damage done to high yield E&P companies set off indiscriminate selling in energy bonds, which spilled over into indiscriminate selling of all high yield bonds as investors sold what they could. Bonds of packaging companies that benefit from lower energy costs saw their prices drop to yearly lows as their stock prices hit yearly highs. More disconcerting for the markets as a whole is the impact of lower oil on emerging markets. Importers such as Korea, China, and India will clearly benefit. At the same time, the damage to energy-oriented countries such as Russia, Venezuela, and Mexico could be so severe that they could curtail investors’ appetites for all emerging market securities.
- Higher Wages
It appears likely that the Fed will hike the target funds rate this year. What is less clear is the pace of hikes with the unemployment rate sitting at a 6 ½ year low of 5.8% and CPI at a more anemic 1.3%. Inflation seems tame, particularly given lower energy costs. One wild card, however, is wage growth. Annual average hourly earnings growth has been hovering around 2% for the last five years while the unemployment rate has dropped significantly. Some economists think payback is coming and wage growth is about to take a step-function higher. This could pressure the Fed to take more dramatic action on rates, which would clearly throw financial markets off kilter.
- ECB with One Bullet Left
The European Central Bank is poised to begin buying bonds in an attempt to move the Euro-based countries out of their economic coma. This form of quantitative easing by the Federal Reserve has been widely viewed as helping the recovery of the U.S. economy. However, the transmission of QE into the American economy was aided by robust capital markets and fluid labor markets, both of which are lacking in Europe. Moreover, European government austerity measures remain a drag on economic growth. It is quite conceivable that the ECB fires its QE bullet and there is limited impact.
Elroy Dimson, a professor at the London Business School, is quoted as saying “Risk means more things can happen than will happen.” In that light, 2015 has the potential to be more risky than the last few years. My base case is that interest rates stay relatively contained, with modest Fed hikes muted by the impact of low rates around the globe and a strong dollar. Given the context of historically low interest rates, equities do not appear rich with real GDP growth estimated at 3% (highest in nine years) and a 16.25x forward PE. This backdrop is also very supportive of high yield. While high yield may remain volatile at times, a 6.9% coupon accruing interest every day certainly helps. And with the five year Treasury at 1.85%, stocks yielding under 2%, and MLPs energy focused, there are not many great places to earn income at present.
Although there may be some supply at the start of the year, we continue to like the bank fixed to floating rate preferred market. These hybrids look attractive on a tax-equivalent basis to traditional high yield and banks continue to de-risk their balance sheets and businesses. In the energy space, there are many babies that have been thrown out with the bathwater- low leveraged natural gas focused names, fee based MLPs, etc. There is also plenty of collateral damage in credits that have nothing to do with energy or might even benefit from lower energy costs. As we have previously noted, more limited liquidity is not conducive to trading high yield bonds. However, for patient investors that are willing to ride out bouts of occasional volatility and price swings, the current environment is creating attractive buying opportunities.
Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The opinions expressed are those of the Granite Springs Asset Management LLC Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies. This material is for educational purposes only. Granite Springs Asset Management LLC is an investment adviser registered with the US Securities and Exchange. Registration does not imply a certain level of skill or training. More information about Granite Springs Asset Management LLC can be found in its Form ADV which is available upon request.