Shouting Fire in a Crowded Theater
with Randy Mansel, Managing Director (Septemeber 3, 2014)
Ninety-five years ago, in a case regarding freedom of speech, Justice Oliver Wendell Holmes wrote a phrase that has since become famous: “The most stringent protection of free speech would not protect a man falsely shouting fire in a theater and causing a panic.” Over the years, this saying has often been paraphrased as “shouting fire in a crowded theater”. I thought about this phrase quite a bit last month as it appears to be a useful metaphor to describe what happened in the high yield market at the end of July and beginning of August. If you can remember that far back, the market was easily spooked by any number of risks: the prospects of the Fed hiking rates sometime in 2015, Fed officials and market pundits opining on high yield valuations, the “fast money” in high yield ETFs, and the perceived illiquidity in the high yield market. Many investors panicked and hit the exit doors; high yield ETF and mutual fund outflows totaled $7.5 billion in July.
Fast forward to today, it appears there was no fire in high yield, a little bit of smoke would probably be stretching it. Treasuries have rallied meaningfully since the end of July, fund flows into high yield have turned positive, and the high yield market posted a + 1.52% return in August, more than gaining back the -1.32% loss in July (source: Bank of America Merrill Lynch). So where does that leave us now that the high yield market has bounced back? At +400, the Bank of America High Yield Master II index’s spread over Treasuries, which compensates investors for high yield’s credit and liquidity risks, remains very reasonable given a decent economic backdrop and historically low default rates. The index is now yielding 5.33%, just about the average for the year to date, but very modest in any other time outside of the last two years. Though a 5.33% yield may sound uninspiring, the five year Treasury (similar duration to the index) is currently sitting at 1.68%, just 32% of the index’s yield.
A year ago, the markets were trembling at the thought of the Federal Reserve Bank tapering its bonds purchases. Tapering was perhaps the most discussed and feared financial event ever (now displaced by the prospect of future Fed rate hikes). The Fed tapering process is almost over, and since tapering began at the beginning of the year, long-dated interest rates have fallen, the S&P has returned over 9% while high yield returns have totaled 5.8%. Rate hike fears have now replaced tapering fears. Financial markets are forward looking, however. While it may not be apparent by eyeballing 10 and 30 year interest rates, the Treasury market has adjusted to the prospect of rate hikes. Short term interest rates have risen while the long end has fallen, flattening the yield curve substantially: the difference between 30 and 2 year Treasuries has shrunk by almost 100 basis points year to date.
Are rates across the curve headed higher? Sure, sometime. But inflation is still tame; the PCE deflator, the Fed’s favorite measure for inflation, came in at 1.6% for July, well below the 2% target. Interest rates around the world have collapsed. Two year German bund rates are negative. Portugal 10 years are trading at 3.22% (remember Portugal needed a bail-out) and Spain just sold 50 year bonds at 4%. U.S. Treasuries look like a bargain by comparison. As convoluted as it may sound, a big risk to high yield is that the European Central Bank is somehow successful in resuscitating the European economy and inflation, causing rates on European sovereigns to rise, pushing U.S. rates higher and high yield bond prices down. If that sounds like a mindbender, it is, and a very tough one to bet on given the moribund state of Europe currently.
Betting on higher interest rates has been a bad wager over the last year, and sitting on the sidelines waiting for higher rates has been a losing proposition as well. Rather than try to time interest rate movements for the right moment to enter or exit high yield, it would seem a better idea to put some portion of your money to work in high yield now and let bond coupons work for you (current yield for the index is 6.7%). More immediately, the high yield new issue calendar is expected to be sizeable over the next two months, which should provide opportunities to invest some of our cash balances.
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.