Q2 2017 High Yield Commentary
The Bloomberg Barclays High Yield Index returned 2.17% during the second quarter of 2017 and 4.93% for the first half of the year, continuing, although at a slower pace, the robust 2016 performance (+17.13%) which was the best since the 2009 recovery performance of 58.21%. Unlike Q1 and all of 2016, the highest rated credit sector (BB rated) outperformed the weaker sectors (i.e., BB rated bonds outperformed B and CCC rated bonds). While the highest rated credits within the universe outperformed the lower quality credits, the entire market was characterized by continued spread tightening – the Index spread tightened from 383 to 364, or 21 basis points over Treasuries and BB rated credits tightened from 252 to 227 or 25 basis points over Treasuries. Spreads are now near their tightest in almost a decade, and while performance during Q2 was positive across all credit subsectors, it is important to note that during 2008 and 2015, the lowest rated credit subsector (CCC) recorded negative returns of 49.53% and 12.11%, respectively. We highlight these returns to point out that with outsized positive returns come outsized possible losses, and the volatility of the CCC credit subsector may not be appropriate for many clients’ risk profile and tolerance levels.
Unlike calendar 2016’s performance that was, in great measure, attributable to the robust recovery of the Energy Sector, Q2 witnessed positive performance by almost all Sectors, led by the Financial Institutions Sector, which was up 3.67%. That Sector accounts for over 9% of the Index, so its performance had a positive impact on the Index performance, but clearly not the significant impact that Energy played during 2016. In fact, Energy posted negative returns of 1.16% for Q2 as oil traded below $50 in the area of $45 per barrel for most of the quarter.
Even as the FED has increased the Federal Funds Target Rate twice this year, yields on intermediate Treasuries have declined with the 10‐year Treasury at 2.31% at June 30, down from 2.39% at the beginning of the quarter and from 2.45% at the beginning of the year. Intermediate term yields more often reflect GDP and expectations for future economic growth rather than actions taken by the FOMC to adjust the Target Rate. The consensus view of most economists suggests a sluggish GDP in the 2% range with inflation expectations at or below 2%. It is easy to understand that the “search for yield” that we have witnessed for several years continues and that the high yield market is benefitting from that search. This search for yield has also been observed in the investment grade universe where the lowest credit rated debt has outperformed the investment grade index as a whole. During Q2, high yield issuance continued to be fairly robust at $76.7BB versus $98.7BB during Q1. Year to date issuance stood at $175.3BB. This pace could see us easily exceeding 2016’s total issuance of $286BB.
Discussed at length during the year by many high yield observers was the fact that, while spreads were tightening, the restrictive covenants contained in the indentures under which the bonds were being issued were becoming more and more “relaxed”. In other words, while investors were searching for yield, issuers were able to negotiate with investors to remove covenants that previously were provided as standard protection for the investor: namely leverage constraints, disposition of assets, etc. More and more, a professional manager is needed to select bonds of quality – bonds that compensate the investor for the risks he undertakes in a high yield portfolio.
Cincinnati Asset Management buys only B3/B‐ and higher rated securities, and, given that the CCC sector underperformed the Index as a whole, it is easily understood that our performance exceeded the Index for the 2nd Quarter (2.24% gross total return vs. 2.17%). During this period, we remained cautious in our investment strategy, maintaining higher than normal cash balances as we become more selective (higher credit quality) in our security purchases. Given the market performance, these cash balances served as a drag on our performance as well.
Further addressing the issue of performance by credit sub-sector, the following table highlights the impact of the performance of the several credit sub‐sectors in the high yield universe on the aggregate high yield performance:
An additional observation: The Index yield for the High Yield Market is 5.62%. Default rates have been low since the Energy sector “crisis” of 2015/16; however, there will always be defaults in the high yield universe. Historically, those defaults have come principally from the CCC and lower subsectors. So pricing needs to reflect that eventuality. With respect to 2017, we continue to be cautious. Many potentially positive factors could favorably impact corporations in the high yield space (changes in the tax code, relaxed and fewer regulations, etc.); however, the impact of changes in trade agreements and the health of the global economy need to be carefully monitored. Defaults, excluding Energy, have remained lower than the long‐term average default rate – a positive sign with respect to the current health of the asset category. On the other hand, the “shrinking” spreads (i.e., implied premium to Treasury bonds) is of concern given that the “search for yield” may have resulted in an overvalued market. The tightening of spreads implies the expectation of a robust recovery in corporate performance.
In this uncertain environment, it is important to focus on credit research and to attempt to buy bonds of corporations that we believe can withstand economic headwinds and can enjoy improved credit metrics in a stable to improving economy.
This information is intended solely to report on investment strategies identified by Cincinnati Asset Management. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. Fixed income securities may be sensitive to prevailing interest rates. When rates rise the value generally declines. Past performance is not a guarantee of future results. Gross of advisory fee performance does not reflect the deduction of investment advisory fees. Our advisory fees are disclosed in Form ADV Part 2A. Accounts managed through brokerage firm programs usually will include additional fees. Returns are calculated monthly in U.S. dollars and include reinvestment of dividends and interest. The index is unmanaged and does not take into account fees, expenses, and transaction costs. It is shown for comparative purposes and is based on information generally available to the public from sources believed to be reliable. No representation is made to its accuracy or completeness.