U.S. High Yield Market Overview
The U.S. high yield market was shaken by the news in early December of the closure and liquidation of the Third Avenue Focused Credit Fund. The high yield market was already on unsteady footing after the Barclays U.S. Corporate High Yield Index turned in its worst calendar quarter return since the third quarter of 2011, down 4.86%. 2015 will also be the first calendar year loss for the Index since the financial crisis. But that is about where the similarities end between these two periods in the high yield market.
Is Third Avenue’s closing the opening salvo in a “contagion” event?
Despite some of the more sensationalist headlines of the past few weeks, the consensus among the high yield managers we have spoken to this month or have issued research reports on the subject is Third Avenue’s closing is an isolated incident and unlikely to have a broader impact on the high yield market. There is no denying the high yield market, and in particular the energy sector, is going through a period of change, but this upheaval is directly related to specific economic fundamentals rather than the near panic-level “risk-off” mentality that drove the Index down over 25% in the final six months of 2008.
Third Avenue’s Focused Credit fund was very different from the average high yield fund in two very important ways. First, as the name implies, the Focused Credit fund held a relatively small number of positions, usually less than 60, whereas the average high yield fund holds more than 200, and the largest funds hold 400-500. These holdings were conviction weighted as well, with 5% positions being common, where the typical high yield fund rarely has even a 2% position in a single name. Secondly, Third Avenue invested primarily in stressed and distressed credits, corporate restructurings and companies already in bankruptcy. This led the fund to have 60-90% of its holdings with a credit rating of CCC or lower or no rating at all. Of the 153 unique high yield funds in the Morningstar database that reported their credit quality breakdown in the last six months, only 17 other funds had more than 30% of their portfolios rated below B or not rated at all and only three held more than 50%.
The combination of concentrated positions, which were fairly well known to the other stressed/distressed traders, and bottom tier credit quality, made Focused Credit a significant outlier in the high yield space. In what turned into a viciously self-reinforcing cycle, redemptions from the fund made Third Avenue a forced seller into a much less liquid market with far fewer trading partners than the more common BB and B rated market. Knowing Third Avenue was forced to sell allowed those trading partners to lower their offers well below fundamental values. Thus the firm decided to halt redemptions to protect the remaining shareholders, rather than continue to be forced to sell at below market prices. Nuveen’s High Income Bond fund is another of the year’s worst performers, down more than 12% this year due to its more than 30% exposure to CCC and not rated issues, has had redemptions of more than 22% of its AUM as of the beginning of the year (through the end of November), but it has more than 200 holdings. Principal’s High Yield fund has seen redemptions of more than half of the $1.7 billion in AUM it started the year with, despite being down less than 4% this year, but it has just 17% in the bottom two credit quality buckets and has more than 500 holdings. In short, it is very unlikely that any other mutual funds will be forced to close and liquidate assets as Third Avenue did, though volatility is likely to remain throughout 2016.
What is driving the volatility and the losses in the high yield market?
An aging credit cycle and the prospect of higher rates certainly have factored into the weakness in the high yield market in 2015, but the most significant factor has been the collapse in commodity prices over the last 18 months, particularly oil, natural gas and coal. This has created a deeply bifurcated market, in which the index level data looks poor, but when broken out shows two very different stories.
From 2009 through 2013 the U.S. high yield market was a “beta” market. That is, any exposure was positive and the Barclays U.S. Corporate High Yield Index beat 85% of the actively managed mutual funds over those five years. This started to change in mid-2014 as oil prices fell from the $85 to $95 range (where it had traded for most of the previous four years) to $60-65 for the first half of 2015 and now, at the end of 2015, below the $40 level. This placed severe downward pressure on revenues for many of the companies in the Energy sector, and as a consequence those companies’ ability to continue to pay their debt service. A similar pattern impacted many of the natural resource/commodity companies. The residual effect was for investors to demand higher risk premiums (spreads) from these sectors to compensate for the increased risk. This became increasingly important as the weighting of the energy sector in the Index jumped from just over 10% at the end of 2013 to 15% by the end of June, 2014 through an explosion in issuance. The impact can be seen clearly in the chart below, as the option adjusted spread (“OAS”) for the Energy sector at the end of the second quarter of 2014 was essentially the same as the broader Index at 3.4%, but over the last 18 months jumped to 10.0% while the OAS for the Index ex-energy is 5.5%.
The key takeaway: the overwhelming majority of the Index’s losses over the last 18 months are driven by economic fundamentals specific to a few sectors rather than fear or a mass exodus from the asset class as was the case in 2008. As the table below shows, there was literally no place to hide in 2008 as not a single sector or industry sub-group had a positive return for the year. In contrast, 24 of the 43 industry sub-groups have a positive return this year (through 12/28). Indeed, a handful of funds have a positive return for the year and roughly 65% of the funds are ahead of the Index for the year through December 28th.
What does all of this mean for 2016?
2016 is very likely to continue many of the same patterns as 2015, with a few new wrinkles added in. With very modest global growth forecasts for the year, oil and commodity prices are unlikely to stage a dramatic enough of a rebound based on demand to change the precarious position of many companies. Default rates, which have been well below historic norms for the last five years, are likely to increase in 2016, but remain well within historical norms and be concentrated in companies tied to commodities. However, some of these weaker companies are likely to be acquired by larger, more stable companies, creating selective upside potential. Even a stabilization or modest increase in commodity prices could allow for a compression in spreads in these sectors.
The consumer sectors and the financial sector are likely to fare better, as they did this year, as long as the economy maintains at least the same modest level of growth as the past few years. One twist this year will be the Fed’s actions, now that the first rate hike since the financial has been delivered. While this should have only a modest direct impact on the high yield market, modestly higher rates in the investment grade market could draw some investors away from the high yield market, particularly late in the year. A strengthening dollar, due in part to the same rate hikes, would make U.S. high yield very attractive to foreign investors as well. The new issuance market remains very accommodative, again outside of the energy sector, severely limiting the possibility of defaults due to the inability of companies to refinance current debt.
After excluding the Energy sector, the Index will start 2016 with a yield to worst of nearly 8.0% and an OAS of nearly 6.0%, providing solid current income as well as potential for capital gains if spreads contract back toward the long term averages. This is very attractive for investors searching for income or total return, relative to the 3.7% yield to worst and 1.7% spread of the Barclays Corporate Index (investment grade). Headline risk and default risk will be higher in 2016 than it has been in the past few years, so investors should be prepared for another bumpy ride. But the bifurcation of the high yield market along with upside potential in the weaker sectors should provide an excellent backdrop for active managers in the asset class to provide significant value over the broader indexes.
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