Opportunity in High Yield Bonds

Transcription

1 Research Opportunity in High Yield Bonds 2016 Q1 Quarterly Commentary Weyland Capital Management LLC - 22 Deer Street - Portsmouth, New Hampshire p This document reflects the views of Weyland Capital Management as of the dates cited. No representation or warranty is made concerning the accuracy of cited data. Nor is there any guarantee that any projection, forecast or opinion will be realized. The views expressed may change at any time. References to stocks, securities or investments should not be considered recommendations to buy or sell. The value of investments, and the income from them, can fall as well as rise and you may not get back the original amount invested. The value of overseas securities will be subject to exchange-rate fluctuations. Under no circumstances should this information be construed as investment advice. Nor should it be construed as sales or marketing material for any financial instrument, product or service. Past performance is not a guide to future performance.

2 Q1 Market Review The asset class returns shown below do not reflect the global market turmoil during the first quarter. U.S. and international stock markets suffered corrections of greater than 10% for the second time in six months. The recovery from the mid-february low was as swift as it was last October. Oil market volatility and slowing growth in China drove fear that a global recession was in the offing. The price of oil dropped 26% in the first six weeks of the year, and the Shanghai Composite Index dropped 25%. The Fed added to the rout by telegraphing four rate hikes in 2016 that investors feared would strangle the U.S. economy. Oil prices and the stock market bottomed out on the same day in mid-february, but it is difficult to determine which was the cause and which was the effect. Further stimulus from the European Central Bank and the Bank of Japan, solid economic reports in the U.S. and the Fed backing away from its plan for four rate hikes all contributed to the turnaround in investor sentiment. Source: Tamaracinc.com Performance Contributors Allocation to Gold Gold was the performance derby winner. Emerging Markets A weaker dollar and the rebound in energy and commodities prices strengthened emerging market stocks. Underweight International Stocks Stock markets in Europe and Japan underperformed the U.S. Performance Detractors Underweight Bonds Falling interest rates and a weaker dollar pushed the global bond index higher. Page 1

3 High Yield Bonds and Default Rates High yield bonds, the gentler term for junk bonds, suffered a rout late last year, providing an opportunity to add to your high yield bond allocation at favorable prices. Selling pressure, driven by fear of higher default rates, sent bond prices lower and yields higher. The drop in the junk bond market was driven primarily by the energy sector. Corporate debt in the oil and gas sector more than doubled during the last five years. The sector borrowed to ramp up production, taking advantage of low borrowing costs and high profit margins when oil was above $100. The profit margins are gone, but the debt remains. Higher yields widened the spread between junk bond and investment grade bond yields. Yield spreads are deservedly higher for the cash-strapped energy sector. However, spreads for the rest of the junk bond market widened too, implying higher expected default rates despite strength in the non-energy sectors of the economy. Source: Standard and Poor s, B of A Merrill Lynch, Federal Reserve Bank of St. Louis The implied default rate tends to track just above the actual default rate. The difference between the two is the premium paid to junk bond holders for the higher risk in speculative debt. Between 1997 and 2007, the spread between implied and realized default rates was reasonably consistent. That changed in During the credit crisis, investors fled from credit risk. The resulting lower bond prices and higher yields implied that investors expected 30% of junk bonds to default. According to Moody s, the realized corporate bond default rate at the height of the Great Depression was 9%. With perfect hindsight, junk bonds were a screaming buy in early When yields contracted later that year, junk bond investors did very well. See how easy it is to invest in the rearview mirror? Both implied and actual default rates increase during recessions. When the economy contracts, lower corporate cash flow squeezes the ability of the weakest corporations to service debt. Page 2

4 Credit spreads also widen when sentiment turns against junk bonds. The spike in the implied default rate in late 2011 was not followed by either a recession or higher realized defaults. Instead, as spreads contracted, investors were rewarded with double digit investment gains in If the U.S. is not headed toward a recession, junk bond investors should again benefit when credit spreads contract from the current wider than normal level. Unemployment and Recessions Our Q Quarterly Commentary included two recession models: the Federal Reserve model and the Gross Domestic Income model. The Federal Reserve model uses employment, industrial production, income and sales data to determine near term recession risk. The Fed model s current recession risk is just 0.7%. The Gross Domestic Income model uses the year over year change in inflation adjusted employee compensation, business profits and taxes. Business profits have been damaged by the energy sector, but Gross Domestic Income growth, while not robust, still indicates economic expansion. A third model for predicting recessions is the historical relationship between unemployment and recessions. Unemployment generally rises as the economy slows prior to recessions. When the unemployment rate climbs above its recent average, a recession has historically followed. The chart below shows the unemployment rate and its 48 month moving average. The average moves with time to capture the most recent 48 monthly reports. Source: U.S. Bureau of Labor Statistics, Federal Reserve Bank of St. Louis Page 3

5 Each recession since the 1960s began when the unemployment rate crossed above the 48 month moving average, and the indicator has been consistently accurate. The average unemployment rate over the last 48 months was 6.5%. The current unemployment rate is 5.0%. The historical relationship between the two implies that unemployment would need to rise to 6.5% to indicate a looming recession. Conclusion Widening credit spreads over the past year increased the implied default rate for junk bonds. According to Moody s, the actual junk bond default rate in 2015 was 3.3%. Moody s estimates that higher energy sector defaults in 2016 will raise the default rate to 4.5%. While that rate is above the 2.1% average rate outside of recessions, it is much lower than the default rate implied by the credit spread. The current yield on junk bonds is over 8% a very attractive yield in this low interest rate environment. If spreads contract, as they have following prior spikes, the rise in bond prices would add to total return for junk bond investors. Given the low recession probability indicated by the recession models, wider junk bond spreads present an opportunity for favorable investment returns relative to the aggregate bond market. We used that opportunity to add to your high yield bond allocation. As always, we welcome any questions or comments you may have. Weyland Capital Management Page 4