Long-dated UST yields are up about 7 bps, this morning, after somewhat hawkish comments from ECB president, Mario Draghi. Meanwhile, demand at yesterday’s 2-year UST note auction was off the charts. In spite of the strong performance of U.S. equities, the much-anticipated (by some) “Great Rotation” from bonds to equities has not materialized. Strategists who called or continue to call for such a rotation seem unwilling to acknowledge that it is demographics, rather than fear, which has been the primary driver for higher portfolio allocations in fixed income. However, that is not a sexy story to sell to clients and prospects. At Bond Squad, we prefer reality over sexy, any day of the week.
Welcome to the Bubble?
Along with equities, high yield bonds have performed quite well. Some of this was due to the recovery in the energy space. Some of the junk recovery has been due simply to a tremendous thirst for yield among aging investors. This has led to nearly the narrowest high yield bond credit spreads since the housing bubble (the narrowest HY credit spreads, ever).
Credit Spreads between B-rated U.S. HY bonds and UST Benchmarks, All Maturities (BAML):
As of close of business, yesterday, the average credit spread between yields found on B-rated junk bonds and their respective U.S. Treasury benchmarks was about 405 basis points. This is roughly half of what was considered “normal.” Even if we consider that strong demographic demand might augur for narrower HY credit spreads than in the past, 405 basis points seems to narrow for my liking. My concern is; if we do see higher UST rates, they could pull all corporate bond and loan yields higher. It is certainly difficult to imagine credit spreads narrowing much further. If higher absolute yields can be found on higher-quality bonds, capital may move up in quality, making credit expensive and/or scarce for lower-rated corporate borrowers. An increased incidence of corporate defaults is likely to follow, in my opinion.
One area of high yield which may offer some value is the energy sector. However, one must be able to tolerate potentially significant volatility and one must do one’s credit homework. When central banks pour on the monetary policy accommodation coals, it tends to push the prices of many asset classes higher. During an easing cycle, one can often simply gain exposure in broad asset classes and do well. However, when monetary policy is renormalized, one must surgically choose to what credits one is exposed. When the monetary policy punchbowl is drained or removed, having very diversified exposure in high yield debt can result in owning as many poor credits as good credits.
Broad portfolios may not work
In my opinion, broad (index) approach to high yield investing offers much less protection against corporate defaults and other credit problems than what is often marketed to investors. Portfolio managers who manage to an index may not be able to jettison problem credits due to a reluctance or inability to deviate from a stated model. In my view, not having the ability to deviate from an index or model, in times of rich asset prices, dislocations or credit turmoil is akin to allowing autopilot to fly you into the side of a mountain when the mountain is clearly visible through your windshield.
My current base-case strategy for high yield bond investing is to focus on companies with relatively-low balance sheet leverage, solid free cash flows and relatively-high interest coverage. I am prohibited from discussing individual credits in reports designed for mass distribution, but I am happy to have one-on-one discussions with subscribers and clients.
I am also focusing my high yield exposure on the short end of the yield curve, typically three years and in. This is not just because the 1-year to 3-year part of the yield curve is steepest (the steepest part of a yield/credit curve often represents the most attractive opportunities, on a risk versus reward basis), but because I want my HY bonds to mature before I expect the next recession to materialize. Recessions are usually not good for HY bonds.
BB and B-rated U.S. HY Corporate Bond Curves (Bloomberg):
BB-rated U.S. Energy Credit Curve (Bloomberg):
Looking at Energy Company Bonds
As you can see, the BB-rated Energy Curve is both steeper and offers higher yields than the all-inclusive BB-rated Credit Curve. This is, obviously, due to falling energy prices and the potential negative impact on corporate profits in the energy patch. However, thanks to greater production efficiencies, oil prices in the low $40s is not the disaster it may have been just a year ago. During my week off, I had several subscribers ask me about a certain oil driller with operations mainly in North Dakota’s Bakken field. I responded with the following:
On May 23rd, 2016, energy industry information site, “Oil and Gas 360” published the following:
“The report found low end for U.S. supply is in the Midland Basin (about $51 per barrel) while the most expensive production is in the Williston Basin Bakken/TFS (about $67 per barrel).”
However, S&P Global published the following on 5/15/17:
“North Dakota’s breakeven price for crude production averaged $24/b in the first quarter of 2017, with the breakeven in the state’s most active county averaging $21/b, according to estimates from the state’s Department of Mineral Resources.”
Look at that. Today’s breakeven for oil in ND is little more than one-third what it was a year ago.
Thus, $40 might be the new $60. This makes it very difficult for supply to fall sufficiently to get the price of WTI to $60. It also means that, with oil currently around $44, U.S. producers may not have profit margins squeezed as much as some energy sector bears believe. Again, one must do one’s credit homework when one is contemplating exposure in energy sector bonds. Credit and profit conditions can vary wildly, within the energy sector.
About Thomas Byrne
Thomas Byrne has achieved a 26-year career in financial services, 23 of which have been spent in the fixed income market sector. In his role as Director of Fixed Income for Wealth Strategies & Management LLC., Byrne is responsible for providing strategic analysis and portfolio management to private clients and institutions, in addition to offering strategic advisory services to other financial services organizations. Byrne's areas of expertise include trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt, and convertible bonds. Additionally, Byrne provides analysis, strategy, and commentary within the fixed income market. Prior to joining WS&M, Byrne worked as Director in the Taxable Fixed Income Department of Citigroup, Inc., in addition to predecessor companies in New York, NY.