“We are all in the gutter, but some of us are looking at the stars.”
― Oscar Wilde
Vermin Lessons for the High Yield Sell-Off of 2015
Hunker down: duration instead of eliminating it. Take a total return approach.
Small doesn’t starve: Levered positions kill the bigger and stronger.Invest income streams into this weakness.
Don’t get caught in a trap: The bottom of the capital structure, common shares, have yet to catch down to credit, but it always does. High yield offers correlation to equity and decent enough yield to make reinvestment mitigate capital losses.
Diversify food sources: High yield is a diversified and eclectic space that offers unconstrained exposures to de-synching FX and interest rate policies.
The summer of 2015 sucked for those of us hunkered down in high yield. The response for some has been to hedge in one shape or another. But for retail investors, the only viable risk management strategy has been to sell. And the prospect of continued bruising losses isn’t over, as the Fed considers a rate hike. This spells yet more pressure on leveraged position in the space.
But after such a string of negative returns, selling is a dubious strategy at this point. Hedging? Come on, the volatility seen makes it costly. Follow the trend through a rate hike cycle? If you think rates are on an upward trajectory every six months for the next few years, sure. Don’t count on it. When it comes to high yield in 2015, we need to take a lesson from the rat.
The theme of the rat is to hunker down and hold on. After all, the leverage is not being deployed by retail investors: this is their greatest strength, as it allows them the patience to hold and get their principal returned and coupons paid. The leverage deployed is via hedge funds, investment banks, and dealers. Leverage forces them to sell to meet margin and the associated volatility shakes out all the weak hands in the process. This is the fixed income habitat, and survival has been hard lately.
“Hunker down and hold on” sounds pretty stupid without understanding the guiding rationale behind it. That rationale is shifting the focus to total return.
The Fed rate hike has caused money to reduce duration, which is fair enough. One of the most crowded trades in the world has been short duration high yield. There are very liquid ETFs that cater to it. The alternative is to still with duration, or even maximize duration by reinvesting the proceeds of high yield investments back in at lower levels. So you will see negative short-term capital appreciation, but reinvestment at depressed levels increases current income.
People made fortunes of a lifetime doing this with the long duration treasuries in the early 80s. The math isn’t right for this to work with government securities having a 2% return on 10 year money. Moving to 4% implies an enormous loss in principal and not enough increased income to mitigate it through reinvestment. But the math works in high yield if you say out of energy companies where the default picture is by no means settled.
Let’s sketch out how a total return emphasis can steal some short-duration flavor.
How We Got To This Point
Through years of central bank easing, people took equity risk in fixed income. This summer, taking that equity risk has been a crazy ride. For a good part of the year, implied yields in IBoxx high yield has been under 400 bps, then starting this summer, asset swap margin moved from 381 bps to 453.
To the equity fan, this may seem next to nothing. But in fixed income terms, it is devastating. This is due to the leverage deployed in credit. When selling triggers get hit in fixed income, the forced deleveraging involved makes the sell-offs persist until some sustainable and rather dismal ground-state level of energy is reached. This is why you see moves in credit that in no way resemble random events like coin flips that chop around an average value. Instead you see a long run of down days that makes price action fall off a cliff. It really doesn’t matter if it is high yield or high grade and the currency of denomination doesn’t matter either. Leverage forces credit markets into one-way reversals that search out a new equilibrium state that can is sustainable without the short-dollar borrowing that created the compression of yield.
Like all bonds, high yield carries its share of interest rate risk (which frankly forms the basis of all leverage and deleveraging decisions) and an outsized share of credit risk. In the past the countervailing forces have balanced each other. So in broad terms, retail money took investment grade as (oh the scowls this crude term brings) safer and thus it got a bigger share of leverage. High yield is not as leveraged because it was not as safe.
Now I understand that this conception of safety is as crude and venomous as a jelly fish. This conception is in fact the root cause of the current troubles. With years of very, very cheap funding and negative real yields in a lot of “safe” paper, retail money had to rethink what income actually meant. That is to say, they couldn’t get capital appreciation and current income in credit. Capital appreciation was easy—just be short dollars and buy anything. Let your central bank do the heavy lifting. But current income—the whole reason for bonds (“fixed income”)—was hard to come by in a world where one received 2.5% for ten year money. In such a world it is possible that your principal won’t be coming back in real terms. It takes no genius to apprehend that ten year money at 2.5% is not safe at all. It turns out that there is no safe fixed income.
So retail demand for ease of entry into fixed income created ETFs, and those looking for income took more credit risk using these vehicles. They still deploy mutual funds, but—for good or ill—ETFs opened up fixed income trading to small money investors.
This worked very, very well for years. As money people jumped into this game, spreads over treasuries compressed. To keep the yield attractive to retail investors, dealers, hedge funds, and money managers deployed the tried and true method to enhancing yield: they bought high yield bonds on margin. This means high yield bond leverage—borrowing money (being short dollars) to get incrementally higher yield. There is a credit risk component to this paper which makes leveraging inherently more volatile and prone to reversal, but this was considered a manageable risk. No matter that high yield has not been historically unsuited to this. Lever it up anyway because yield is the need.
Currently, Fed policy cautiously but incrementally tightened since mid-2013 yet this still worked well enough. In fact, retail money stepped into 2013 and stopped what could have been an avalanche. But the appreciating dollar starting in 2014 has caught a growing number of dealers, hedge funds, and in a short squeeze. Add to this rising interest rate risk, and short dollars is a dubious proposition. Short dollars and long very risky paper have caused a deleveraging cycle, and a sustained and persistent drubbing for high yield.
Total Return and the Summer of the Rat
Risky bonds sell for a reason: changing conditions reflect greater likelihood of default and loss of principal. The total return approach doesn’t shy away from this reality. Total return focus reinvests cash flows at higher yields to recoup losses. When fundamentals improve, the result is capital appreciation and fatter income streams with it.
I mentioned that this worked with Treasuries in the nasty bear market in the late seventies and early eighties. It won’t work now because the yields are so miniscule they don’t mitigate loss of capital. That is to say: duration has to be managed relative to yield.
If you think that the name will not default and the investment horizon is greater than five years, then there is an argument for buying the common shares. I think this argument flawed for three reasons. The snag is that at this point in the liquidity cycle, equities are only beginning to catch down to credit—and equity always does eventually. And common is by nature a residual security with no assurance of a dividend. Finally subordinated debt, a big part of the high yield space, is naturally correlated to equity, so you get a share of that upside.
Finally, high yield credit is a widely diversified space that includes domestic and international bonds in a number of currencies, maturities, and risk profiles. An unconstrained approach to fixed income is essential when central banks are not in synch and policy uncertainty is the word.
How many times have you marveled at some anecdote about our little frenemies’ survival skills and said: “Hey look, those rats! Rugged little brutes, these are. If they can survive this, they can outlast anything, yes?”
Don’t underestimate the power of small-scale strategies to weather the storm. Situated atop Mount Garbage, the rat prospers amid the margin calls and hubris that hedge funds and investment bank leave behind. And never forget that many times the rat caused near extinction to Homo sapiens by carrying the plague and other pestilence right into civilization’s inner core.