Certainty, Rates and the Year Ahead

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“The American Republic will endure until the day Congress discovers that it can bribe the public with the public’s money.”

“I do not know if the people of the United States would vote for superior men if they ran for office, but there can be no doubt that such men do not run.”

― Alexis de Tocqueville, Democracy in America

The government tells us not to worry, as the Federal Reserve comes to rescue with QE-Forever. Certainty with fiscal policy doesn’t seem to change the demand equation and cheapened money doesn’t do anything if demand isn’t present. Treasury rates remain at 0% for the foreseeable future making yield hard to find. Read this position paper by Peritus Asset Management scrutinizing how all this has come to pass and what indicators are foretelling the near future effects on the high yield asset class.

Cliffs, Taxes and Insanity

Are there two more appropriate quotes given the last few months? Let’s get this one out of the way since it is front and center. Taxes are going up, and don’t believe the headlines that it is just on the “rich;” all working Americans will take a hit via the higher payroll tax. People looking for certainty on the fiscal cliff now have it. So now that we have established this certainty, will it grow the economy and jobs? We don’t expect it to, though for some reason many people seem to be waiting for a massive rally in equities once we “fix” the fiscal cliff issue. But we don’t see how raising taxes and cutting the growth in spending fixes anything. Governments and consumers still have too much debt, deficits are enormous and growing, and our entitlement/benefit programs of Medicare and Social Security are unsustainable. Interest rates are near all-time lows, liquidity is near all-time highs and yet we continue to push on a string with anemic economic growth and high unemployment.

If businesses have opportunities to grow profits and need people, they will hire them. This is why the notion of “uncertainty” constraining the job market and economic growth doesn’t make any sense. Certainty isn’t going to change the demand equation. So raising the debt ceiling and agreeing to a higher tax rate on incomes above $400,000 and higher payroll taxes has led to a short-term equity rally, but it will not assist in growing the overall economy. It doesn’t seem to change the major problem that we levered up for the last 20 years, effectively borrowing demand from the future.

If you think this through, why were all of these automatic funding cuts and tax increases put into place? They were put there to force us to deal with the unsustainable budget deficits and long-term solvency issues we are now flirting with. The “cliff” was created by both parties the last time we had to increase the debt ceiling (August 2011). It appears that we have put a temporary band aid on, but have done nothing to address the real structural issues. But the government is telling us to worry not, as the Federal Reserve (The Fed) is coming to the rescue with QE-Forever. So in addition to buying $40 billion worth of mortgage securities every month, they will do some more “twisting” by purchasing Treasuries, and of course keeping rates at 0% for the foreseeable future.

In particular, the Committee decided to keep the target range for the federal

funds rate at 0 to ¼% and currently anticipates that this exceptionally low

range for the federal funds rate will be appropriate at least as long as the

unemployment rate remains above 6-1/2%, inflation between one and two

years ahead is projected to be no more than a ½% above the Committee’s

2% longer-run goal, and longer-term inflation expectations continue to be

well anchored. The Committee views these thresholds as consistent with its

earlier date-based guidance.1

So now they will target an unemployment rate of 6.5%. The recent payroll reports would seem to suggest this could happen soon as more and more people just stop looking for work. The old program had the Fed selling shorter dated Treasury bonds to purchase longer dated bonds. Now, they are just going to print money to buy the longer ones. The question on my mind is why does the Fed feel the need to do this? The first reason I can think of is that they feel they don’t have any other options. Secondly, are they are trying to pre-empt a run on the U.S. dollar and the Treasury market from our foreign creditors? The fact is rates are at or near all-time lows and have been for a number of years; we have already cashed in that benefit and even lower rates will likely have no real economic impact going forward.

Demographics, Global Economics and Demand

Let’s turn our attention to the often overlooked issue of demographics. The following chart depicting a declining working-age population was displayed in Jeremy Grantham’s excellent quarterly client letter entitled, “On the Road to Zero Growth.”2, 3

The reality is that most of the developed world is facing the same issues. Earners (and therefore consumers) are rapidly decreasing, meaning they will pay fewer taxes, consume less and, of course, begin to tap the massively underfunded social programs. Think about the largest economies of the developed world outside of the U.S., including Japan, Germany, Italy and France. You don’t have to be an economist to realize that these economies are struggling mightily to grow.

This is why we expect that keeping interest rates suppressed will have almost no impact going forward. It doesn’t matter how cheap money is if there is no demand for goods and services. Take a look at domestic capacity utilization. The economic “recovery” over the past three years has basically pushed the capacity utilization number to the bottom of the range for the recessions of 1982 and 2002.4

Final demand for goods and services in the western world is not being made up for by the emerging world in the near-term. How about those “BRICs” that we hear so much about? Brazil, Russia, India and China have been producing most of the growth for the last decade but reality has set in. They will still be growing, but in the best case, it will likely be about half the growth rate of the past ten years.


Source: FactSet

What about the “recovery” in housing? Won’t that spur an economic recovery, as many seem to believe? While we are all happy to see the bottom in housing, what we need to do is put things into perspective. We were build­ing over 2 million homes per year at the peak, and now we are at about 40% of that level.6 So while residential construction may be a positive economic contributor, we would expect that its impact would be muted.

All of this data points to our conclusion that GDP growth in the U.S. and globally will likely be constrained for the foreseeable future. This means earnings growth may also be limited. This backdrop is problematic for those expecting a strong equity market during 2013. While there will surely be rallies over the coming year, the backdrop does not support sustainable P/E7 multiple expansion or earnings growth.

Interest Rates

As we look to 2013, we believe that nothing will be more important than interest rates. It is tough to see rates get­ting a whole bunch lower, though the flight to quality/fear trade remains a possibility. The 5-year Treasury began 2013 at a yield around 0.7%. Surprisingly, even last year there was considerable volatility in this yield.8

Source: BofA Merrill Lynch Global Research Past performance is not indicative of future results

The most difficult thing to assess is what impact the Fed is having on these yields, and the fact they are printing money does not make this assessment any easier. But whether rates rise because of negative market events (bond vigilantes and/or foreign investors leaving, necessitating higher rates to attract buyers) or a more positive reason (some global stabilization or at least perceived as such), a case can be made for 5-year rates to move back up. For instance, if rates were to approach their highs of last year (1.2%), this 50 basis point (0.50%) move off of a beginning yield of 0.7% would be problematic for many fixed income investors, particularly those who have been gobbling up investment grade (“IG”) corporate debt, which has little spread over Treasuries. The IG trade remains confusing to us because regardless of how comfortable you are with those ratings, you have credit risk, duration (interest rate) risk, often limited trading liquidity, and limited covenants, all while clipping a low yield.

On the other hand, while high yield investors understand they have greater credit risk (whether perceived or actual), but high yield bonds benefit from tighter covenants, generally greater trading liquidity and lower interest rate risk. Duration (interest rate sensitivity) is minimized because high yield bonds tend to have shorter maturities and higher coupons. The higher the initial spread a portfolio has, the less sensitive it is to rising rates. For instance, a 50 basis point (0.50%) change in interest rates would have significantly less impact on a credit with a 7% beginning yield than one with a 1.5% yield.

Overall, the high yield asset class today possesses a spread-to-worst of over 550 basis points (5.50%) above Treasuries.9 As can be seen by the following chart, there is actually a negative correlation to the 5-year Treasury for bonds with spreads over 400 basis points (4%) above Treasuries, so rising rates are not the enemy of high yield as they are for many other lower yielding fixed income asset classes.

Past performance is not indicative of future results. OAS is the option adjusted spread range for products (spread buckets) with a 0 to 400bps spread over Treasuries, a 400 to 600bps spread over Treasuries, and an over 600bps spread over Treasuries. Data covers the period from 9/2/2005 to 11/16/2012.

Leveraged Loans

While we are on the topic of interest rates, we need to address the recently popular, and what we view as a somewhat misguided, notion that leveraged loans are simply a better investment than high yield bonds. This sounds intuitively appealing, as the pitch goes something like this: leveraged loans have similar yields to high yield bonds, have less risk as they are senior in the capital structure and offer floating rates which protect investors from a rise in rates. While there is nothing wrong with any of this, the reality is generally a little cloudier.

Let’s start by saying that Peritus has and will continue to invest in the leveraged loan market. Currently, the market size for loans, at approximately $1.3 trillion11, is very similar to that of high yield bonds.

Within these markets, there are companies that issue just bonds and companies that issue just loans. So for us, while the benefit of potentially reducing volatility and further reducing interest rate risk (duration) with an investment in the loan market is attractive, it is the ability to access certain credits that do not have bonds in their capital structure that we are primarily interested in. With the loan market, we are able to expand our available investment universe without having to sacrifice a huge amount of yield.

However, two additional points about the loan market need to be made. First loans are tied to the London Interbank Offering Rate or “LIBOR.” The relationship between LIBOR and Treasury rates is not a perfect correlation. So you could see a sell-off in Treasuries with a corresponding rise in rates, while LIBOR does nothing. Secondly, if LIBOR does experience a substantial rise, loans could suffer as well. This is purely a fundamental issue. A company that has substantial exposure to floating rate debt will see its interest bill rise and could see its credit metrics deteriorate.

Similar to the high yield market, investing in the leverage loan market does take some work and as such, we do not believe in a market or “index” trade (in other words, buying a passive or index-based vehicle). There are lots of bad loans that need to be avoided. To fully explain this, a brief history lesson is in order. The leveraged loan market began to grow in earnest in the late 1990’s due to the aggressive ramp of the collateralized loan obligation (“CLO”) business. This growth ramped up significantly in the mid part of the last decade as loans were the vehicle of choice to fund the LBO (leveraged buyout) heyday. Fast forward to today, we are faced with the reality that the expected default rates for loans over the coming couple of years are actually higher than those for the bond market (profiled later).12 This is primarily due to those loan-heavy structures of some of the biggest LBO’s from the mid 2000’s.

In addition, much has been made about the recent use of proceeds for new issues in the leveraged finance world. Specifically the use of proceeds toward dividend deals for private equity sponsors. While we have commented about this in prior correspondence (see our piece, “More than a Feeling”), it should be noted that the leveraged loan market has been the primary sponsor of such dividend deals, not the high yield market. We would expect this to continue as CLO issuance has created a tremendous amount of money available, desperate for loan product, and these desperate investors tend to be a bit more lenient.13

Past performance is not indicative of future results.

Now all of the dividend and use of proceeds talk needs to be put into perspective. Leveraged finance investors do not like to fund dividends to sponsors as it is a non-productive use of capital and lessens the commitment these owners may have to their companies should they experience a problem down the road. Even considering both markets, nearly $75 billion of dividends14 against a $2.5 trillion bond and loan market15 is less than 3%. In high yield the number is closer to 1%. That is hardly a disturbing figure and one that has been blown way out of proportion in the media.16

State of the High Yield Market

What high yield investors, such as Peritus, are primarily concerned with is credit risk. Overall high yield default rates for the coming years are forecasted to be nearly half of the historical average of approximately 4%.

Given the shaky economic backdrop, how can anyone have confidence that these default forecasts will hold? There are several factors that provide some support for these forecasts. First, corporate liquidity and access to capital have rarely been greater, as evidenced by a record setting new issue market in 2012. But what has caused the default rates to spike three times in 30 years gets back to that use of proceeds more than anything else. Back in the late 1980’s, the market grew from the LBO business and over the course of time, leverage multiples became excessive causing the hiccup in the early 1990’s. In the late 1990’s, it was the financing of business plans with no revenues or cash flows (known to us as “TMT,” or telecom, media, and technology businesses during the internet bubble). The latest issues in 2006-2007 that led up to some of the problems of 2008 (though that was a systemic issue not just a high yield or leveraged loan issue) were of the same making as the late 1980’s, namely massively over-levered LBO’s. However, the last few years in the high yield space have seen the use of proceeds primarily directed at refinancing, which we view as a positive.17

Additionally, we just have not seen the re-leveraging of balance sheets; leverage metrics remain relatively conservative.18

So in an environment of historically low default rates and conservative balance sheets, let’s take a look at the high yield market as it stands today. Contrary to many media reports, high yield is not in bubble territory and, even when looking at the index, represents what we believe to be attractive value.19

While the average spread is 583 basis points (5.83%) over the 5-year Treasury, this “average” is deceiving and skewed, particularly given the 2008 period. The median spread levels are closer to 530 basis points (5.30%). More importantly, nearly 60% of the time the market has traded below the average spread level.20 The outlier periods of 1990, 2002 and 2008 were created by increasing default rates which were caused by excessive leverage and a poor use of proceeds. None of these conditions are present today in the high yield market. Given this, we see the potential that existing spreads could be coming in over the next year.

Summary and Conclusion

So to summarize our thoughts on why we believe high yield is positioned well for 2013:

  • High yield has a short duration and has limited interest rate sensitivity, given the shorter maturities and higher coupons. If rates were to increase in 2013, which we view as likely, that would punish investors in high grade bonds that are more sensitive to rate changes.
  • The primary risk for high yield investors is credit risk, which we believe will be manageable over the coming years, as evidenced by the historically low default rates projected and conservative leverage metrics.
  • While all the talk is about the leveraged loan market, we have our own questions about this asset class. The default outlook for this market is even higher than that for high yield bonds, which would indicate to us that this market does not really have “lower risk.” Additionally, while higher rates would favor the lower duration/ floating rate of leveraged loans, the higher interest cost would hurt the credit metrics of loan-heavy capital structures. The value we do see in the loan market is that it allows investors to expand the number of opportunities to invest in.
  • While generally low rates and a risk-on mentality appear to favor equities, poor global growth patterns will likely put a cap on returns and may hamper earnings growth and multiple expansion.

We truly do believe that even after a strong showing in 2012, the high yield bond market remains well positioned for 2013.

1 Board of Governors of the Federal Reserve, press release, December 12, 2012.

2 Grantham, Jeremy, “On the Road to Zero Growth,” GMO Quarterly Letter, November 2012, p. 4. OECD indicates the Organization for Economic Cooperation and Development countries.

3 The y-axis represents the annual working age population growth rate and projected growth rate.

4 Federal Reserve Statistical Release, “Industrial Production and Capacity Utilization,” December 14, 2012. Chart includes data through November 30, 2012. The Capacity Utilization Rate is a metric used to measure the rate at which potential output levels are being met or used. Displayed as a percentage, capacity utilization levels give insight into the overall slack that is in the

5 “Growing Pains in the BRICs,” Neuberger Berman, Investment Strategy Group, September 2012. Real GDP growth rate measures the economic growth from one year to another expressed as a percentage and adjusted for inflation. Data is from January 2005 through June 2012

6 Mikkelsen, Hans, Oleg Melentyev, CFA, Vineet Ahluwalia, Christopher Hays, and Neha Khoda, “High Yield, Loans in 2013: Against All Odds,” Bank of America Merrill Lynch, December 26, 2012, p. 8. SAAR is the seasonally adjusted annual rate. Data covers the monthly periods from January 1990 to September 2012.

7 P/E (Price to Earnings) is a valuation ratio of a company’s current share price compared to its per-share earnings.

8 Mikkelsen, Hans, Oleg Melentyev, CFA, Vineet Ahluwalia, Christopher Hays, and Neha Khoda, “High Yield, Loans in 2013: Against All Odds,” Bank of America Merrill Lynch, December 26, 2012, p. 10. Data covers the period from 10/3/11 to 11/19/12.

9 Blau, Jonathan, Daniel Sweeney, and Karen Friedlander, “Leveraged Finance Outlook: 2013 Outlook for U.S. High Yield and Leveraged Loans,” Credit Suisse Fixed Income Research, December 3, 2012, p. 2.

10 Mikkelsen, Hans, Oleg Melentyev, CFA, Vineet Ahluwalia, Christopher Hays, and Neha Khoda, “High Yield, Loans in 2013: Against All Odds,” Bank of America Merrill Lynch, December 26, 2012, p. 17.

11 Blau, Jonathan, Daniel Sweeney, and Karen Friedlander, “Leveraged Finance Strategy Weekly,” Credit Suisse Fixed Income Research, January 4, 2013, p. 34.

12 Blau, Jonathan, Daniel Sweeney, and Karen Friedlander, “Leveraged Finance Outlook: 2013 Outlook for U.S. High Yield and Leveraged Loans,” Credit Suisse Fixed Income Research, December 3, 2012, p. 13.

13 Miller, Steve, “Dividends, though off from October peak, surge to record high,” Standard & Poor’s Leveraged Commentary & Data,

www.lcdcomps.com, December 7, 2012.

14 Miller, Steve, “Dividends, though off from October peak, surge to record high,” Standard & Poor’s Leveraged Commentary & Data, www.lcdcomps. com, December 7, 2012.

15 Blau, Jonathan, Daniel Sweeney, and Karen Friedlander, “Leveraged Finance Outlook: 2013 Outlook for U.S. High Yield and Leveraged Loans,” Credit Suisse Fixed Income Research, December 3, 2012, p. 4, 34.

16 Blau, Jonathan, Daniel Sweeney, and Karen Friedlander, “Leveraged Finance Outlook: 2013 Outlook for U.S. High Yield and Leveraged Loans,” Credit Suisse Fixed Income Research, December 3, 2012, p. 34.

17 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, and Rahul Sharma. “2012 High-Yield Annual Review” J.P.Morgan North America Credit Research, December 2012, p.16.

18 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, and Rahul Sharma. “2012 High-Yield Annual Review” J.P.Morgan North America Credit Research, December 2012, p.25

19 Blau, Jonathan, Daniel Sweeney, and Karen Friedlander, “Leveraged Finance Outlook: 2013 Outlook for U.S. High Yield and Leveraged Loans,” Credit Suisse Fixed Income Research, December 3, 2012, p. 2.

20 Based on monthly data for the Credit Suisse High Yield Index for the period 1/31/86 to 11/30/12. The Credit Suisse High Yield Index is designed to mirror the investible universe of U.S. dollar denominated high yield debt market. One cannot invest directly in an index.

Peritus I Asset Management Disclosure:

Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all invest­ments, investing in high yield corporate bonds and other fixed income securities involves various risks and uncertain­ties, as well as the potential for loss. Past performance is not an indication or guarantee of future results. Historical performance statistics and associated disclosures available upon request and qualification.

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