The Tide Is Going Out On High Yield, Here Is An Alternative

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Includes: JNK, LQD, PFF
by: Rubicon Associates

Summary

I believe the tide is going out on high yield and present an alternative.

It is possible to replace the majority of the yield, while reducing volatility and increasing creditworthiness.

The trade is credit risk for duration risk, which, I believe, will lead to better returns.

As many readers know, I have been involved in the fixed income and preferred stock markets for a long time on a personal and professional basis. Lately, I have been following spreads within the corporate credit markets closely due to their vacillation within a broader trend wider.

Moody's has stated that the default rate for all corporate issuers rated by Moody's Investors Service is expected to rise more than 30% in 2016 to its highest rate since the 2008-09 crisis. It is expecting the rate to climb to 2.1% from 1.7% in 2015. That implies 138 defaults in the year, which would be almost a third more than in 2015. Moody's has said:

Elevated spreads will suppress credit demand in the coming months, and on the supply side we will see a continuing investor flight to quality, away from speculative-grade corporate issuance. Various signals suggest that investors are concerned about quasi-recessionary conditions, potential contagion from the Oil/Gas and Metals/Mining sectors, and the continuing slowing of China's economic activity, a matter that also affects emerging markets economic activity.

Wide credit spreads portray an investor base that does not trust what it sees. US based data has not yet provided irrefutable evidence of an imminent recession, but tepid global economic growth despite prolonged and aggressive monetary policies, has debt investors retrenching and searching for alternative signals of positive economic activity on which to base their investment decisions. Our internal measures suggest that the broad US market (excluding Oil/Gas and Metals/Mining) is not at immediate risk, but industrial commodities-related developments have captured the market's attention and are suppressing credit-related activities.

Wharton had the following to say:

Analysts expect junk bond defaults to start rising this year and continue increasing through 2017, as the current stretch of below-average default rates is reaching the end of a typical cycle. Since the 1980s, low-default periods ran six years from 1985-1990; eight years from 1992-1999; and six years from 2003-2008, noted Standard & Poor's Steve Miller, managing director for Leveraged Commentary and Data, who wrote that in surveys, "managers use many sports-driven metaphors to describe the current state of the credit cycle: late innings, the third period, the back nine, etc.

Morningstar opined:

Despite recent rally in high yield, volatility will re-emerge. Recent commodities price bounce shrinks spreads in high-yield debt. Negative credit rating trends continue in first quarter. In our last quarterly outlook, we warned investors that the corporate bond markets would experience a significant bout of volatility during the first quarter. This came to fruition as the average spread of the Morningstar Corporate Bond Index widened significantly over the first six weeks of the year, bottomed out in mid-February, and recovered during the beginning of March.

Finally, to round out the commentary, we cut to a chart from Standard & Poor's on the default rate and expectations:

With all this gloomy talk and information, what is a yield-focused investor to do?

Recall, earlier I said I have been focused on both fixed income and preferred during my professional career. In this case, one dovetails right into the other.

What seems to be a long time ago, I was talking to a leader/pioneer in the preferred stock market, and he explained the attraction to preferred as follows:

"Would you rather buy a weaker company higher up in the capital structure or a stronger company lower in the capital structure?"

Such a simple concept, and yet, such a compelling one. Buying a stronger company lower in the capital structure reduces the risk of default and, therefore, the need for being higher in the capital structure in order to increase the recovery rate in the event of bankruptcy.

If it isn't obvious by now, I believe now is a good time to trade out of high yield and into preferred stock. This, to me, is even more compelling when I heard that U.S. corporate high-yield funds saw inflows of $2.156 billion in the week ended March 23, 2016 versus inflows of $1.679 billion in the previous week, according to Lipper US Fund Flows data. This is the sixth straight week of inflows; most inflows since the week ended March 2, 2016. The tide comes in and the tide goes out, and I would rather be on the beach with the more fun (Jimmy) Buffett when the tide goes out.

The nature of the trade is, essentially, out of high credit risk and into lower credit risk and duration. The trade is, therefore, contingent on an investor's belief that credit is a higher risk than duration and will underperform duration.

During the rest of this analysis, I will be focused on the comparison between preferred stocks (NYSEARCA:PFF), investment grade corporate bonds (NYSEARCA:LQD) and high yield (NYSEARCA:JNK).

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If we take the quote/question I received some years ago, the starting point is the quality of the underlying issuers. In order to accomplish this, a look at the top holdings within the three ETFs will help. First, the preferred stock ETF:

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As the table above shows, the majority of the largest holdings within the ETF are among the largest financial institutions on the planet, as well as other highly rated corporations. Keep in mind, the ratings shown above are the ratings of the securities, not the issuer. Issuer ratings will, on average, be two notches higher. The larger holdings are, primarily, investment grade.

Next, a look at the high yield ETF:

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As the table above shows, the ratings on the securities within the high yield ETF are low - as one might expect within the high yield market. I believe it is worth noting that the ratings of the larger holdings are not only below investment grade, but weak within high yield.

Finally, a look at the investment grade corporate ETF:

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The corporate investment grade ETFs are the largest issuers within the space. The largest issuers are typically solidly rated within investment grade. These are the massive issuers who do "benchmark" size deals across the maturity spectrum.

After getting a feel for the issuer composition, we will turn our attention to the industry allocation within the ETFs.

Within the preferred ETF, banks make up the largest industry exposure, as one might expect. Given the ability to have preferred stock count as capital (whether it is "traditional" preferred stock, hybrid/TRuPs or the newer CoCo preferred) and the amount of capital required (which is only increasing) to operate their business, banks will always be the largest exposure within the preferred stock market. Second to that is REITs, which take advantage of the perpetual maturity and the ability of the preferred stock dividend to count towards the required dividend payment. Many of the remaining sectors include issuers who issue convertible preferreds, "baby" bonds and the occasional small retail preferred stock.

The high yield market industry allocations follow the trend of levered growth (oil and gas, pipelines, mining) and levered M&A (media and telecom).

Finally, within the investment grade corporate arena, we once again see banks leading (they are a levered business), telecom (through growth/acquisition of wireless and wired) and again, oil & gas (larger integrated and stronger MLPs).

Finally, after looking at the composition of the various ETFs, a discussion of price/yield/return is appropriate.

As the chart below shows, the bank exposure within PFF crushed the sector in 2008 (recall that EBS stopped some of its dividends, and Citi (NYSE:C) was impaired), but since the recovery, the ETF has been stable - more stable than its fixed income peers over the last year, despite the volatility within the rates market.

Similarly, the yield has been stable as well (note that the yield spikes at the end of the year as the ETF pays out a larger dividend).

The relationship between the various ETF yields can help discern if they are trading rich or cheap to each other from a historical perspective.

The first relationship shown is high yield versus investment grade (JNK versus LQD). The financial crisis took a severe toll on the high yield market and increased the spread between the high yield ETF and the investment grade ETF yields.

The spread between the high yield and preferred stock market has remained narrow. This is part of the opportunity I believe exists. As the high yield market weakens, the yield should increase (as the price falls). Investors in preferred stocks have the ability to replace the majority of the yield of the high yield ETF with the preferred stock ETF without a similar amount of risk.

As might be expected, volatility within the high yield market (JNK, blue line) is higher than that within the preferred stock market (PFF, green line) and the investment grade market (LQD, red line).

The five-year average of the 30-day (price) volatility is as follows:

Ultimately, an investor can replace the majority of the yield of the high yield market with less volatility by investing in the preferred stock market.

Finally, a look at the total returns within the market:

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Over the one-, three- and five-year time frames, preferred stocks have outperformed both high yield and investment grade credit.

For those investors interested in buying the preferred market through an ETF, there are multiple ETFs to choose from. The following are the ones of which I am aware:

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The returns to the various preferred stock ETFs are listed below:

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Bottom Line: I believe the tide is going out on the high yield market, and when it does, those investors seeking the income of that market will ultimately lose money. An alternative is the preferred stock market, where investors can replace a significant amount of the high yield market's yield without a similar amount of credit/default risk. An investor must realize, however, that she is trading credit risk for interest rate risk (duration).

Over the coming days, I intend on refreshing my preferred stock closed-end fund series - Preferred CEF showdown - that I did some years ago (to update management, performance and find the shootout pick).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long various bank/REIT preferreds and preferred CEFs