High Yield: The Place To Be, Now More Than Ever

by: William E Waite


The potential for above-average gains exists in the market for investors who buy non-investment grade shorter-term paper from companies that are in (or correlated with) the energy sector.

Larry Summers is correct: secular stagnation — “low interest rates, below target inflation, and sluggish output growth” — is likely to plague the U.S. for some time.

High-yield spreads are still high, but moving down to more reasonable levels. As spreads decrease, opportunities to buy at attractive prices will as well.

Roger Lowenstein's most recent book, America's Bank: The Epic Struggle to Create the Federal Reserve, is well worth reading if for no other reason than it illustrates how important the human element is in the conduct of both monetary and fiscal policy. Institutions don't make decisions, people do. Furthermore, the humanity of economic policy is never more important than in times of extremes - times like now.

Below, I briefly discuss last Wednesday's FOMC decision. However, the majority of this report is dedicated to my investment thesis that, as lackluster as the macroeconomic situation is, the current environment has created dislocations that nimble, sophisticated investors can exploit to add alpha.

I focus on one area I see as being ripe with opportunities: the high-yield debt sector. Specifically, I argue that the potential for above-average gains exists in the market for investors who buy non-investment grade, shorter-term paper from companies that are in (or correlated with) the energy sector.

Last Week's FOMC Decision

Given the tremendous pressure the FOMC was under, and the data available to the Committee, virtually no one was shocked by its decision last Wednesday to leave rates unchanged. Furthermore, as expected, in their statement, the FOMC cited labor market weakness along with "transitory effects of past declines in energy and import prices."

Wednesday's report was not entirely devoid of news. The "dots" shifted downward considerably, lowering fed funds expectations for 2017 (to 1.6% from 1.9%), 2018 (to 2.4% from 3%), and the long run (to 3.0% from 3.3%). Additionally, the number of officials who see only one rate increase this year increased from one member three months ago to six during this meeting.

Even if Jeffrey Gundlach is overstating the case when he recently commented that "central banks are losing control," the Fed clearly faces a difficult situation. By insisting that decisions be data driven, Chairwoman Yellen has painted herself and her colleagues into a corner to a large degree. Now, instead of exercising the human characteristic of free choice, the Committee must justify its decisions to an unprecedented degree based on the latest data points.

Many economists, financial analysts, and commentators - including the author of this report - believe that the Fed should be less sensitive to individual data points and focus more on long-term economic growth and its explicit dual mandate. Data is important, certainly. But when it comes to policy, being a slave to data that both lags the real world and is frequently revised comes with its own set of risks. Paramount among those risks is that the Fed will miss its window - if it hasn't already - and steer the economy down a path of stagflation, or something very similar.

To be fair, in a very real sense, the Fed is being asked to do the impossible. Monetary policy is not an economic panacea, especially in situations like the current one we are in where slower-than-usual economic growth is demand-driven. Monetary policy is most effective at addressing supply-side imbalances. In short, Yellen & Co. just don't have the tools for the job they've been asked to do.[1]

U.S. and Global Growth

Larry Summers commented in a recent Washington Post article that the likelihood of the United States following Japan's economic trajectory is increasing. Furthermore, Summers noted that secular stagnation - "low interest rates, below target inflation, and sluggish output growth"[2] - is likely to plague the U.S. for some time. I couldn't agree with you more, Larry. Secular stagnation seems to be exactly where the U.S. - as well as many other developed countries - is headed.

Bond guru Kyle Bass recently joined the throngs of lesser-known pundits in highlighting China's weakness. Kyle has quite a bit of company. In fact, last week, while maintaining its annual GDP forecast targets, the PBoC revised its forecast for exports down dramatically after monthly data showed the tenth decline in twelve months.

China is not the only Asian economy feeling the pressure. On June 8th, South Korea's central bank reduced its base rate by 25 bps, citing weak growth. So far this year, 32 central banks have eased policy, while only 17 have tightened, according to the website Central Bank News. While the banks' tightening were universally located in emerging market countries where inflation is a concern, those institutions' loosening have primarily done so due to growth concerns.

So why is economic activity so anemic? Ask any group - be they professionals or bar patrons - and you'll get a wide assortment of answers. However, inevitably one of more of the respondents will lay the blame squarely on monetary issues, usually tight credit conditions.

While the availability of, and access to, credit remains tight in some specific sectors - bulk dry shipping, I hear from industry contacts, is one such example - commercial and industrial credit is at an all-time high. The simple fact is that money is available, in aggregate, to be used for productive projects.[3]

Even though consumption remains reasonably robust, cracks are beginning to show. The June Reuters/UofM Consumer Sentiment reading came in weak, with that group noting that, "Consumers were a bit less optimistic in early June due to increased concerns about future economic prospects." Meanwhile, gross private investment appears to be rolling over, while inventories remain high.

It is no wonder, then, that with so many cross-currents and weaker-than-expected data prints (and sentiment), the FOMC revised its GDP forecast figures down on Wednesday to 2.0% from 2.2%, and 2.0% from 2.1%, for 2016 and 2017, respectively.

Opportunities in the High-Yield Market

In addition to economic uncertainty, investors face increasing policy uncertainty with the upcoming U.S. presidential elections, the pending Brexit vote (June 23rd), labor reform issues in France, Chancellor Merkel's political future, and the ever-present specter of armed conflict in the Middle East, and terrorism (both at home and abroad). Economic policy is, as Lowenstein reminds us, largely the fruit of people making choices, not automatons crunching data - nor should it be otherwise. Bearing that fact in mind, Scott Baker, Nick Bloom, and Steven Davis developed an economic uncertainty index that paints as clear a picture of the situation as any.[4]

The arithmetic average is 108; the equation for the linear trend-line is y = 0.0509x + 98.3.[5] The current value of the Baker-Bloom-Davis index is 122.14. I expect the index to increase-based both on an analysis of its individual components, as well as our overall outlook - and with it volatility, particularly in the equity markets. The increase in volatility is already manifest. On June 10th, the VIX broke through its technical resistance level at 16.3 and is now above 20.

While uncertainty tends to be detrimental for the market in toto, as experienced fund managers know, fear provides opportunities for sophisticated, knowledgeable investors to acquire assets at attractive prices. It is this phenomenon that underlies my recommendation to selectively buy high-yield debt.

The general carnage in the high-yield market in early 2016, which hit companies in the energy sector especially hard, has partially reverted. Spreads spiked in early 2016 as default rates - and forecasts of more bad news to come - rose. However, since then, spreads have narrowed. I expect spreads to continue to narrow as the weakest members of the herd have largely been "thinned out" already, and, as noted earlier, money (and/or credit) is available to companies with solid fundamentals. That the price of crude has stabilized, and, according to some projections, expected to rise, provides an additional tailwind to companies in that sector.

While 6% is still high from a historical perspective,[6] spreads are moving down to more reasonable levels. As spreads decrease, opportunities to buy high-yield bonds at the attractive prices currently available will likewise decline. However, with the majority of investors rushing to the (perceived) safety of large-cap equities and government and investment-grade debt, there are still plenty of opportunities available. Of course, the challenge is to pick the right individual bonds.

A rifle-shot approach necessitates considerable research. Under many circumstances, such a labor-intensive exercise might not be practical - or profitable. However, we maintain that in the current environment, the juice is worth the squeeze.

[1] One cannot help but be reminded of von Mises assertion in The Theory of Money & Credit that, "It is not the State, but the common practice of all those who have dealings in the market, that creates money."

[2] For a detailed description of secular stagnation, see: Gauti B. Eggertsson & Neil R. Mehrotra & Lawrence H. Summers, 2016. "Secular Stagnation in the Open Economy," American Economic Review, vol 106(5), pages 503-507.

[3] There are counter arguments to this position. For example, some argue that banks are hoarding cash to satisfy regulatory requirements. While theoretically valid criticisms of the position presented here certainly exist, my analysis supports the conclusion that such problems are not large enough to have a material impact on the overall economy.

[4] www.policyuncertainty.com/us_monthly.html

[5] With an R2 of 0.03, the trend-line is clearly not a great fit from a statistical perspective. But I am more interested in the average long-term trend. What is key is that the slope of the trend-line is positive. While the monthly index values will continue to fluctuate considerably, I expect the overall trend to continue, and most likely increase.

[6] Spreads were nearly 9% just after the beginning of 2016. The last time high-yield spreads were at 6% was in November of 2012 when stocks dropped precipitously on fears that then-Chairman Bernanke was going to take away the punch bowl of quantitative easing (specifically QE4). Equity markets declined precipitously. Interesting - and certainly relevant in today's situation - it was not economic fundamentals that helped stocks rebound, but rather Fed President Bullard's reassurance that the central bank would continue to provide substantial liquidity.

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. I have no business relationship with any company whose stock is mentioned in this article.