Distinguishing between bonds that suffer price declines but no change in quality from those that could suffer permanent damage.
Long-term investors should not confuse credit risk with market volatility — market volatility sometimes creates opportunity. This distinction is particularly important for bond investors who have watched the recent high-yield market selloff.
There are good reasons to believe that the bloodletting in the energy sector is not over and that further declines will again influence the broader high yield market.
There is, however, a distinction between bonds that suffered price declines, but no change in credit quality, and energy industry credits that are likely to see permanent impairment.
The former are “money good” — paying 100% of principal at maturity (or earlier if redeemed by the issuer prior to maturity — and offer long-term opportunity; the latter presage a loss of capital. The key for investors is doing the research required to understand the difference.
In the second half of 2014, Federal Reserve Chair Janet Yellen warned of speculative lending conditions causing the tide of the high yield market to begin to rush out as capital outflows gained momentum. Just as market conditions began to settle, the oil bubble popped and high yield investors began to worry about permanent impairments in their portfolio.
SELLING BONDS
The sharp decline in high yield energy credits, combined with an acceleration in fund redemptions caused portfolio managers to sell whatever bonds they could, even if completely uncorrelated to the energy market, to avoid further losses and raise liquidity.
As might be expected, this caused option-adjusted spreads (OAS) to widen sharply. More importantly, the difference in the OAS of the H100, an index of the most liquid bonds in the high yield market, and that of the H0A0 index, reflecting the entire high yield market, widened from its level of 40-45 basis points early in the year to 138 basis points at year end. Thus, the selloff created opportunities for buyers of money good bonds as yields widened for non-energy issuers for reasons unrelated to credit quality.
The recent bout of high yield weakness is not unlike the sharp decline in the high yield market in 2002 that followed a rash of issuance in the cable, telecom and utility sectors. At that time, bonds issued in these industries accounted for more than 25% of the high yield market, with many of these financings speculatively premised on projected growth — smacking of venture capital.
As a result, the high yield market suffered many defaults and a negative return in 2002. In 2003, money good credits, depressed in the downdraft, rebounded, providing returns in excess of 20%. Today, energy credits account for 15-20% of the high yield market with a significant portion issued over the last two years with similarly dubious underwriting standards.
That said, while telecom metrics often proved to be of questionable real value, oil in the ground is worth something. Its value to bondholders will depend on the level of a company's debt, the cost of extraction and the going price for oil. If oil prices remain low for an extended time, we will almost certainly see a higher incidence of distress among exploration and production companies, equipment suppliers and service providers, but, even in a challenged energy industry, there will be opportunities to achieve attractive returns in credits that prove to be money good.
A bond buyer, by definition, has limited upside. In the best-case scenario, you get your money back along with coupon payments. Recovering from a loss of capital is hard in the bond world, so credit mistakes cost dearly.
The Fed, and the potential for rate increases, represent another overhang for the market. For long-term investors, speculating on the Fed is generally a fruitless undertaking.
A more productive course would be to focus on shorter maturity bonds to minimize the mark-to-market risk of the portfolio, while seeking to pick up the money good bonds left on the beach after the tide goes out.
David Sherman is a principal at Cohanzick Management and portfolio manager for the RiverPark Strategic Income and RiverPark Short Term High Yield Bond funds.
