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Energizing High
Yield Bond Investors:
Finding Opportunities Amid
Shifting Market Conditions
Energizing High
Yield Bond Investors:
Finding Opportunities Amid Shifting Market Conditions
Contents
3
Energy: The big story
3
From volatility to opportunity
4
A history of rewarding
patience
5
Economy is favorable to high
yield bonds
5
Back to fundamentals
7
Conclusion
Executive summary
The story in high yield bonds for the past six months is one of energy. As
oil prices have tumbled, investors have scrambled to re-evaluate their
holdings to help ensure they’re positioned to weather a downturn in the
oil markets and any additional effects outside the sector.
The Barclays® U.S. Corporate High Yield Index, which has a 13% allocation
to energy, dropped 12.9% during the second part of 2014 as oil prices were
cut in half.1 Investors who have been enjoying tightening spreads due to
the financial crisis began to move capital elsewhere.
Declining oil prices weighed heaviest on the market and caused high yield
bonds to fall from their post-crisis highs. “Oil and energy are the story
in high yield,” said James FitzPatrick, Managing Director and Portfolio
Manager of the RidgeWorth Seix High Yield Fund and RidgeWorth High
Income Fund.
However, experienced investors aren’t shying away from high yield bonds
because there are potential opportunities to be found, especially in the
current environment. Many of these lie in the energy sector, where some
companies appear to be positioned to weather the downturn in prices. In
addition, there is the chance to find high quality issues at attractive prices,
thanks to lower investor demand. Other factors, such as an improving U.S.
economy, continued low default rates and more responsible leverage also
continue to make high yield bonds an attractive asset class for investors.
Key takeaways:
• Oil prices are affecting the market as a whole, but overall, defaults
are expected to remain below historical averages.
• Spreads have stabilized; spread tightening is likely.
• There are opportunities to invest in quality credits, particularly in
the energy sector.
• A strengthening economy, solid fundamentals and other factors
can also make high yield bonds attractive to investors.
• Low interest rates helped many companies lock in favorable
financing and shore up balance sheets; corporate profits will
offset higher borrowing costs from higher rates.
1. Barclays® Live, 2014
Energizing High Yield Bond Investors
2
Energy: The big story
It’s all about oil and investors in all asset
classes are watching where the price per barrel
will stabilize. In the interim, the quick decline has
caused many to worry about defaults across
asset classes.
Oil exploration and production companies that
benefited from low interest rates and higher
oil prices are now feeling a squeeze to service
their debt. Oil prices around $50 a barrel mean
it’s harder for companies to pay high levels of
debt, particularly smaller, more speculative
credits, which may increase the number of
defaults. Spreads of high yield bonds widened
by more than 100 basis points, ending the year
at 504 basis points over Treasuries with comparable
maturities.2
EXHIBIT 1: COMPOSITION OF BARCLAYS® U.S.
Corporate High Yield Index (2004 & 2014)
Market Value %
Market Value %
As of 12/31/2004
Financial Institutions
2.5%
Energy
4.3%
Utility
16.0%
Industrial
77.1%
As of 12/31/2014
Financial
Institutions
11.2%
Utility
3.5%
Industrial
72.1%
Energy
13.3%
Note: Numbers may not equal 100% due to rounding.
Source: Barclays® Live, 2014
The weakness was not confined to the energy sector, but bled into the entire high yield market
because energy has grown in size relative to other sectors. In December 2004, energy made up
just 4.3% of the Barclays® U.S. Corporate High Yield Index, but that climbed to 13.3% by the end
of 2014.3
From volatility to opportunity
Despite the drop in high yield bonds, savvy investors should have plenty of opportunities.
“The most significant potential opportunities lie in energy,” said FitzPatrick.
Energy services as well as oil exploration and production companies bear watching with
caution because the decline in oil prices could trigger higher levels of defaults. Some oil
exploration and production companies have done a better job of hedging the price of oil than
others. “Investors should look for credits that have hedges in place to protect against a decline
in oil prices and the subsequent likelihood of default,” cautioned FitzPatrick.
“The midstream pipelines have the least commodity exposure and they are like the toll
collectors of the energy market,” further explained FitzPatrick. “And refiners benefit to some
degree from the decline in oil prices because oil is their biggest input. While energy services
and oil exploration and production companies are most directly affected by low oil prices, we
are seeking potential opportunities in all five energy sub-sectors.”
“While energy is proving to be challenging to high yield holdings, this decline in prices may have
run its course,” FitzPatrick said. Oil prices have somewhat stabilized and, though they may
move lower in the short term, many high yield bonds have been repriced in anticipation of this
move. This move should not be as dramatic as it was in the last half of 2014. However, the selloff repriced other bonds within the high yield market, many of which are independent of oil.
2. Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/fred2/series/BAMLH0A0HYM2
3. Barclays® Live, 2014
Energizing High Yield Bond Investors
3
Defaults to stay low. Despite the turmoil in the energy sector, few have predicted widespread
defaults. “We expect default rates to stay steady,” said Michael Kirkpatrick, Managing Director
and Senior Portfolio Manager of RidgeWorth Seix High Yield Fund and RidgeWorth Seix High
Income Fund. “We do think it will increase from where it’s been, but still be below
historical averages.”
The high yield bond default rate for 2013 and 2014 stayed around 2%. Defaults could climb to
around 3%, however, that is well below the historical long term average of 4.4%, according to
Moody’s Investors Service.4
“While depressed oil prices will cause some energy names to default, this is unlikely to be a
widespread problem,” said Kirkpatrick.
There are a couple of reasons for this muted view on defaults. First, many energy companies
have hedged their oil prices at about $80 a barrel, and those hedges are in place through 2015
and into 2016. “After that, it’s a different story,” warns Kirkpatrick. “ The default rate could rise if
oil prices do not rebound.”
Second, the combination of the low rate environment and the improving economy has spared
U.S. balance sheets. With less money going to debt service, companies have more cash on hand
to weather tougher economic climates.
Spread levels are not a full reflection of that balance sheet strength. “Spreads very much
compensate investors for the current default environment and the default rate for the
foreseeable future,” said Kirkpatrick.
A history of rewarding patience
Despite the recent downturn, keeping some capital in high yield bonds can be a good idea in
order to capture steady returns. On a risk-adjusted basis, the return on high yield bonds is
greater than investment grade bonds and stocks over the long term. (See Exhibit 2)
Many investors, still skittish after the crisis, moved funds away from high yield issues as they
worked to understand the new market fundamentals. In 2014, investors redeemed more than
$17 billion of high yield mutual funds. That’s in contrast to the $57.3 billion that flowed into
these funds in 2008.5
EXHIBIT 2: HIGH YIELD BONDS, INVESTMENT GRADE
High yield bonds have delivered an equity-like 7.7%
return for the 10-year period ended December 31, 2014, BONDS AND EQUITIES: TOTAL RETURN AND STANDARD
DEVIATION (2005-2014)
but their volatility has been significantly less than
equities.6 At the same time, high yield bonds returns
Total Returns
Standard
surpassed investment grade bonds. The Barclays® U.S.
Index
Annualized
Deviation
Aggregate Bond Index returned just 4.7% during that
Barclays® U.S. Corporate
time frame. (See Exhibit 2)
7.7%
9.0%
High Yield Index
There are two reasons for this risk-adjusted
performance: first, the steady coupon income accounts
for the biggest proportion of the asset class’s returns,
not capital appreciation. Second, high yield bonds are
senior to equity in the capital structure, exhibiting less
volatility than stocks.
Barclays® U.S. Aggregate
Bond Index
4.7%
3.6%
S&P 500® Index
7.7%
15.1%
Source: FactSet, data pulled 02/26/15
4. Barron’s, 10/23/14, http://blogs.barrons.com/incomeinvesting/2014/10/23/high-yield-default-rate-down-to-1-7-should-stay-low-moodys/
5. Morningstar, 01/15/15
6. FactSet as of 12/31/14
Energizing High Yield Bond Investors
4
Economy is favorable to high yield bonds
The high yield bond market is especially
sensitive to the health of the overall
economy and the strength of the
economy has not disappointed the asset
class. Gross domestic product (GDP)
growth of 2.4% in 2014 and a further
decline in the unemployment rate signal
an improving financial system.7
EXHIBIT 3: CORPORATE PROFITS AFTER TAX IN TRILLIONS OF
DOLLARS (2010-2014)
$1.895T
$1.625T
However, many investors remain wary
of high yield investments as the U.S.
Federal Reserve contemplates when it
will raise interest rates. As much as low
interest rates provided the support for
the asset class’s performance in recent
years, higher rates don’t signal the end.
High rates may already be priced into
the high yield bond market.
$1.375T
Q2 ‘11
Q3 ‘12
Q3 ‘13
Source: http://ycharts.com/indicators/corporate_profits, 02/26/15
In fact, higher rates owing to a strong economy demonstrate corporate strength. Because
stronger corporate profits put companies in a better fiscal position, they more than offset
higher borrowing costs.
Back to fundamentals
Against this economic backdrop, high yield bond fundamentals look solid. Much of the new
issuance during the lower rate environment was used to retire older, higher cost debt and push
back maturities. The result: stronger corporate balance sheets.8
EXHIBIT 4: Purpose of High Yield Bond Issuance
First Half of 2014 ($180 billion in issuance)
Other
11%
Project Financing
1%
Refinancing/Bonds
28%
Recap/Divided
5%
Recap/Other
3%
LBO
4%
Refinancing/Bank Debt
13%
M&A
22%
Refinancing/General
13%
Source: S&P Capital IQ/LCD, 2014
7. Bureau of Economic Analysis, Feb. 27, 2015, https://www.bea.gov/newsreleases/national/gdp/gdphighlights.pdf
8. S&P Capital IQ, http://www.highyieldbond.com/primer/#!lbos
Energizing High Yield Bond Investors
5
Responsible borrowing. “Issuers have not used the low rate environment of the last few years
to engage in reckless corporate financing,” said Kirkpatrick. For example, leveraged buyouts
(LBO), and the debt that goes along with them, have dropped as a percentage of issuance. In
2014, LBO debt made up 16% of the total new issuance volume compared to 43% in 2008.9 With
stock markets continuing their advance, many companies prefer to access financing this way,
issuing initial public offerings at rich price-to-earnings multiples, rather than tapping the debt
markets for a cash infusion. This deleveraging is good news for the remaining high yield market
as existing credits and many new issues continue to look solid.
EXHIBIT 5: Leverage for High Yield Issuers Remains Low (2008-2014)
Leverage Ratio
5.5x
5.0x
4.5x
4.0x
1Q14
2Q14
4Q13
3Q13
2Q13
1Q13
4Q12
3Q12
2Q12
1Q12
4Q11
3Q11
2Q11
1Q11
4Q10
3Q10
2Q10
4Q09
1Q10
3Q09
2Q09
1Q09
4Q08
3Q08
2Q08
1Q08
3.5x
Source: J.P. Morgan, 2014
Further spread tightening ahead. “Though high yield bond spreads have already tightened
dramatically from their wide levels in 2008, the move is not yet over,” said Kirkpatrick. Spreads
continue to tighten for an average of 80 months after the end of a recession.10 As of December
2014, spreads had tightened for only 66 months, meaning there should be room for additional
price appreciation.
Technically speaking, high yield is attractive. Those looking to put capital to work in the asset
class should look beyond current market trends and dive into bond structures themselves
for areas that may be mispriced. “The way to gain an advantage in this market is to look for a
technical that’s being played out,” said FitzPatrick. He and Kirkpatrick have identified certain
investing themes based on these technicals that have altered the prices at which some high
yield issues are trading.
Regulatory changes. Recent regulatory changes have led to a dearth of parties available
to make bids. Since the financial crisis, the Dodd-Frank Wall Street Reform and Consumer
Protection Act’s Volcker Rule restricted banks from trading with their own money. At the peak
in 2007, primary dealers held $233 billion of corporate debt with maturities of more than a year.
As of December 31, 2014, they held $5.7 billion in below investment grade bonds and notes.
With major liquidity suppliers staying away, the market favors investors with a ready supply of
liquidity.11
“Dealers are not the liquidity absorber they were in the past, so investors want to take
advantage of that,” said FitzPatrick.
9. S&P Capital IQ, http://www.highyieldbond.com/primer/#!lbos, 02/26/15
10. J.P.Morgan, 2014 Leveraged Loan Annual Review.
11. Federal Reserve of New York, http://www.ny.frb.org/markets/gsds/search.html#
Energizing High Yield Bond Investors
6
Flows drying up. Flows into high yield mutual funds have also slowed, creating an opportunity
for investors to step in and offer some liquidity. When high yield bond prices dropped along with
oil prices, investors withdrew more than $17 billion from high yield mutual funds in 2014, leaving
prices depressed.12
A steady stream of redemptions could set the stage for favorable conditions by providing buyers
with potentially better prices. “Investors who have cash on hand can respond to that and buy bonds
possibly at better prices than they could in the past, simply because the demand is not there,”
FitzPatrick said.
Rating category mispricing. Finally, there is an opportunity to take advantage of the prices for
different rating categories. “The ratio of B to BB is at a four-year high,” said Kirkpatrick. “Investors
are compensated for the additional risk of moving into B rated bonds and we believe this is a sweet
spot from a valuation perspective.”
EXHIBIT 6: Effective Yield of B and BB Issuance (1996-2014)
20
18
16
Yield (%)
14
12
10
8
6
4
B Issuance
2
BB Issuance
0
1/1/96
1/1/97 1/1/98 1/1/99 1/1/00 1/1/01
1/1/02 1/1/03 1/1/04 1/1/05 1/1/06
1/1/07 1/1/08
1/1/09
1/1/10 1/1/11 1/1/12
1/1/13 1/1/14
Source: Bank of America Merrill Lynch, 2014
Conclusion
While lower energy prices have caused turmoil in the high yield market lately, investors looking
to put capital to work can still find opportunities, particularly when they work with managers
who have experience in the space.
The high yield market is still fundamentally strong, with measured corporate debt issuance,
strong balance sheets and a resurging U.S. economy. Opportunities exist to find quality and
underpriced credits, particularly in the energy sector itself.
Managers with expertise in high yield bonds may be poised to take advantage of market
disruption created by reduced flows, ratings mispricing and regulatory changes, which have
caused some to flee the asset class.
Because conditions in the high yield market are constantly changing, working with an active
manager can help identify where to put money to work and how to take advantage of
market disruptions.
12. Morningstar, 01/15/15.
Energizing High Yield Bond Investors
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About the RidgeWorth Investments Research Series
This report is part of the RidgeWorth Investments Research Series, an ongoing
educational program that explores various investment topics. For more information
about this and other educational programs offered by RidgeWorth Investments,
please visit www.ridgeworth.com or call 866-595-2470.
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Investment Risks: Bonds offer a relatively stable level of income, although
bond prices will fluctuate providing the potential for principal gain or loss.
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Credit Ratings noted herein are calculated based on S&P, Moody’s and Fitch
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lowest, with BBB and above being called investment grade securities. BB and
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Barclays® U.S. Aggregate Bond Index is a widely recognized index of securities
that are SEC registered, taxable, and dollar denominated. The Index covers
the U.S. investment grade fixed rate bond market, with index components for
government and corporate securities, mortgage pass-through securities and
asset-backed securities.
A basis point is equal to 0.01%.
Coupon is the interest rate stated on a bond when it’s issued.
Gross Domestic Product (GDP) refers to the market value of all final goods and
services produced within a country in a given period. GDP per capita is often
considered an indicator of a country’s standard of living.
Leveraged Buyout (LBO) is the acquisition of another company using a
significant amount of borrowed money (bonds or loans) to meet the cost of
acquisition.
Price-to-Earnings Ratio (P/E) is a valuation ratio of a company’s current share
price to its per-share earnings. The higher the P/E ratio, the more the market is
willing to pay for each dollar of annual earnings.
Spread is the difference between the bid and the ask price of a security or asset.
Standard Deviation is a statistical measurement of dispersion about an average,
which depicts how widely returns varied over a certain period of time.
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©2015 RidgeWorth Investments. All rights reserved. RidgeWorth Investments is
the trade name for RidgeWorth Capital Management LLC, an investment adviser
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Barclays® U.S. Corporate High Yield Index measures the market of USDdenominated, noninvestment grade, fixed rate, taxable corporate bonds.
Securities are classified as high yield if the middle rating of Moody’s, Fitch,
and S&P is Ba1/BB+/BB+ or below, excluding emerging market debt.
Investors cannot invest directly in an index.
RFWP-hy-0315