High Yield Bond Market – Signaling more trouble ahead?

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High Yield Bond Market – Signaling More Trouble Ahead?

Historically, during transitional and bear markets, we have seen durations of buys to be much shorter in nature. While our strategies have historically captured shorter total-return opportunities in the past, not all trades were successful. We continue to adhere to our sell discipline, which has been a main driver in our historical success. As you may know, our investment decisions are dictated by quantitative models that seek to minimize discretionary biases, a majority based on price action. As prices have continued to depreciate across all risk markets (even treasuries as well), these models once again took to a defensive position, most certainly locking in our first negative year in the Managed Risk 23 year history.

There is no doubt that the past year+ has been challenging from a performance and trading perspective. The past 6 months have become extremely challenging for nearly all diversified market participants, including some of the best global macro managers in the industry. With that said, throughout the past 18 months and turmoil in commodities, we have managed to keep drawdowns to approx 6% gross of fees in Managed Risk (lower in our Multi-Sector Strategy as the asset classes we utilize – preferreds, converts, strategic income, and EM Debt have had less susceptibility to energy) . Below provides some detail on price action and the overall state of the current market from a technical landscape. We conclude with a chart that looks at longer-term spreads – this year’s volatility may turn out to be “healthy” for the market. This doesn’t necessarily make this time period to be the best entry point, as there may be further widening, resulting in lower prices. With that said, in the intermediate and longer term, from a yield perspective, this may become one of the best entry points into high–yield since 2009, setting the stage for strong return opportunities as we move toward the years ahead.

The Larger Picture, and Our Commitment at Large

Our philosophy has always been focused on minimizing drawdowns that can be devastating to a portfolio, while at times attempting to capture market rallies. However, we will not sacrifice our risk objectives to chase returns. Despite our recent buy, current weak market activity has lead our quantitative strategies back into a defensive posture. This design is to react to continued price depreciation that can lead to a potential deepened selloff. With new concerns surrounding continued commodities pressure (more specifically from oil), federal reserve actions, and a global economic slowdown, price behavior so far has been inconclusively volatile.

1. Long-Term High-Yield Price Trends Are Still Bearish.
One of the technical trend charts we look at involving bullish and bearish bands (a themes from our previous commentaries) still remains bearish. During these times, we expect heightened volatility, as well as more active trading. Historically, we have been able to capture short-term rallies, while ultimately staying more defensively biased.

 

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Sources: Redwood, Bloomberg. Chart represents a composite of a high-yield bond fund blend. Data as of 12/7/15. Past performance is not indicative of future results. For illustration purposes only and does not reflect actual trading signals. Please see disclosures for more information.

2. Balancing Return Objectives With A Risk-Management Discipline.
Generally, in sync with the downward trend pattern in the bullish/bearish chart above, spreads have been slowly widening and contracting in a technical channel upward. Below displays shorter term contractions. As prices recovered and spreads headed toward the lower range of the channel, this created return opportunity leading to a buy. However, recent market pressure caused by external global macro factors (as mentioned above) put greater stress on high-yield spreads. Recently, volatility in energy spreads yet again began to dominate the high-yield market.

 

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Source: Bloomberg. Dates from 1/1/12 to 12/8/15. For illustration purposes only. An investor cannot invest in an index. Past performance is not an indication of future results. Please see disclosures below for additional information.

3. A Narration of Volatility: Oil has been a lesser impact outside of high-yield corporates.
One of the drivers of volatility, as mentioned above, has been the massive selloff in oil. The implications of potential defaults in the high-yield energy sector has caused heightened volatility in high-yield prices in general. The below chart shows the divergence of volatility starting mid 2014 between high yield funds (white) and strategic income funds (orange, funds that are used in our multi-sector strategies). While high-yield has historically been the best asset class to operate our rules-based approach, we find that as of late, our other strategies that trade other asset classes that share very similar quantitative characteristics have been performing better. Until these macro environment factors normalize, we believe this to be an ongoing trend.

 

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Source: Bloomberg. Dates from 12/31/12 to 12/9/15. For illustration purposes only. An investor cannot invest in an index. Past performance is not an indication of future results. Please see disclosures below for additional information.
4. The Broader Market Has Not Yet Shown Strong Positive Investor Sentiment.
The broader market (represented below by the S&P 500 Index) has not yet shown technical strength as it may be having trouble holding a range that dictated the first half of 2015. While we saw some upside momentum towards a recovery following the selloff in mid-August, price momentum has so far been fading, potentially dropping out of a technical trading range.

 

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Source: Bloomberg. Dates from 12/8/14 to 12/8/15. For illustration purposes only. An investor cannot invest in an index. Past performance is not an indication of future results. Please see disclosures below for additional information.

5. A Period of Quantitative Confusion.
Fixed-income in general has been in disarray this year due to the uncertainty surrounding the Fed, leading to never-before-seen phenomenon such as negative U.S. Swap Spreads. This “conventional relationship between government debt, long considered the risk-free benchmark, and other assets has been turned upside down.” – (http://www.bloomberg.com/news/articles/2015-11-15/debt-market-distortions-go-global-as-nothing-makes-sense-anymore). We find it to no surprise that strange phenomenon in the debt markets are impacting the volatility in all fixed-income prices.

 

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Source: Bloomberg. Dates from 12/8/14 to 12/8/15. For illustration purposes only. An investor cannot invest in an index. Past performance is not an indication of future results. Please see disclosures below for additional information.

Conclusion
When looking at longer-term spreads, this year’s volatility may turn out to be “healthy” for the market (specifically making yields more attractive for high yield). See the chart below. This doesn’t necessarily make this time period the best entry point, as there may be further widening, resulting in lower prices. With that said, in the intermediate and longer term, from a yield perspective, this may become one of the best entry points into high-yield since 2009, and like always, all things come to an end and may normalize eventually.

 

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Source: Bloomberg. Dates from 3/31/87 to 12/07/15. For illustration purposes only. An investor cannot invest in an index. Past performance is not an indication of future results. Please see disclosures below for additional information.

We recognize these have been difficult markets, especially with money market paying nothing, but we strongly believe that these are times that test patience and endurance, and that in investment management, risk-management discipline will ultimately be rewarded in the long-term. Maybe the market continues to sell into a bear, or perhaps the market needs to capitulate with greater volatility prior to heading higher with greater sentiment – only time will let us know. With that said, Redwood believes that any strategy with the goal of protecting capital, must have a mechanism that seeks to sidestep unfavorable market environments, and we will continue to implement our rules-based risk-limiting disciplines.

Our team is here to assist with any questions on our strategies, positioning, markets, etc.

Click here if you have questions about your portfolio’s exposure to high yield bonds.

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This commentary is for informational purposes only and should not be deemed as a solicitation to invest, or increase investments in Redwood products or affiliated products. Information and commentary provided by Redwood are opinions and should not be construed as facts. There can be no guarantee that any of the described objectives can be achieved. There is no guarantee that any trade or trading activity will be profitable. Past performance is not a guarantee of future results. Information provided from third parties was obtained from sources believed to be reliable, but no reservation or warranty is made as to its accuracy or completeness. Definitions and Indices: Indices are shown for informational purposes only; it is important to note that Redwood’s strategies differ from the indices displayed and should not be used as a benchmark for comparison to account performance. While the indices chosen represent broad market performance of each asset class, there are report limitations as to available indices and blends, which index can be selected, and how they are presented. High-Yield Bond is a high paying bond with a lower credit rating than investment-grade bonds. Volatility is used to describe uncertainty or risk in terms of statistical measure of dispersion (variation in prices). Drawdown is a measure of peak to trough loss in a given period; a maximum drawdown is a measure of the maximum peak to trough percentage loss in a given period. Yield is the income return on an investment. This refers to the interest or dividends received from a security. Risk assets or risk markets generally refers to assets that have a significant degree of price volatility, such as equities, commodities, high-yield bonds, real estate and currencies. Technical analysis is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts typically use charts and other tools to identify patterns that can suggest future activity. Spread contraction refers to a situation when yields of securities (usually bonds) decreases relative to some benchmark (usually treasuries), indicating rising prices. Bank Loan (Leveraged Loans) Funds typically invest in floating or adjustable rate senior loans which are business loans made to borrowers that have interest rates that periodically adjust to a generally recognized base rate, such as the London Interbank Offered Rate (LIBOR). A bull market is a market in which share prices are rising for an extended period. A bear market is a market in which share prices are falling for an extended period (sometimes considered 20% lower than the market’s highest value). Correlation is defined as a statistical measure of how two securities move in relation to each other. U.S. 10-Year Swap Spread is the difference between the fixed rate component of a swap and the yield on the U.S. 10-Year Treasury Bond. The High Yield Bond Fund Blend represents a blend of 15 open-ended mutual funds, which were a result of the following objective criteria: Inception date prior to 1/1/1988; Total Assets of funds as of 5/31/15 as supplied by Morningstar greater than $1B; all searchable funds categorized in Morningstar as “Taxable High Yield Bond”; and available data – available upon request. The Strategic Income Bond Fund Blend represents a blend of 17 open-ended funds, which were a result of the following objective criteria: Inception date prior to 1/1/2004; Total Assets of funds as of 5/31/15 as supplied by Morningstar greater than $1B; all searchable funds categorized in Morningstar as “Taxable Bond: Multi-Sector”; and available data – blend is available upon request. The S&P 500 Index is a stock market index based on the market capitalization of 500 leading companies publicly traded in the U.S. stock market, as determined by Standard & Poor’s. The High-Yield CDX Index is Markit’s North American High Yield Index, which is composed of 100 liquid North American entities with high-yield credit ratings that trade in the credit default swap market. The S&P/LSTA U.S. Leveraged Loan 100 Index (SPBDLL Index) is designed to reflect the performance of the largest facilities in the leveraged loan market. The Barclays U.S. Corporate High Yield Total Return Index (LF98TRUU Index) is a market value-weighted index which covers the U.S. non-investment grade fixed-rate debt market. The CSI BARC Index is the calculated spread between the Barclays Capital U.S. Corporate High Yield Yield-to-worst and U.S. Generic Government 10 Year Yield. UNLESS OTHERWISE NOTED, INDEX RETURNS REFLECT THE REINVESTMENT OF INCOME DIVIDENDS AND CAPITAL GAINS, IF ANY, BUT DO NOT REFLECT FEES, BROKERAGE COMMISSIONS OR OTHER EXPENSES OF INVESTING. INVESTORS CANNOT MAKE DIRECT INVESTMENTS INTO ANY INDEX. Redwood Investment Management, LLC (“Redwood”) is an SEC registered investment adviser. Such registration does not imply a certain level of skill or training and no inference to the contrary should be made. Redwood’s advisory fees and risks are fully detailed in Part 2 of its Form ADV, available upon request. This material may not be published, broadcast, rewritten or redistributed in whole or part without the express written permission.