The second half of summer has challenged high-yield fixed income investors with volatility fueled by developments on a number of fronts. That volatility, however, may have created some potential opportunities. Below, Chad Gunther, portfolio manager of Ivy High Income Fund, shares his views.
One investor’s volatility…
This year is probably starting to have a bit of a familiar feeling for high-yield investors. The sector’s big story last year was what happened after the collapse in oil prices. Oil-related companies are one of the larger sectors within the high-yield space and when investors became nervous about the prospects for some of those companies, the entire sector felt the fallout.
Now, a year later, we see a new round of commodity-related concern weighing on the high-yield market. This time, however, the pressure is on not only the oil sector, but also in metals and mining. This pressure is in addition to some of the continuing economic uncertainty that has pressured the market, notably the slowdown in China. Meanwhile, of course, investors continue to consider the implications of what will happen when the Federal Reserve (Fed) begins to increase interest rates – a prospect that has hovered over markets in recent years.
...may be another’s opportunity…
The combination of these factors, and a few others, has resulted in a significant widening of the spread between yields on high-yield bonds and Treasuries of similar duration. That spread widened more than 100 basis points between early June and early August, as measured by the JP Morgan Developed Market HY Index. On Aug. 24, the spread widened to 670 basis points. Other than a brief period in late 2014, the 670-basis-point spread was the widest since June 2012.
We believe that this widening has increased the value in the space and yields are attractive. We think this is going to cause investors to come back into the space after some periods of significant sector outflows over the past year. We also think that when the Fed does finally make its first move to raise interest rates, investors may move into the space with more conviction than we have seen in recent months.
High-yield, in our view, continues to remain attractive relative to other fixed income asset classes in a potential rising rate environment. That said, it continues to be our view that the Fed will be cautious with any interest rate moves. While we believe Fed officials want to move off of their zero-interest-rate policy, challenges and economic uncertainty remain. We do believe that when the Fed does move, the increase will likely be small and the Fed will then likely sit on the sidelines for several months before making another move.
… if you do your homework.
While broad sector information, such as the spread data, can provide an indication of the overall market, we have always believed the high-yield space is an area where detailed analysis and a thorough understanding of individual credits is absolutely critical. We think credit quality ratings made by the rating agencies provide one way to help illustrate this point.
Without getting into a lengthy discussion about the agencies and their processes, we will instead focus on a single ratings tier: CCC, which is one of the standard ratings that may be given to non-investment grade debt. It is not the lowest rating and it is also not the highest rating in the non-investment grade universe. Recently, the average yield on CCC-rated debt has been a little more than 11%, which is the level of return the market says that investors demand for taking on the risk of those credits. However, not all CCC-rated credit is the same. Some CCC-rated credit may yield significantly more or less depending on the market’s view of the individual securities. For example, the Ivy High Income Fund currently holds some credits rated CCC yielding around 6% and a number of credits yielding 7%. From an investment perspective, the yield level is a far more important number than a credit quality rating and that is the key number as we explore the risk/return potential on each of the credits in which we invest. Credit ratings do not drive our investment decision making.
Another example of the importance of detailed analysis is the energy market. I have frequently described our view of energy companies broadly as “poor stewards of cash.” They can be cash-intensive businesses and may face a number of risks depending on a range of factors related to their experience and segment of the energy industry in which they operate. Given our views, it is not surprising that the Fund has been underweight its benchmark on energy, which has been a benefit to performance. However, we are now kicking the tires on some select energy credits. While we expect to remain underweight the benchmark, we also expect to selectively increase our exposure with credits that we believe offer attractive returns and asset coverage. We are not adding distressed credits, but we do believe there are some favorable opportunities in energy at these levels.
Finally, one of the questions that seems to always come up during a discussion of the high-yield market relates to possible defaults. Our view continues to be that we do not see a substantial increase in defaults on the horizon. One caveat to this would be if oil prices were to sustain these low levels for an extended period of time, it is inevitable that defaults in the energy sector would pick up over time.
Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Aug. 20, 2015, and are subject to change due to market conditions or other factors. Holdings and weightings are subject to change.
Investment return and principal value will fluctuate, and it is possible to lose money by investing.
The J.P. Morgan U.S. High-Yield Index measures the investible universe of U.S. dollar domestic high yield corporate debt, and the BofAML U.S. Master II High Yield Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market.
Risk factors: An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Loans (including loan assignments, loan participations and other loan instruments) carry other risks, including the risk of insolvency of the lending bank or other intermediary. Loans may be unsecured or not fully collateralized may be subject to restrictions on resale and sometimes trade infrequently on the secondary market. These and other risks are more fully described in the Fund’s prospectus.
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Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available a summary prospectus, containing this and other information for the Ivy Funds, call your financial advisor or visit us online at www.ivyfunds.com. Please read the prospectus or summary prospectus carefully before investing.
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