Reading the signals within today’s fixed income markets.
<br></br>
In this webinar, Delaware Investments will provide a detailed analysis of the current “State of the Union” within taxable fixed income markets. Get prepared to speak to your clients, as panelists will explain today’s fixed income landscape in terms that matter to investors: technical conditions, credit fundamentals, and the yield curve. As a backdrop, the discussion will also include a general overview of macroeconomic conditions.
<br></br>
IMCA has accepted this program for 1 hour of CE credit towards the CIMA®, CIMC® and CPWA® certifications.
The Certified Financial Planner Board of Standards (CFP) has approved this program for 1 CE credit hour.
Video Image:
Duration:
0000 - 00:56
Recorded Date:
Thursday, March 17, 2016
Transcript:
Erica Kay - 00:03
Good Afternoon, my name is Erica Kay and on behalf of Delaware Investments I'd like to welcome you to our capital markets coaching clinic webinar today, featuring the discussion of the technical, fundamentals and economics of fixed income markets. Whether it's keeping you ahead of the curve when it comes to technology and social media trends, helping make your workday more efficient, or learning about the market from our team of experts, Delaware Investments strives to be your partner in growing your business and serving your clients.
Now, let's get started. Joining us this afternoon is the head of Fixed Income Investments, Roger Early.
01:10
Good afternoon.
Head of Investment Grade Corporate Bond Trading, Kashif Ishaq.
Good afternoon.
And co-heads of Credit Research, Craig Dembek--
Good afternoon.
--and John McCarthy.
Good afternoon.
Moderating today's panel will be our director of Fixed Income Product Management, Sean Connor.
Great.
Sean Connor - 01:32
Thank you, Erica, and thank you to all who have dialed in to today's call. As you know, there's been a significant amount of volatility and uncertainty in the fixed-income markets recently, so we're very pleased to have these key members of our Fixed Income team here today to discuss what they're seeing in their markets. Today's presentation will cover several important topics, including the global macro environment and the current state of the corporate credit markets. Kicking things off will be Roger Early, who will cover sections one and two - the Fed, and the general economic overview. Following Roger, Craig and John will cover section three, providing an update on corporate credit fundamentals in both investment-grade and high-yield. Kash will then discuss technical factors influencing the corporate credit markets in section four. And then finally, we'll hand it back to Roger, who will close with some thoughts on investment positioning in the current environment. We certainly have a lot to talk about today, so without further ado, I'll hand it off to Roger to begin the presentation.
Roger Early - 02:25
Thanks Sean. I think the first section, we'll deal with Fed policy, central bank policy in general. I think we want to prove right up front what incredible forecasters we are, so we can win your confidence right from the beginning, so here's our forecast. The central bank in New Zealand will cut rates on Thursday - that's tomorrow - guaranteed. Quick introduction, think about it this way we're going to talk about interest rates, economics, and fixed income for almost an hour. So in my opinion, we need to start out the right way. Here's my general feeling about where the Fed is and what's going on with the Fed. If you think about the Fed with all their mood swings over the last couple of years, and the fact that even today I don't believe they know where policy will be over the next few quarters. The Fed reminds me of an old story about Yogi Berra driving the family to Cooperstown for the induction ceremony - beautiful day in upstate New York - but the family's complaining, "We're lost. We're lost." Yogi finally pulls the car over to the side, turns to the family and says, "Look, I know we're lost, but we're making great time." That's where we are with the Fed. The Fed seems to be lost. They certainly aren't going the same direction as most central banks on Earth - but I guess they're convinced we're making great time.
So I think what we need to do is start out - maybe even before we hit the first slide - with some details about our belief in terms of the real impacts of Fed policy, maybe just a quick update on what do we think the Fed's outlook really is? I think the meetings on March 15th and 16th, let's face it, little chance of any move next week, but I do believe that we'll see a message come out of them next week that could give them the flexibility to lift rates if they choose to between now or that meeting in June. I think that's the goal, is really the message that comes out of that meeting. I think overall for 2016 we're in the camp that says no more than two moves by the Fed this year. Frankly if you did the over-under game and put the over-under line at two, we'd be more likely to take the under than the over. The Fed will certainly come in well below their dots, if you will, as we look through 2016.
I'm guessing that that gives you a bit of a hint as to our view on the economy. Our view certainly doesn't include a return to 3+% GDP growth. It doesn't include a substantial increase in inflation, or a CPI that trades consistently above 2%. If we're continuing to look for relatively low economic growth, modest growth like we've seen recent years, I think we're looking for inflation to continue to be below target. Overall, the Fed will face challenges that will probably keep them from acting too aggressively.
On the slides themselves, we do have a slide that tries to tell a simple story, and that is, what's really been going on with Fed policy especially over the last several years. Has it really just been a flat line or is there more to it than that? And so, on this particular slide, you see the blue line, if you will, that gives us a sense of where the fed funds rate target is or has been. You'll see this little blip upwards at the end of that blue line representing the increase in December. But the green line represents what's been termed the shadow fed funds rate. It's the Wu-Xia shadow fed funds rate worked out by members of the University of Chicago and University of California faculty in their research. And it, in essence, tries to get at the question of what's been the impact of the unconventional monetary policy that began literally at the end of the financial crisis. And so that green line looks at large asset purchases and forward guidance, and it looks at really the question of what kind of ultimate impact- what's the implied fed funds rate that we've really been living with in recent years. So, where would they actually have been in terms of stimulus. And I think what you see, obviously, is a green line that with QE and the Twist program and QE to infinity. All of those steps along the way brought us to what in their particular shadow fed funds rate study suggests we approach the negative 3% fed funds rate. That occurred near the end of 2013 as a QE was then-- we tapered, if you will. We began to take QE off and stopped QE by late 2014, the tightening really began. So long before a blip in rates the end of December, there has been, in this study's opinion, a substantial increase in the feds funds rates and the impact in terms of the lack of stimulus or the turnaround in stimulus. So if we were to see some pressure and economic conditions or market conditions. People might ask themselves the simple question, "How could a quarter percent increase by the Fed really create all of this?" The answer might be told out of the green line, if you will.
A couple of comments while we've got that line up and we're thinking about QE. I would point out two things. One is that QE- if you study that line very carefully and break it down into great detail, what you will learn is - and it is completely counter to what you would hear on CNBC for example - what you will learn is when the Fed was buying treasuries and, in essence, printing money, interest rates rose. So the buying of treasuries did not cause interest rates to fall. Interest rates on intermediate bonds rose during those periods. The asset that did better during those periods, in terms of price, was the stock market - the S&P - and there's a very clear correlation there and actually a negative correlation to interest rate. When the Fed paused and when they turned, and they weren't printing money to a significant degree, interest rates fell. The intuition of, "The Fed's buying treasuries, therefore it's good for treasury prices," you need to break yourself of that assumption and not necessarily listen to some of the talking heads on television who assume that as well. Because it clearly has been exactly the opposite. I do think one important point, here, as we look forward, is we still have some central banks on Earth doing QE, and being relatively aggressive on the stimulus side, and we do need to address that.
10:12
Before we address that, I think the next slide just gets the impact of the yield curve. Clearly, what you would expect over a long period of time, is if short rates are being increased by the Federal Reserve, you should expect some increase in rates on short treasuries and potentially, some reaction, a slightly different reaction, to intermediate longer treasuries. I think the main message on this slide is the lower box, the yield curve flattening, which compares 10 year treasury rates to two year treasury rates. The flattening has occurred, really, since the summer of 2015. In past economic cycles, this flattening of this kind doesn't really begin to occur until late in the business cycle. In other words, the first increases in the Fed funds rate, generally result in an increase in short term rates, and almost an equal increase in intermediate long term rates. The fact that even prior to the first increase in short term rates by the Fed, that the yield curve in the treasury market has substantially flattened, would suggest to us that economic conditions are challenging. That we could be closer to the end of the business cycle than you might expect after one Fed increase, and that we need to try to understand what's behind that possible factor. I do believe one of the keys behind that possible factor is the interaction globally.
As we turn to the next slide we speak to the concept of divergent central bank policy. I think here we're living this today, so we point out the balance sheet tug-of-war and currency devaluations. I would define currency devaluations around the world - the U.S. seems to be the recipient of all these devaluations - they are really just an effort to export deflationary conditions across country lines and put some of that pressure back on the U.S. with our currency strengthening relative to most global currencies. That's an important factor, and so as we look at central banks around the world that will continue to ease and we know the ECB meets tomorrow, they may hold steady, but they may at least give some verbiage that suggests further easing is possible. We know the Bank of Japan meets next week on the 15th. They obviously have recently implemented negative interest rates. We have to be prepared to see some impact on the U.S. dollar which would mean some impact ultimately on the U.S. economy and our ability to, for example, export. This relative tug-of-war between central banks will continue, and will continue to be an important factor in terms of understanding the outlook economically. By the way, very important, as I go back over the QE story longer-term - looking backwards as I mentioned, what QE in essence did for risk assets was it pushed prices higher on things like stocks. The argument could be made today, if the central banks in Europe and Japan will continue to print money, and continue to be very stimulative, then that should continue to push prices higher on risk assets.
13:54
I think we should be careful about that. We don't think that this will necessarily save us from an asset price standpoint. It hasn't helped economically. Economics haven't really responded to these policies, asset prices certainly have. But for some reason, asset prices have disengaged from that in recent months, and I think we've come to the conclusion that the impact really is this. When you look not just at the U.S. Central Bank, the ECB, and Japan, but when you include central banks globally, which would include important central banks in the emerging markets, what we find is the reserves that have been, in essence, removed within central banks in the emerging markets have more than offset the printing of money by the ECB and the Bank of Japan in recent quarters. And so, we've actually come to a place where, unlike early 2014 when all central banks were in essence printing money, we now have, if anything a balance that maybe even a slightly negative impact from all central banks. Where the QE is only happening in a couple of cases, and are being more than offset by reserve management especially in the emerging markets. We as a manager for a long time worried about, "Don’t want to get in front of central banks if they're printing money, asset prices can be elevated just based on that alone." I think that fear right now has been diminished. Maybe the last point on this slide would be on the right hand side, we've got on the lower level, we've got a picture of competitive devaluations focus on the EM FX index, EM is a key area to keep an eye on.
EM currencies on average have fallen in value relative to the dollar. This is a market place where significant borrowing has taken place in dollar terms. Where that decline probably means that in certain countries the debt service has become much more difficult, because the value of the debt in dollar terms has increased relative to their local currency. A key factor as you look forward. Last point on the next slide, global monetary policy simply stated - and I think it's clear from what we've already said - central bank policy divergence continues. This seems to have created market volatility in the past number of years, and certainly in recent years, and we would expect that to continue.
16:35
With that I will move forward to the next section which will deal with the general economic overview and outlook. So, on the slide titled The Economy, we come to basically the fact that we face a world where, on average, we have weak economic growth. If you look at the first piece of that slide, annual GDP and constant prices, and you look across there, you'll see the general decline. What might be very important to cite here are some comparative statistics that we have. If we look back to the period 2000 to 2007, global nominal GDP was about 8%. Emerging market GDP during that period was about 12%. When we look now at global nominal GDP, right now it is running at just below 4%, and EM is running at about 4%. So we have a change in world conditions, a change in that growth rate. It would seem as though that leads us to a potential problem with over-capacity relative to demand, and it may very well be why we are seeing deflationary conditions come through economically across the globe.
The next issue that probably relates to some headwind for economics across the globe is the debt burden. And again we have a small part of this slide that highlights one simple point. For all the stories about the deleveraging that's occurred in certain types of borrowers since the global financial crisis, the reality is, there has been no deleveraging. The other reality is, the replacement borrower for some of those private borrowers that have deleveraged has been sovereign borrowing. So that's an important point, because ultimately sovereign borrowing is usually put to work in less productive ways than private borrowing, and it may continue to mean some debt pressure on economic growth. Overall, if you ask us, "What's your view?" Slow wage growth, the debt burden, higher capacity relative to demand globally - all of that suggests to us that we are likely to continue to see a slow growth version of the economy. A 2% kind of GDP growth as we've seen in the recent years would continue to be, actually, a relatively positive outcome. If we're going to vary from that, the odds that the variances for weaker economic growth seems to be much, much higher than a much stronger outcome.
19:38
The second point that we might want to consider is the idea of where are we in the cycle, what's the chance of some type of downturn? I would simply point out that you should open your minds to this idea. In my lifetime, in everybody in this marketplace's lifetime, there is a standard version of recession. We overheat, the Fed raises rates, short rates exceed long rates, the curve inverts, if you will, and we ultimately come to a recession. That's been the version every single time since World War II. The argument here may be that with these deflationary conditions being an important factor globally, that a pre-federal reserve type of analysis may be necessary to understand what the other version of a downturn could be, and that version is generally driven by asset price declines leading to a recession. Now, you have to go back to the late 1800s to find that, but that's the way it worked the last time we had deflationary conditions for any length of time, in the U.S. economy, anyway. We're just arguing very high odds. We muddle along at 2% growth, but if there's an outlier here, keep your eyes open for the possibility that without an overheating, economic conditions could still wane.
I think what we would do is turn to the next page and look at basically two key ingredients in terms of the pressure on-- the disinflationary pressure on economic conditions, the headwinds, if you will. The price collapse in commodities, the dollar rally, both of these have created headwinds for key components of economic growth. Within the U.S. market companies that export have been pressured in terms of their pricing competitiveness. So I think these points continue to argue that there may be some economic impact from disinflation.
And then the next slide, lower commodities and a strong dollar, also highlights this debt burden in emerging markets, but I touched on the pressure on U.S. exporters but also the fact that the consumer tax break from lower energy prices doesn't seem to be a simple plus for the economy. Maybe we've all figured that out. One of the factors that's very important is highlighted on this chart - to the right and below - where we show oil and gas employment growth over the recent years relative to all non-farm, and here's the interesting point: it's been a key area of growth. And obviously, that has turned, and so you have to keep your mind open to the idea that the simple analysis - lower energy prices equals more consumer spending, better economic growth - may be a broken model, and we may have to muddle along with relatively slow growth despite that factor. I think with that I would only highlight one other set of headwinds that probably sustain slow growth and are the reason why the Fed has predicted that economic growth is in a 1.8% to 2% range for as long as they can forecast right now.
And that is our debt overhang is a problem, it does slow future growth, we borrowed from the future. Demographics in our country in particular, but other key developed countries, are such that productivity is not likely to expand from a demographic sense. If anything, it's likely to be a slight headwind. I think with that you've got the sense that slow growth is the condition that our analysts and traders have to deal with in terms of building corporate bond portfolios. What I would like to do now is spend the rest of the time turning over to the team that does that research, that does that trading, that helps us build those portfolios. I'm going to turn it over to Craig Dembek, who is co-head of our credit research team.
Craig Dembek - 23:47
Thank you, Roger. I'm going to talk about the investment-free credit fundamentals and the differentiation that we're seeing between what I call the non-financial sectors and the financial sectors over the last year and a half, two years. What we've been witnessing here for the last couple of years is that the non-financial investment grade credit fundamentals have begun to deteriorate, and it's really being driven by four major themes.
The first and most obvious of those themes, is the climbing commodity prices. Whether it be oil, the various metals, etc., this is having a large negative impact on the oil and gas sector of our universe, as well as the metals and mining space. The second theme that they're seeing, and Roger mentioned it briefly, is the strong U.S. dollar. Any U.S. companies that have a significant amount of revenue generated overseas are being negatively impacted by the U.S. dollar. Again, that's been going on for over a year now. Thirdly, a large amount of levering - what I'll call, "levering M&A activity." That's not what you think about in a traditional sense of LBOs, it's more really just in the low-growth environment, firms doing large leveraging acquisitions. We've seen it in healthcare, technology, TMT, even some of the food and beverage space. As those sectors do large debt-finance acquisitions coming to the investment trade market with large deals causing massive repricing and increases in leverage at those companies. Finally, the last trend we're seeing, but an incredibly important trend, is the increased shareholder-friendly activities. That's really coming through the use of increased share repurchases, special dividends, and increased dividend payouts.
Turning to page 14, looking at the use of debt in this current cycle, it's really being dominated - like I said - by the M&A or share buy-back activity at the expense of capital expenditure. Looking at this page, it's a nice graph that really shows, over the last several years revenue growth, and how it has continued to weaken. The blue line's representing the entire investment-grade universe, which has been negative to the tune of 9% most recently on an LTM basis, but you have to strip out the commodity sectors that we talked about: energy, metals, and mining. And even after you strip those out, you're getting a very modest 1% to 1.5% growth in revenues over the past year. The chart to the right takes it to the different level. The level we look at obviously is level of cash-flows or EBITDA. The story is similar with decline to 7.2% year over year, which is really the weakest-- the biggest decline we've seen since the fourth quarter in 2009. And again, when you factor out the commodity-- hard-hit commodity sectors, you're still only getting very modest growth in cash flows.
27:02
That's a leveraging event in and of itself, but as you turn the page to 15, you can see how that really starts to impact the corporate balance sheet. We're looking in the top left at leverage, gross leverage has begun to tick up approaching in the high two times on a non-energy adjusted basis and these are levels that we last saw back in 2001, 2002 timeframe. And it surpassed the financial crisis levels, which are a bit of an anomaly just because that was more financial driven than anything. It also shows it on a net leverage basis. The chart on the right, again, similar story. Even after you factor out the energy and metals and mining sectors, you're still getting an increase in leverage to the low to mid two times, and again, approaching those levels that we last saw back in 2001. Again, all the fundamental credit deterioration that we've seen really falls back to those same four themes that I've talked about that have led to not only the declines in cash flow, but then increases in absolute debt through the use of the M&A and also the shareholder-friendly activity.
The two charts underneath show more interest coverage, and how that's begun to deteriorate as well. What you see coming out of the financial crisis is a pretty steady increase in interest coverage ratios, as a lot of the companies were able to refinance their debt when markets opened back up, at much lower interest rates. That's begun to change as we've seen absolute debt added and for non-refinancing purposes - for some of these themes we just talked about. So you're seeing coverage ratio's begin to decline almost two times over the past year and a half to two years.
The weakened credit metrics really also point out that these corporate balance sheets, in our mind, are beginning to exhibit sort of late cycle behavior on the industrial side in particular. However, there are industries and individual companies that do have business models that can perform in this current slow growth environment that Roger referenced. The largest of these industries being U.S. banking industry.
So, if you turn to page 16, I'll just make a few quick points about what we're seeing in the banking sector, that is behavior that's quite a bit different than some of the things I've just mentioned to you from what we call the industrial sectors. First and foremost, the regulations and the legislation coming out of the global financial crisis has created a complete secular change to the banking business model which is fundamentally positive for creditors or bond-holders like ourselves. As you can see from the first chart which is the good depiction of what net loan charge-offs have looked like at the bank - in the banks - just before the financial crisis to current up through the end of 2015. Loan losses have peaked back in the fourth quarter of 2009 and they're steadily improved to levels that now I would call historic lows. You're talking less than 50 basis points in loan losses. Asset quality is everything for a bank and that drives your earnings, that drives your capital, where your capital ratios are going to get to. So that is an incredibly positive fundamental that, if I was to extend this line out through 2016, I wouldn't expect it to continue to improve. I think the consumer part of the universe is going to help but you've had-- the energy sector is going to start to exhibit some loan losses. So we'll expect to see a slight tick-up in loan losses but, again, still only around that maybe 50 to 60 basis point level, which is still historically very low.
The other main fundamental driver that really came out of the financial crisis that is driving banks-- the strength in banks' balance sheets is the requirement to increase capital ratios. Not just the old tier one capital ratios, but now regulators are more focused on what the true loss-absorbing capital is, which is your common equity. The charts below show you a snapshot in time of what capital ratios looked like entering the global financial crisis and where we sit today. And you can see banks here in the U.S. have added over 400 basis points of loss-absorbing common equity. And there's two ways to do that. The one way is just purely raising more equity, which all the banks have done at some point post-crisis. And then the second way is to reduce your risk-weighted assets and de-lever your balance sheet, which the banks have been doing here in the U.S. over the last four to five years. That created a strength, or a cushion to absorb future losses that the banking industry, in our lifetime, has never seen.
32:20
So to sort of wrap up these thoughts and why the banking-- why the financial sectors are sitting in more of a position of strength, I'll just wrap up with reiterating those four themes. First, the declining commodity crisis, how they've impacted industrials. They will impact financials, but to a much, much lower degree. You'll see some loan losses and delinquencies, again coming out of the energy sector, but completely manageable. Except for a few, maybe smaller regional banks that are heavily exposed in those impacted regions, we expect that to be not material to the banking sector. Secondly, the strong U.S. dollar does not impact the U.S. banking sector on the revenue line. Leveraging M&A is another area that does not impact the banking sector, because really the Federal Reserve is not allowing bank mergers. There are smaller regional banks that may still be allowed to merge, but again, it has to go through strict regulations and we're not seeing large leveraging-type deals come out of that. And finally, the shareholder-friendly activities that we're seeing in the industrial sector with the sharing purchases and dividends is really-- there's a hard cap on all of that activity and the banking sector has every-- the banks have to go through annual stress tests with the Federal Reserve, where their balance sheets are stressed under various economic scenarios and then they go ahead and ask for permission within their capital plans, "Can we raise our dividends? We would like to raise our share repurchases by this amount." And then the Federal Reserve comes back and lets them know what they can and can't do. There's a very, very strict regulation on shareholder-friendly activity, which has been absolutely beneficial to the fundamental profile, and it hasn't allowed management team bad behavior, we would call it, on the banking-- on the bond side that we've seen in the industrial side. So that wraps up my section on the investment grade fundamentals. I'd like to turn it over to my colleague, John McCarthy, to address what we're seeing in the high-yield side of the market.
John McCarthy - 34:27
Thanks, Craig. A lot of the themes that you'll hear me speak to over the next five to ten minutes are going to be very similar to what you've already heard from Craig, in that credit quality within the high-yield universe has been what we would call okay. Recently, the energy space, the commodity space in general, has definitely added enhanced volatility in the high-yield market versus the IG market, and that's just inherent in the lower credit quality that you'll see within the energy space. But before we get there, I think it'd be nice to start from scratch, right after the post-financial crisis and frame a picture for you, and show you how we got to where we are today.
If we start on slide 17, Roger has spoken to the low rate environment we've been in for an extended period of time. And with that came the natural, over the course of the last, call it five to six years, a need for yield within the marketplace and under the backdrop of a low-rate environment that's supportive of stronger fundamentals, the corporate credit markets were the place to go to pick up that incremental yield. And these two-- this slide here on the left-hand side, you see the growth of the high-yield market since 2006, but if you'll really look at 2010 time frame, you'd see that's really where you started to see the significant growth. So we've seen 80% growth in the high-yield market since 2008 and in the IG market, very much the same story - where you've seen 110% growth. To give you an idea, during the course of this growth, the high yield market traded its low, within the high-yield index, as low as 5.25% yield to worse, and spreads got the inside 400 off roughly 375 off, I think at the low. That was during the spring of 2014, and I think it's pretty safe to say at that point in time if you looked at the underlying fundamentals of the companies that we were following on a day to day basis, it was hard pressed to really support spreads at 375 off versus average spreads that were historically in the 550 area.
So if we move on to the next page, slide 18. During the course of this time you can see corporate issuers took advantage of the demand in the low rate environment, and you saw significant amounts of new issuance, which really took leverage higher during this period and time. EBITDA, you saw modest EBITDA growth during this period of time from 2010 to mid-2014. We did see interest coverage ratios that were reasonable. That's kind of how I would describe them, but that was more due to the sort of the low rate environment and the inability of a lot of companies to re-buy it at significantly lower rates, which allowed them to show higher coverage ratios. So it's a little bit artificially lower. But then when you really see in 2014, you start to see the spike in leverage and you start to see it decline in interest coverage ratios. And that, not coincidentally, was the same time oil started to see it's decline from a $90 oil price late in 2014, to $38 price I guess is where we are today.
38:18
If we move on to slide 19, what we'll see is during this period of time where we saw the massive amounts of new issuance, the energy sector played a significant role in that. Energy issuance really from 2009 through 2014, anywhere from as low as 12% of all new issuances in the energy space, to as high as 17.9% in 2014. Not to be ignored is if you look down a few lines, you'll see metals and mining as well and that's not-- we also saw a lot of significant new issuance in the metals and mining space. If you add that in, you're looking at roughly 20% of all new issuance in that timeframe was in the commodity space. The problem with that was the business models within the energy new issuance largely predicated on $90 to $100 oil. These business models were not built on $38 oil. They were not built on $50 oil. They were not built on $60 oil. They were not built on $70 oil. They were built on $90 to $100 oil and the assumption was that the credit markets were going to remain open for an extended period of time to allow them to continue to fund their growth plans. So lo and behold, what happens in 2014 when oil drops from $90 to $60 very quickly, now we're at $38, those business models just don't work anymore. In the metals and mining space, which is the space that I cover, most of that new issuance, that 5 to 7% new issue volume was in tier two - what we've called tier two, tier three minors. Not very attractive. These guys are essentially defined by single commodity plays in very high cost jurisdictions. So we've stayed away for most of that new issuance and those are the guys that are today distressed in the lower commodity environment.
If we go to Slide 20, this will just give you an idea of the distress ratio, pre-crisis lows. You can see it spiked dramatically in 2008 which is at the financial crisis. The distress ratio is defined as bond prices that traded $70 price or lower - that's how that's defined. We saw a large spike in 2008, after the financial crisis, QE kicked in, over time that dropped down to a more normalized level. But then, lo and behold again what you saw in late 2014: oil begins to decline, the structure ratios start to spike again, and we actually have seen - more recently we've seen a bifurcation. We thought we had seen the energy - there has been a natural correlation between this two lines for pretty much the entire period, but we started to see some separation throughout 2015, where ex-energy, although it was growing as well, was not growing quite as quickly from a distress ratio standpoint as the energy sector was.
41:27
If we go to slide 21, again this is just another graph that shows the number of ex-commodity bonds experiencing more than a 10% price loss in any one given month. That really started to take root late in 2015, where oil really just kind of continued with pressure, downward pressure in oil prices. The rest of the market really started to sell off pretty dramatically, and we got through year-end spreads that were in the 875 range, yields probably in the 8% or 7% range, 8% range, and we got as wide as 10% yields shortly after that in January '15, and spreads widened out to 900 off. So what this really did was create substantial opportunities, in our opinion, in ex-energy, high yield names.
If you go to page 22, what you'll see is a couple of graphs that will show high-yield fundamentals, ex-commodities. You'll see a leverage graph there on the left, which shows that leverage around a four times range, not ideal in a high-yield space, but certainly manageable. And what you've seen most recently is you're starting to see a decline. It spiked up to around four and a half times. You started to see a decline in the ex-commodity leverage metrics. And what you see is, given the pressure on markets in general, is management teams have gotten very cautious with their approach. They've become very disciplined. Capital allocation policies are benefiting bottom-holders. Balance-sheet is become a priority. Free cash-flow generation has become a priority, and we're starting to see that. We're starting to now see leverage levels come down. If you look to the graph on the right, it's the similar story with interest coverage. We went through a period of time ex-commodities 2012 through, call it since the beginning of 2015 where we saw interest coverage levels at around three times, not ideal again. We'd like to see them higher. They did start to creep up a little bit higher again as markets put pressure on companies and they again - discipline was put in place with free capital generation and debt pay-down interest coverage levels start to spike. EBITDA levels have been fairly consistent. We're not seeing large declines in EBITDA levels ex-commodities. EBITDA has held in fairly well, and that's enabled us to see a better improving interest coverage outlook.
44:18
The last slide, slide 23 again just shows the bifurcation in spreads between energy and ex-energy. The yellow line is the energy spread. You can see massive spread widening within the energy sector; that's not a surprise at $38 oil, given what I had said before. That bottom black line is ex-energy. If you look at where that stands now, that's north of 600 off. That's north of average high-yield spreads, historically. We think there is value in that ex-energy component of the high-yield market, so we're looking there. We're disciplined in our approach, in how we're approaching it. We're looking for management teams that are being disciplined, as I spoke to, with their capital allocation policies. Management teams that are looking to strengthen their balance sheets with free cash-flow generation. We're looking for the right places on the capital structure to put our money to work, that's also important. And we're just being very disciplined and cautious with our approach but we definitely think there's opportunities there with the-- outside of the ex-energy names within the high-yield space. So with that I'll turn it over to Kash and he can quickly walk us through market technicals.
Kashif Ishaq - 45:38
Thank you, John. It is not surprising that the overall liquidity of the U.S. corporate bond market has declined post the financial crisis, as a result of tighter regulation and tremendous growth of the U.S. corporate bond market. But we are seeing some positive technicals that are being developed that will help ease some of the recent liquidity challenges that we are seeing in the market place. We will talk about these positive technicals in the next few slides but it is true that dealer-- the ability of dealers to position risk on the balance sheet has been reduced. Before the financial crisis it was common to see broker dealer position fifty to hundred million of a bond within their balance sheet. But post financial crisis - you look at the regulation - dealers lost the ability to prop-- to create risk on their balance sheet. And this is resulting in a lower liquidity environment. But I think the key thing over here to remember is that liquidity is not uniform across all different sectors - as John and Craig mentioned - and across all different sectors. And it varies across all different investors as well. Certain sectors, such as financials, are relatively more liquid given the good fundamentals that Craig talked about. But sectors that are more headline driven or have weaker fundamentals experience less liquidity. For example, the recent turmoil in the commodity prices resulted in reduced liquidity for energy and metals and mining sector. The price action of this bond got further magnified and investors become forced sellers due to downgrades in the sector in a low liquidity environment. All this is being priced-in in the current spreads and investors are demanding higher premiums in the more challenged sector.
The overall market is open for business and liquidity can become challenged in the more volatile sectors. The recent liquidity environment is creating an interrupting technical in the marketplace where investors are willing to pay up more for all their owned securities versus other owned securities. Before the financial crisis and the liquidity premium between on-the-run and off-the-run securities was much smaller. Total written accounts tend to favor more of on-the-run securities to maintain it, trading liquidities of the portfolios or to meet a potential fund source, or to take advantage of the new issue market onslaught. It's hard to see this market technical go away any time soon as we are expecting another era of strong supply.
48:36
We are seeing a number of electronic platforms coming to the fixed income market to address the low liquidity issues. Market access has taken some market share, but trading volume is still dominated by the traditional broker-dealer. It is hard to see these platforms gain significant market share, as they don't have the ability to position risk on the balance sheet and they don't have the new issue business. The key thing over here is to remember that at end of the day it is a very relationship driven business and investors like ourselves who have spent many years in developing these deep and strong relationships with the broker dealer continue to receive better liquidity from the broker dealer versus hedge funds, or accounts that are not playing fair in the market place.
Record IG issues was one of the negative catalyst for spread in 2015, as we printed roughly 1.2 trillion in supply. The uptake in supply was driven by an increase in M&A related supply, and almost 22% of the total IG supply was M&A related. Anheuser-Busch came in our market in the month of January, with a $46 billion M&A related deal, and the deal was well received by the market and had an order book of over $112 billion. This also highlights a strong demand for quality new issues in the marketplace. Recent quality new issuance and debt is coming to our market, is outperforming the broader market. For example, Berkshire came in our market yesterday with a $9 billion deal and it's priced with the usual concession of few basis points. The order book on this deal was over $35 billion deal-- $35 billion, and the deal performed well in the secondary market and tightened up another 15 basis points.
Another positive technical we are seeing in the IG market is an increase in demand by the U.S. corporate bond by foreign investors, and we are expecting this demand to grow an additional $150 billion in 2016. This is mostly driven by low rate yield away from the U.S. market and relatively better trending with liquidity of the U.S. market. This should prove to be another positive technical prospect. High-yield new issuance is expected to be relatively light in 2016, but the high-yield market is expected to grow from falling angels, and has grown going from IG into the high-yield market. Over $100 billion of fallen angels are expected to enter the high-yield market this year and they are expected to be more concentrated in commodity-related sectors. This initially put a negative technical for liquidity in the high-yield market but proved to be a positive technical for quality high-yield bond away from the commodity-related sector. The new issues in the high-yield market that are coming are being well-received by the market and are performing well in the secondary markets. Bond calls impact different asset classes in a different way. For example, IG market tends to be more driven by institutional investors, and the retail and ETF don't have much impact on the IG market. ETF has a little bit more influence on the high-yield market and can potentially work into current liquidity in a volatile market. At this point, I will ask Roger for closing comments.
Roger Early - 52:33
Thanks, Kash. So, we certainly appreciate your participation today. I think we would make a couple of comments here at the end, a couple of points of emphasis. In terms of yield, I think we've made the point we see tremendous value, significant value in corporate bonds in general, but in terms of market volatility that volatility is likely to continue. And so the world of credit work and understanding the underlying technicals in the market and in individual issues is all-important. I think as you face good value but volatility, it's our job to build portfolios that can help your clients to protect themselves, and what I mean by this is simply managers who build portfolios that run on bull markets - but also decline sharply on bear markets - encourage clients to do just the wrong thing at just the wrong time. I think building portfolios with ample liquidity, building portfolios with higher quality biases, and constructing portfolios that actually have enough high quality duration to help self-hedge the risk of credit that's in the portfolio, allows us to have sustainable risk and that's critical in these markets. We have stayed with relatively low foreign exposure, and foreign currency exposure in particular, because that often feels like it brings volatility without a particular increase in return. And of course, the consistent source of return in our world is income and so, our focus in income continues. I think ultimately, we look at rate risk versus credit risk. We're not afraid of any significant increase in interest rates. We recognize credit risk exists in individual issues, but through good credit work and good understanding on the trading side, I think we can deliver the consistent returns that the income in the market provides. And again, thank you very much for participating today.
The views expressed represent the manager’s assessment of the market environment as of the date of this presentation, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the manager’s current views.
The performance quoted represents past performance and does not guarantee future results.
This information is provided with the understanding that Delaware Investments is not engaged in rendering accounting, legal, or other professional services.
Advice (if any) related to federal taxes that is contained in this communication (including attachments) is not intended to be used and cannot be used for the purpose of avoiding penalties under the Internal Revenue Code. Individuals should seek advice based on their own particular circumstances from an independent tax advisor.
Charts shown throughout are for comparison purposes only. Source data are the most recent available data.
Investors should carefully consider the Delaware Investments Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting the fund literature page or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.
Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.
Citigroup Economic Surprise Index - is constructed daily by taking a weighted average of the data “surprises” (actual releases versus Bloomberg survey median forecasts) observed over the past three months. The index focuses on key data releases, such as the monthly jobs estimate and the monthly change in the consumer price index, as well as other data releases. Older surprises are discounted relative to more recent surprises to prevent the index from becoming stale. A value greater (less) than zero denotes stronger- (weaker)- than-expected data, whereas a value near zero indicates that the data have been coming in as expected.
The Consumer Price Index (CPI) - is a measure of the average change in prices over time of goods and services purchased by households.
CRB Commodity Index - The TR/CC CRB Excess Return Index is an arithmetic average of commodity futures prices with monthly rebalancing.
Distressed ratio—issues with an option-adjusted spread over 1000 basis points
Fallen angel - a bond that was once investment grade but has since been reduced to junk bond status Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.
The Fund may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Fund may be prepaid prior to maturity, potentially forcing the Fund to reinvest that money at a lower interest rate.
High yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment grade bonds.
The high yield secondary market is particularly susceptible to liquidity problems when institutional investors, such as mutual funds and certain other financial institutions, temporarily stop buying bonds for regulatory, financial, or other reasons. In addition, a less liquid secondary market makes it more difficult for the Fund to obtain precise valuations of the high yield securities in its portfolio.
The Fund may invest in derivatives, which may involve additional expenses and are subject to risk, including the risk that an underlying security or securities index moves in the opposite direction from what the portfolio manager anticipated. A derivative transaction depends upon the counterparties’ ability to fulfill their contractual obligations.
If and when the Fund invests in forward foreign currency contracts or uses other investments to hedge against currency risks, the Fund will be subject to special risks, including counterparty risk.
The Fund may experience portfolio turnover in excess of 100%, which could result in higher transaction costs and tax liability.
International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.
Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.
Companies:
Delaware Investments
Select Player:
Media Manager
Video ID:
56eaa9a340d76bba6d8b4567
Media manager Account:
1
Structured for CPD:
unstructured
Primary Channel:
600
Contact Details:
Financial advisors: 877 693-3546
Institutional investors: 215 255-1200
www.delawareinvestments.com
Select Info Type:
Custom
People:
Roger A. Early
Craig C. Dembek
John P. McCarthy
Asset Class:
Taxable Fixed Income
Add Preroll:
Core Video ID:
100 454
Owner:
Delaware Investments
Hide Contact Me:
Player Subscriptions:
Activation Dates:
Thursday, March 17, 2016 - 15:30
Active:
0
Archive Date:
Thursday, March 17, 2016 - 15:30