A Tale of Two Markets
October 31, 2019
Divergence in today’s high yield market can be challenging, but also provides opportunity.
How's the high-yield market doing?
That’s usually a simple question for credit investors to answer. However, the answer today is contingent on what part of the high-yield market you’re asking about. The market traditionally has had a fairly high correlation among similarly rated credits, but recently we’ve seen a distinct separation between the haves and have-nots. So, how’s the high-yield market doing? That depends. It’s either smooth sailing or exceptionally choppy seas.
Spreads between higher-quality BB rated companies and highly speculative CCC rated companies are a simplistic but relatively accurate measure of how comfortable the high-yield market is with risk. That spread was 674 basis points on Sept. 30, which was 88 basis points higher than at the end of June (one basis point is equal to 0.01%). The broad flight to safety was driven largely by weaker economic growth fueled by the U.S.-China trade war, but it only tells one part of the story.
Companies experiencing calm seas not only carry a high rating, but are also U.S.-centric, consumer-driven and not competing with behemoths such as Amazon. Among the new issues that came to market in the third quarter, Restaurant Brands (franchisor of Burger King, Popeyes and other quick-service food companies) brought $750 million of eight-year secured, Ba2 rated bonds at a remarkable yield of just 3.875%—less than 1% more than the 10-year Treasury yielded a year earlier. Demand was such that the offering was substantially upsized, and the final yield lowered from the initial price talk.
Navigating rougher waters are companies such as L Brands, which are finding the market much less accommodating. The parent company of Victoria’s Secret and Bath & Body Works is similarly focused on the U.S. consumer, but it has most of its locations in shopping malls that are becoming increasingly irrelevant in the digitally-driven retail market. While L Brands is rated one notch better than Restaurant Brands, similar maturity L Brands bonds yielded close to 7%.
That comparison just scratches the surface of the bifurcation of the high-yield market today. Companies in the energy, retail, chemical, wireline, and other sectors find few bidders, but there is abundant capital for companies in the finance, leisure, media, and consumer services sectors.
Navigating this type of market is challenging, but also provides opportunity. Our focus in Pacific Funds High Income is now to own a responsible number of the low-risk names while utilizing credit research to select companies offering a significant yield premium and solid long-term value. While we’ve limited our exposure to the energy and retail sectors, we continue to find value in select industrial and restaurant bonds. We also are maintaining a larger-than-normal cash allocation; as we saw at the end of last year, cash in times of poor liquidity can provide exceptional opportunities.
Visit Pacific Funds High Income for recent top 10 holdings and other fund information.
Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest).
Flight to safety occurs when investors move capital away from perceived riskier assets to safer assets.
About Pacific Funds
Pacific Funds offers U.S. equity, fixed income, and multi asset mutual funds designed for growth, income generation, and diversification. Our managers seek to deliver consistent results with downside protection strategies to help shareholders meet their long-term financial goals.
Important Notes and Disclosures
All investing involves risks including the possible loss of the principal amount invested. There is no guarantee the Fund will achieve its investment goal. Corporate bonds are subject to issue risk in that their value may decline for reasons directly related to the issuer of the security. Not all U.S. government securities are checked or guaranteed by the U.S. government, and different government securities are subject to varying degrees of credit risk. Mortgage-related and other asset-backed securities are subject to certain rules affecting the housing market or the market for the assets underlying such securities. The Fund is subject to liquidity risk (the risk that an investment may be difficult to purchase, value, and sell particularly during adverse market conditions, because there is a limited market for the investment, or there are restrictions on resale) and credit risk (the risk an issuer may be unable or unwilling to meet its financial obligations, risking default). High-yield/high-risk bonds (“junk bonds”) and floating-rate loans (usually rated below investment grade) have greater risk of default than higher-rated securities/higher-quality bonds that may have a lower yield. The Fund is also subject to foreign-markets risk.
This commentary represents the views of the portfolio managers at Pacific Asset Management as of 10/22/19, and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Sector names in this commentary are provided by the Fund’s portfolio managers and could be different if provided by a third party.
Pacific Life Insurance Company is the administrator for Pacific Funds. It is not a fiduciary and therefore does not give advice or make recommendations regarding insurance or investment products.