On recent volatility within the high yield market

You know it’s obviously been a roller coaster in high yield really beginning in late June and going into July and going into August into September -- in fact, even a little bit into October, thus far. Before I kinda get into that, let me sort of talk at a high level just to remember what the high yield bond market’s all about. There are really two components to the extra yield you get out of high yield bonds: One is for credit risk, which is obvious because they’re below investment grade securities, and you have higher default risk and therefore you need extra yield. But the other is liquidity risk and liquidity risk really refers to the fact that the high yield bond market is an over-the-counter market and for me to trade I need to go through the big investment banks in New York. They frequently don’t have a bid as deep as I need if I’m selling or they can’t offer as many bonds as I need if I’m buying. As a consequence, it can take quite a while to move positions around and it can become quite costly if you’re trying to move a lot around so you get an extra yield premium in high yield bonds for that liquidity risk.

So now let’s go back to late June and July – there was a spade of news articles that came out talking about how the high yield bond market was getting frothy and they sort of caught hold and they started showing up in not only newspapers but Bloomberg and all sorts of places and that began a process of selling by retail investors as they sold, this liquidity situation manifested itself. Selling drove prices down, as prices went down it brought on more sellings, so you saw in July that $20 billion left the market which has led to a 1.3% loss for the market. Now one result of that is that as high yield bond prices went down, the yields went up, so a lot of thoughtful investors said oh wait a minute, credit quality is excellent in the high yield bond market but now I can get an extra 100 basis points of yield, so that looks pretty good. So what happened in July? $3 billion came back in and that pushed prices back up 1.5%.

And then in September, you had -- it wasn’t purely liquidity-driven – you had the situation with the United States getting back involved in the Mideast in a military way, you had the festering Ukraine situation, you had concerns about Chinese growth, you had concerns about the Brazilian political situation and the Brazilian economy which went into recession, you had some uneven economic data coming out of the United States, and all that led to a lot of volatility in the equity market – also, volatility in the Treasury market – and all of that kind of led to a risk-off trade, and that led to money leaving the high yield bond market.

And by the way, when there’s a risk-off trade, that tends to affect not just high yield bonds but things like emerging market bonds and so you saw those markets going down, so all of the more speculative markets have this tendency to sell off when there’s a lot of bad news. And that was the September situation. About 2 billion dollars left the market and in September the market went down 2.1%. So: we’re down 1.3 in July, we’re up 1.5 in august, we’re back down 2.1 in September, and now in the first week or so of October another billion dollars has come back into the market (because yields have gone back up), and we’re up just under one percent in October. So you’ve got this rolling up-and-down situation because of liquidity and also more recently because of geopolitical events.

One more comment on liquidity: the high yield bond market has doubled in size in ten years. It’s a 1.3 trillion dollar market , it was about a 600 billion dollar market ten years ago, so if you think of that as the mouth of the funnel [gestures with hands to mimic a funnel] into which trading takes place, then if you think of the neck as liquidity — bear in mind that in 2008 we lost three of our largest market makers for high yield bonds, Lehman Brothers, Bear Stearns, and Merrill Lynch (which merged into Bank of America) so those three guys are gone — the guys who are left are committing much less capital to high yield trading, so you have a bigger market going through a thinner neck [continues mimicking funnel] when you have any of these ebbs and flows of cash, and that’s what creates this exaggerated effect on pricing when money comes in or goes out or comes back in.

I guess my final comment would be that liquidity never tends to improve as you head toward the end of the year. The market makers are trying to lock in any gains they have, they don’t want to take on a lot of merchandise on their books — it might go down and wreck their year — so there’s no reason to believe that this volatility is going to get better over the near term. Now having said that, yields are wider, spreads are wider, that’s all good for the market, and finally, credit quality is excellent and that’s the key in the high yield bond market; whenever credit quality is good, you never have a bear market. You can have volatility, good-month-bad-month-good-month-bad-month, but you never have a pronounced bear market in high yield when credit quality is excellent (and it really is excellent). So my parting words would be: If you have the fortitude for some volatility, if you need yield, if you’re a long-term investor, high yield is still an excellent place to be.

Market data cited in this commentary is based on sources that include: J.P. Morgan (market returns); Credit Suisse (total value of high yield market); Lipper (changes in flows).

For institutional client use only. Not for use with the public.

The views expressed represent the Manager's assessment of the market environment as of October 2014, 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.

Investing involves risk, including the possible loss of principal.

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.

Funds that invest in bonds 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, noninvestment grade bonds (junk bonds) involve higher risk than investment grade bonds.

For institutional client use only. Not for use with the public.

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