First Eagle Investment Management December 2015 commentary titled, “High Yield: A Challenge and an Opportunity”.
First Eagle – High Yield: A Challenge And An Opportunity
Liquidity in the high-yield market has been a challenge over the past several quarters, as several structural factors have adversely affected traditional sources of liquidity. Historically, counterparties like banks and brokers served as market-makers, allocating capital to provide down bids in periods of market distress, as they did in 2002 and 2008/09. However, higher regulatory capital assessments pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act and tighter trading regulations such as the Volcker Rule have made it more cumbersome for them to carry out these market-making functions. As they have stepped back, individual investors have been left holding a larger share of high-yield liquidity risk. Elevated volatility is, unfortunately, an unintended consequence of such regulation.
An investment fund is only as liquid as its underlying investments. There are, today, a number of ETFs and mutual funds available in the market that focus on distressed bonds, leveraged loans or workout-situation bonds—assets that are not always fully liquid. Nonetheless, these funds are supposed to provide investors with daily liquidity.
The recent volatility in the high-yield market has been driven by the intersection of two factors: the reduced willingness and ability of banks to trade securities and the growth of investment vehicles that mismatch daily liquidity with less liquid underlying investments. Investor uncertainty regarding the timing and impact of Fed rate liftoff, the scope of the slowdown in China (and other emerging markets), and weakness in commodities (including oil) have been catalysts for the recent market weakness. We believe that the price movements have been magnified due to the seasonal decrease in trading activity that historically occurs post-Thanksgiving and extends through year end. The high-yield market experienced a similar trading environment late last year. When volatility becomes elevated, there are usually opportunities to pick up attractively priced assets that have been punished in the sell-off.
At First Eagle, we have prepared for a period of rising volatility and, possibly, constrained liquidity by constructing our portfolio from the bottom up and focusing on securities that meet stringent standards for cash flow, asset coverage and covenant quality. While we do have exposure to the energy sector and we do own some distressed securities, we believe one of the keys to sustained success in the high-yield market is to avoid defaults and collect coupons.
We do not believe that the credit cycle is about to enter the bear-market phase because we haven’t yet seen the swift erosion in investor underwriting standards that typically precedes a period of rapidly rising defaults. That said, we are holding more cash and intend to take advantage of market volatility by adding to existing holdings at what we consider attractive yields. Additionally, we have stress-tested the portfolio from a days-to-liquidate perspective, and we believe that our holdings are sufficiently liquid in this environment.