It is hard to get across the right message efficiently in 6mins but here I speak with Frances about the correlations of HY bonds to interest rates:
We have written on how important inflow/outflow data becomes during periods of interest rate rises (which have rallied quite nicely as of late). Well as tough as June was with on the HY market, and every other market (save for cash) in the world, we seem to have bounced back on a performance basis and I am sure that was driven by the inflow basis.
Here are U$ HY Mutual Fund and ETF (resp) daily flows for the past week:
Mon 07/15 +$750mm and $250mm
Tues 07/16 +$650mm and $180mm
Wed 07/17 +$660mm and $150mm
Thurs 07/18 +$950mm adn $390mm
Fri 07/19 +$1290mm and $280mm
Fri 07/19 at $1290mm for HY Mutual Funds was the largest single day inflow on record. And in terms of AUM it was the 4th largest single day inflow at .75% vs Oct 2011 at 1%.
Flows matter, as do fundamentals, which haven't changed. Fundamentals are very supportive of HY.
I am not sure the journalist at the ROB will allow me to Comment but here is pretty much what I was trying to post:
A few facts and thoughts on HY, Interest Rates, and Leveraged Loans:
1. I am not sure how the BMO C$ HY Index performed overall in June, but it would be good to know, not just two individual bonds. The BAML C$ HY Index was -1.15% for June...not bad, given it was +1.00% for May. We owned some bonds that were actually up in June: North American Energy, Alliance Grain Traders.
2. Why were some HY bonds up in price in June? Because HY is credit risk, not interest rate risk. If we look at correlations of returns between various fixed income asset classes, we will note that HY has very little correlation to interest rates, both short term and long term, over 5-20 year periods. Note the correlation over 20yrs between U$ HY and:
10yr Treasury Bonds = -9%
3mos Tbills = -11%
While Investment Grade Bonds have the following correlations to 10yr Treasury Bonds over 20yrs:
BBB = 55%
A = 67%
AA = 78%
AAA = 88%
Note the further up the credit spectrum one invests, the more interest rate risk one assumes, and the less credit risk one assumes. (BAML data 06/30/13. Data is very similar for 5yr returns as well).
3. U$ HY has NEVER had a negative return period over the same period when rates were rising, until now. We looked at both Fed Fund Rate increases and periods when 10yr treasuries had large moves higher on a yield basis. (All BAML and Bloomberg data).
Feb/88-Mar/89 Fed Funds +327bps = HY +10.4% ann return
Dec/93-Apr/95 Fed Funds +302bps = HY +6.45% ann return
Jun/04-Jul/06 Fed Funds +421bps = HY +8.32% ann return
Why is HY able to perform quite well in a rising rate environment? Because as the economy improves, cash flows of HY issuers improves and cash flows pay our coupons...the more, the better.
10yr Rate Increases:
Dec/86-Oct/87 10yr rates +166bps = HY +1.2% ann return
Sep/93-Nov/94 10yr rates +252bps = HY +1.6% ann return
Oct/98-Jan/00 10yr rates +207bps = HY +3.65% ann return
Dec/08-Jun/09 10yr rates +132bps = HY +77.8% ann return
May/13-Jun/13 10yr rates +90bps = HY -18.9% ann return
Although HY is credit risk and has 0% correlation over 5-20yrs to interest rates, we do need to drill down to shorter time periods. What we find is that the flow of funds become important. Historically, BAML notes that on average, through a rising rate environment, we see outflows of about 8% of total assets in U$ HY mutual funds and etf's through the period. Currently, we are already at 6%, and as they note, "we are in the 7th Inning". The end result is the rise in rates becomes absorbed in the lower spread to treasury bonds. Demographic demand for HY will be a significant factor, and one that will be at play for 20yrs, as we have written on many times before.
4. Leverage Loans are based on 3mos Libor (altho many loans have Libor floors of about 1.25%). Libor currently sits at ~.25%. Adding ~4% in coupon when Fed Funds may not rise for 2+yrs and you have a low coupon, albeit with low duration, investment. Investors need to look a the entire yield curve and ascertain whether short or longer term rates are rising. Lev Loans should be part of a HY strategy, not the entire strategy.
High Rock Capital