High-Yield Funds Hold Up Relatively Well in a Rough Year for Credit

It had been a rough year for the high-yield bond markets even before Third Avenue announced that it had shuttered its Focused Credit fund on Dec. 10, 2015. On Thursday, though, we noted that we don't expect to see other high-yield funds follow in Third Avenue's footsteps. In this piece, we'll take a closer look at what's been driving the sector's troubles.

Losses in the high-yield market for the year and month to date have been largely driven by companies with exposure to oil, energy, and mining. That's not a new story: The sectors' troubles date to mid-2014 when oil, previously trading in the $100 per barrel neighborhood, began its fall out of bed. As Morningstar senior analyst Sumit Desai pointed out earlier in 2015, the second half of 2014 was bad for the high-yield bond Morningstar Category. Desai compared the category to a dog being wagged by its energy tail: The BofAML US High Yield Energy Index fell 13% during the same stretch.

Things have only gotten worse for companies with fortunes tied in one way or another to oil, as a combination of factors, including slowing growth in China, have further fueled the commodity's downward spiral below $40 per barrel. The high-yield bonds of companies across the chemicals, forestry/paper, metals/mining, and energy industries constituted more than 23% of the BofAML US High Yield Master II Index at the end of 2014, and two of the largest among them, energy and metals/mining issuers, lost 21% and 27%, respectively, for the year through Dec. 15, 2015.

That isn't to say it's been completely smooth sailing for non-commodity high-yield bond issuers. Several of the high-yield market's largest issuers have had a rough time this year because of seemingly company-specific issues.  Sprint  was downgraded deeper into CCC territory somewhat unexpectedly, for example, triggering double-digit losses among its longer-maturity bonds. Pharmaceutical distributor  Valeant (VRX) has also relied heavily on the high-yield market to finance its massive acquisition spree, and while that firm's bonds were later helped by some favorable news about a new distribution deal with  Walgreens (WBA), its bonds also dropped following publicity about iffy business practices and scrutiny over its aggressive business model. Meanwhile, the debt of satellite communications company Intelsat makes up a much smaller slice of the market, but its bonds were nearly halved in value owing to concerns over its heavily indebted balance sheet.

High-Yield Funds Navigate a Rough Environment Relatively Well
On average, high-yield bond funds have fared comparatively well despite the huge losses suffered by oil- and commodity-related names and a few other high-profile junk-bond issuers. That partly reflects the fact that the broad high-yield market has suffered much more modest losses than those experienced by the energy and metals-and-mining subindexes. The BofAML US High Yield Master II Index was down 4.8% for the year to date through Dec. 17, 2015, while a Barclays index covering the rest of the high-yield market other than energy fell less than half that amount. But funds have done even better. The median distinct fund in the category was down almost exactly 100 fewer basis points (or 1 percentage point) for the same period. There have been a few notable exceptions, but, on average, high-yield managers have done a decent job of navigating the sector's potholes.

Not surprisingly, the hardest-hit funds have been those with the most significant exposures to energy- and commodity-related debt. Some managers anticipated the difficulties in forecasting oil prices and thus avoided or held underweight positions to those sectors and performed comparatively well as a result. On the other hand, many of the managers who carried large stakes in energy and commodities debt did so largely based on expectations that supply and demand would eventually balance out and oil prices would stabilize and eventually rise. Many of these funds, which include  Franklin High Income (FHAIX),  Western Asset High Yield (WAHYX), and  American Funds American High-Income Trust (AHITX), have suffered outsized losses and languish near the bottom of the category for the year to date.

A Gut Check
There is, and always has been, risk involved with holding junk bonds. It's an area of the market that offers the promise of higher levels of income in exchange for greater credit risk, but one that also draws in borrowers and borrowing that fare well during good times but often stumble badly when the broad economy or subsectors with significant representation in the high-yield indexes come under pressure. That's true today, as important questions remain as to how much worse things could become for commodity-linked borrowers if oil prices remain low.

However, as long as we don't revisit the precipice of a depression on which the economy arguably stood in late 2008, risks for the average, well-diversified high-yield bond fund aren't likely to be any more substantial than they were in earlier periods of stress, such as those of 1989-90, 1998, and 2001-02, for example. The recent sell-off provides a good gut check for investors and argues for prudence in sizing junk-bond allocations, but it doesn't portend disaster.

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