High-yield markets are seeing the spotlight shine directly on them today, as earlier the Wall Street Journal reported a full liquidation and winding down of a well-known high-yield mutual fund. According to the Journal article, high-yield assets in mutual funds had tripled in June 2014 from their 2009 levels, amounting to some $305 billion. The article stated that the halt in redemptions from the fund will yield challenges for both the individual fund as well as the mutual fund industry. One of the primary reasons the fund ran up against today’s problems was the illiquid nature of its asset selections. Illiquid assets generally offer wider spreads in this space and don’t allow for ease of favorable price execution by investors.1
High-yield (HY) markets have certainly experienced painful pressures throughout 2015. Financial markets are currently anticipating a 75-80% chance that the Fed will raise short-term interest rates next week. As we approach the inflection point at which the Fed makes the decision whether to initiate liftoff, the markets are showing significant volatility in specific asset classes, including high-yield.
For the week ending December 9, HY funds saw outflows of $3.463 billion versus $397.55 million the previous week. This has been reported as the highest amount of outflows since August and has created a strong perception in the market regarding the uncertainty of performance of the HY asset class crossing over into 2016. Trading within the high-yield space definitely comes with its own pressure points, beyond the expectation that the Fed will raise rates after a 7-year ZIRP (Zero Interest Rate Policy).
High-yield assets may expect to see increased defaults due to the impact from falling oil prices, and the energy sector itself may see defaults grow into the low double digits in 2016 & 2017. These defaults will also create concerns about trading liquidity. Some reports are projecting that while HY issuance for 2016 will be robust; this segment of the market might expect just slightly over $½ billion in supply. This would be about a 10% decline from 2015. Furthermore, while the widening of spreads over the last year may change to tightening in 2016, the returns relative to the risk may not be the profile most investors will wish to embrace.
At Cumberland Advisors, we don’t believe the high-yield corporate sector is a safe place for our clients. We are focused on quality in our portfolio design, and we include neither high-yield assets nor mutual funds in our portfolios. We do follow the HY asset class to a limited degree, as it has a strong correlation to oil. We believe the volatilities that are expected in the marketplace next year will be better protected against by higher-grade assets. The quality of the investment-grade corporate-sector holdings in our portfolios offers diversification and credit enhancement (A rated or better) to protect clients during what are expected to be uncertain times following Fed liftoff.