Institutional manager DDJ Capital Management is anticipating a volatile market in 2015 offering bond pickers numerous and compelling buying opportunities.
The firm’s 2015 outlook says certain high yielding corporate debt instruments can offer an attractive return stream not only this year but for several years to come.
Following a torrid pace in the first half of 2014, reaching a peak return of 5.73% on June 24, the US leveraged credit market turned choppy and then headed south, says David Breazzano, DDJ’s president and chief investment officer, in the firm’s review of the past year and outlook for 2015.
In DDJ’s view, the run-up during the first part of 2014 saw the leveraged credit market become meaningfully over-priced due to an imbalance between voracious demand from yield-starved investors seeking high-yielding credit instruments on the one hand, and relatively limited supply on the other. This condition led to widespread investor buying that appeared indiscriminate and coincided with signs of issuer excesses, such as deteriorating underwriting standards and creditworthiness, thereby driving high yield returns to an annualised pace of over 11% and spreads to their lowest levels seen since the 2008 crisis.
Reasons for the ugly second-half market varied, Breazzano says, but were primarily the result of macroeconomic influences as opposed to changes specific to leveraged credit market issuers. The key drivers of the market pullback, he added, were interest rate expectations, economic sluggishness overseas, political unrest in many regions around the world, and oil price declines.
“For many, the leveraged credit market went from beauty to beast in just six months. But to us, the opposite was the case,” says Breazzano. “We expect the coming year to more resemble 2014’s period of volatility than the prolonged, virtually uni-directional – up! – market that leveraged credit investors have enjoyed over the past several years.”
Oil prices will continue to be a major source of leveraged credit market volatility in 2015, and until those stabilise, DDJ expects the high yield energy sector in particular to remain volatile. Other industry sectors and companies should benefit from increased consumer spending resulting from lower prices at the gas pump and a corresponding reduction in other energy-related expenses. Over the longer term, DDJ anticipates that certain energy issuers, such as service providers and high-cost producers, will face the prospects of credit defaults, which will likely push market yields higher and spreads wider.
DDJ also views the potential actions of foreign governments and their central banks as likely contributors to leveraged credit market volatility in 2015.
Additionally, two structural factors contributed to leveraged credit market swings in the second half of 2014: increased mutual fund ownership of high yield bonds and leveraged loans, thereby exposing the market to swings in retail investor sentiment, and declining inventories held by broker-dealers, which historically had stabilised price declines by serving as market intermediaries and using their own capital. As with the macroeconomic and geopolitical factors, “we believe these two market-specific factors will again contribute to higher-than-normal volatility in 2015,” says Breazzano.
“To successfully manoeuver through a more volatile market in 2015, we believe that managers must not only possess reliable and independent valuation capabilities, but also have a long-term investment horizon and access to ‘patient’ capital. Being a provider of capital in a market with high volatility and low liquidity can be quite advantageous to clients as long as the targeted opportunities are afforded the time needed to achieve fruition of the manager’s investment theses,” he said.
“Whether these opportunities arise because of a temporary interruption of an ongoing bull market or because an inflection point in spreads is reached, signalling the end of the current credit cycle, there will be beauty to be found in the leveraged credit market in 2015,” says Breazzano.
