Thursday December 11, 2014 | David C. Wright
After a relatively productive start to the year, Ocean Park’s High Yield Corporate Bond (HYCB) Program is slightly negative for the year (as of 12/10/14) as a result of significantly increased volatility in this asset class during third and fourth quarters.
In the beginning of August 2014, the HYCB market declined and we executed “Sell” signals in all HYCB positions. By the third week of August, as HYCB funds moved up in price, we executed new “Buy” signals, which quickly reversed and triggered another round of Sell signals to move all positions again to 100% cash. We started getting new Buy signals in the third week of October and slowly began allocating cash back to HYCB funds. Now, two weeks into December, with about 55% allocated from cash into HYCB funds, the HYCB market began a third wave of declines and we are once again 100% in cash.
The greatest potential for HYCB price gains occurs when the spread or yield differential between them and the 10-year U.S. Treasury note yields are at their greatest. As spreads widen, HYCB prices typically decline. This downturn often sets up a potential rebound, as was the case in 2003 and 2009, when Ocean Park HYCB Program accounts profited significantly. Narrow spreads don’t necessarily infer a period without profits, but imply that the potential for gains beyond the yield will likely be limited.
The accompanying chart illustrates the concept of rising and declining spreads. High yield spreads peaked at 21.8% on Dec. 15, 2008 and narrowed to 3.4% on June 24, 2014. The wide spreads of December 2008 led to exceptional returns in 2009. Narrow spreads, as we are experiencing now, make the prospects for strong returns more difficult, but not impossible.
Source: BofA Merrill Lynch via research.stlouisfed.org
High yield spreads have historically bottomed around 2.5%. This suggests that we may have a little more spread narrowing ahead of us, which is supportive of price appreciation. Of course, there are no guarantees this will happen and indeed it may not happen this time around.
The HYCB category is driven by multiple factors:
- Credit risk or chance of default
- Investor sentiment
- Interest rate risk
- Credit spreads vs. Treasuries
In the historical performance table you can see two very strong years (2003 & 2009) surrounded by a number of good, moderate, mild to weak years. The 8.69% annualized compounded rate of return in the HYCB Program Quarterly Performance sheet takes into account the entire time period from 1/1/95 through 9/30/14 and is an average, i.e., it does not mean a client will earn 8.69% each year in a linear fashion.
It is important to note that upside performance is limited to whatever the market will grant us. Downside risk is something that we can control, but this often means having to sustain temporary setbacks along the way.
Unproductive markets can be trying. We like to help our clients focus on the long-term results for Ocean Park managed accounts.