“If one is concerned about valuations and the future performance and volatility of the equity markets, from a historical perspective, high yield appears cheap relative to equities at this point in the cycle.”
The following is a summary of an excerpt from our 2020 DDJ Virtual Investment Conference. To access the video featuring David Breazzano, DDJ’s President, Chief Investment Officer and Portfolio Manager, addressing this topic, please click here.
In order to better understand the current state of the high yield market and where we see opportunities, let’s first take a step back and look at it from a broader market perspective by comparing high yield to equities, with equities represented by the S&P 500 index. I believe it's important to make this comparison to better understand the relative value between the two asset classes. In addition, before we look at the current environment, it is informative to get a historical perspective, so let’s review the past two major inflection points and subsequent recoveries in those markets, with the first such inflection point occurring during the 2001 to 2004 period.
Before going through the chart below, I want to touch on how the S&P 500 index is displayed and why. More recently, there has been a lot of discussion about the performance of the S&P 500 index being skewed by a handful of large cap FAANG stocks, the Facebook, Apples, Amazons, and so forth. These stocks have significantly outperformed the broader S&P 500 index this year, thus artificially inflating the performance of the overall index relative to the “average” stock in such index. To account for this, we are displaying two different versions of the S&P 500 index. One is the “official” S&P 500 index, which is market capitalization weighted and thus subject to the claims mentioned above. The other is the equal-weighted index (labeled “S&P 500 EW” in the charts), which, as the name suggests, weights each stock in the S&P 500 index on an equal basis, so its performance will not be distorted by the performance of a group of large cap stocks that are skewing the overall performance of the S&P 500 index. Including the performance of the equal-weighted index gives us a different data set to examine what has occurred during these different cycles.
As we would expect, looking at the chart above, when the turmoil hit the market as a result of the telecom/Dot-com bubble bursting, high yield and equities traded down. However, the equity market traded down more than the high yield market, and the high yield market recovered quicker, resulting in high yield significantly outperforming equities over the full period. In addition, when we look at the S&P 500 index broken down the way I described above, specifically between market-weighted and equal-weighted, we see that during this cycle, the market-weighted index underperformed the equal-weighted index. In other words, large cap equities (e.g., the manufacturing companies, or the “old economy” companies) underperformed the rest of the S&P 500.
The primary reason this occurred is because at that time, the economy was going through a transformation. The U.S. economy was moving from a traditional manufacturing-oriented economy to the modern high-tech digital economy we live in today. And the “new economy” segment of the equity market, which comprised companies that generally had relatively smaller market capitalizations, began to outperform the larger cap, traditional manufacturing segment. So that's why there was a dispersion in the two versions of the S&P 500 index above, which is actually the opposite of the dispersion that is occurring today.
Looking at the next major inflection, which occurred during the global financial crisis, and again, one can see a similar relationship between the performance of high yield bonds and equities.
In short, when the trouble hits, all markets trade down, but then the high yield market had a relatively fast recovery while the equity markets lagged. During this crisis, the dispersion between market-weighted and equal-weighted equity indices was less pronounced. There wasn't the bifurcation of the overall economy or the equity markets that we witnessed during the previous inflection point described above, when the economy was going through a transformation. But again, the broader relationship was consistent: the high yield market traded down less than equities and recovered faster and more significantly than equities, resulting in high yield outperformance over the course of this entire period.
Now, let's look at what is happening currently. The chart below shows what has happened in the high yield and equity markets since the beginning of 2018.
Here we have what I call the “first part of the cycle”, where for most of 2018, equities traded up while high yield was relatively stable. And then in the fourth quarter of 2018, both markets traded down over concern the Fed’s interest rate increases would stifle economic growth. Equities, which had outperformed high yield until this point, experienced a sharper drawdown than high yield. From there, the markets began to recover again, with both versions of the S&P 500 index outperforming the high yield market until the COVID-19 pandemic hit, and all markets traded down significantly before subsequently starting to recover. However, looking at the two S&P 500 indices, you see that the market-weighted version, which has been dominated by the handful of large cap stocks that I touched on earlier, has significantly outperformed the equal-weighted S&P 500 Index as well as the high yield index.
When compared to the market-weighted S&P 500 index, we believe that high yield is still relatively cheap based on both historical performance patterns as well as what we see from a fundamental perspective. High yield is also relatively cheap when compared to the equal-weighted version of the S&P 500 index; however, not to the extent as when compared to the market-weighted index. So, if you take out the dispersion that's occurred due to a handful of large cap stocks and look at the performance of the equal-weighted S&P 500 index, you see a more normal relationship relative to historical inflection points highlighted above. However, If that normal relationship continues along its historical path where the strong performance of high yield continues as the recovery progresses, then on a relative basis, high yield presents an attractive opportunity. In our view, if one is concerned about valuations and the future performance and volatility of the equity markets, from a historical perspective, high yield appears cheap relative to equities at this point in the current cycle.
The above was a summary of an excerpt from our 2020 DDJ Virtual Investment Conference. To access the video featuring David Breazzano, DDJ’s President, Chief Investment Officer and Portfolio Manager, addressing this topic, please click here.
The ICE BofA U.S. High Yield Index (“HYBI”) tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market. The Index data referenced herein is the property of ICE Data Indices, LLC, its affiliates (“ICE Data”) and/or its Third Party Suppliers and has been licensed for use by DDJ. ICE Data and its Third Party Suppliers accept no liability in connection with its use. Please contact DDJ for a full copy of the Disclaimer. The indices does not bear any fees and expenses and an investor can not directly invest in such indies
S&P 500 and S&P 500 EW
The S&P 500® Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies by market value. The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities and serves as the foundation for a wide range of investment products. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization. The S&P 500 Total Return Index (“S&P 500”) is a subset of the S&P 500® Index and is calculated intraday by S&P based on the price changes and reinvested dividends of S&P 500®. The S&P 500 Equal Weighted USD Total Return Index (“S&P 500 EW”) is a calculated by equally weighting each constituent rather than weighting by float-adjusted market capitalization.
DDJ Capital Management is a privately held investment manager for institutional clients that specializes in investments within the leveraged credit markets. Since our inception in 1996, DDJ has sought to generate attractive risk-adjusted returns for our clients by adhering to a value-oriented, bottom-up, fundamental investment philosophy. DDJ has extensive experience investing in securities issued by non-investment grade companies within the lower tier of the credit markets, including high yield bonds, bank loans and other special situation investments.
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