For the past several years, the investment landscape has been characterized by low interest rates and low yields. The quest for yield has investors contemplating the opportunities available in the non-investment grade credit space. Here we explain why in our view the asset class remains attractive on a relative basis and why we believe our strategy positions us for success in today’s environment. As a reflection of our high degrees of freedom, we consider both the high yield bond market and the leveraged loan market as components of the non-investment grade credit asset class.


A Low-Rate Environment

Low interest rates have been a near-constant theme of the bond market since the 2008 financial crisis. Since then, central banks globally have looked to fill the void created by disappointing economic growth and stagnant inflation through a campaign of unprecedented monetary stimulus that pushed interest rates to all-time lows—and in some countries, into negative territory (Exhibit 1).

More recently, with economic growth improving, albeit modestly, across most regions, central banks have looked to pull back on the extraordinary level of stimulus and move toward policy normalization. A decade after the crisis, the Federal Reserve is well on its way toward normalized policy after having completed a handful of rate hikes, and is telegraphing its plans to reduce the size of its $4.5+ trillion balance sheet. Elsewhere, the central banks of Japan and Europe have followed suit—signaling their own shifts away from exceptional monetary accommodation.


Exhibit 1. 10-Year Sovereign Debt Yields

Exhibit 1. 10-Year Sovereign Debt Yields

Source: Bloomberg.


Though jawboning on policy normalization has pushed up interest rates from all-time lows, bond yields still remain historically low and are likely to remain so for the foreseeable future. Exhibit 2 shows the range of yields seen across varying asset classes over the last 10 years along with where yields stand now. The recent era of modest global growth and subdued levels of inflation has kept a lid on markedly higher interest rates. Concurrently, global investors’ voracious appetites for income have put additional downward pressure on interest rates. The days of ultra-accommodative monetary policy may be coming to an end, but for investors, the quest for yield still remains a daunting task.


Exhibit 2. Range of Asset Class Yields (10 Years ended 30 June 2017)

Exhibit 2. Range of Asset Class Yields (10 Years ended 30 June 2017)

Source: J.P. Morgan; Bloomberg; S&P. As of 30 Jun 2017. Past performance does not guarantee and is not a reliable indicator of future results. Universe represented: US Stocks (S&P 500); MBS (BBgBarc. US MBS Index); Investment Grade Bonds (JPMorgan JULI Index); Emerging Market Bonds (JPMorgan EMBI Global Index); Leveraged Loans (JPMorgan Leveraged Loan Index); High Yield Bonds (JPMorgan US High Yield Index). Yields are presented as yield to worst for MBS, Investment Grade Bonds, Emerging Market Bonds and High Yield Bonds. Leverage loan yields are represented by yield-to-three-year-takeout. US stocks are represented by 12-month dividend yield.


Non-Investment Grade Credit: Attractive on a Relative Basis

Achieving one’s total return objectives can be a challenge against a backdrop of low yields. Not only does total return become more dependent on price appreciation, but there is also greater risk of loss if rates rise. In a yield-starved world, we believe non-investment grade credit offers a more attractive risk/reward profile relative to most other fixed income opportunities. Though non-investment grade credit yields are no longer as attractive as they were in early 2016—when commodities-related dislocation caused credit markets to sell off and yields on lower-rated credits to spike to about 10%—today’s yields of around 6% are still relatively attractive when compared to government yields of 2% or less, or the mid-3% yields available from US investment grade corporates (Exhibit 3).


Exhibit 3. Income Alternatives

JPM US High Yield Index JPM Leveraged Loan Index US 10-Yr Treasury US 3-Mo Treasury JPM US Investment Grade Index (JULI) 7-Yr German Bund 7-Yr Spanish Sovereign 7-Yr Italian Sovereign JPM EMBI Global Index
Duration 3.52 0.25 8.82 0.24 7.20 6.34 6.19 6.47 6.81
YTW 6.12% 6.02% 2.31% 1.02% 3.69% 0.00% 0.87% 1.56% 5.56%

Source: J.P. Morgan; Bloomberg. As of 30 Jun 2017. Past performance does not guarantee and is not a reliable indicator of future results. For illustrative purposes only. Sovereign bonds are backed by the full faith and credit of the issuing sovereign. The sovereign debt of some countries carries more risk due to the increased potential for a payment default.


When considering the fixed income space and the array of opportunities, investors must weigh various risks—including credit risk and duration risk. Given that higher yields are the typical compensation for higher risk, fixed income portfolio managers are tasked with identifying investments where yields may overstate potential risk. Yields are naturally higher in non-investment grade credit as compensation for the higher credit risk associated with weaker balance sheets. However, we believe there are several pockets of the market, such as Spanish or Italian sovereign debt, where investors are receiving substantially lower compensation for different—but possibly very significant—credit risk.

The same line of thinking applies to duration risk. The common assumption that rising rates will result in poor performance across the board for fixed income instruments is a misconception, in our view. High-yield bonds and leveraged loans have historically posted positive returns on average in rising rate environments, while investment grade bonds experienced negative average returns.1

What are the mechanics behind high-yield returns’ historic resilience in the face of rising rates? Fundamentally, non-investment grade assets typically do better when the economy is healthy. Rising rates often go hand-in-hand with economic expansion, rising corporate profits and healthier balance sheets, which reduce default rates and lead to spread compression—all of which are favorable for the non-investment grade asset class. Additionally, we believe the non-investment grade space’s larger spread cushion versus investment grade assets leaves it relatively better positioned to absorb the impact of higher Treasury yields. The non-investment grade market has accordingly tended to correlate more highly to equities than bonds—as evidenced by returns during and following recessions, as shown in Exhibit 4.


Exhibit 4. HY Bonds vs US Equities: Performance During and Emerging from Recessions

Exhibit 4. HY Bonds vs US Equities: Performance During and Emerging from Recessions

Source: BofA Merrill Lynch. High yield Bonds are represented by the BofA Merill Lynch US High Yield Master II Index. Past performance does not guarantee and is not a reliable indicator of future results.A recession is defined as two consecutive quarters of negative economic growth.


Historically Less Volatile than Equities

Leveraged loans and high yield bonds are historically less volatile than equities. In fact, over the past 25 years (through June 2017), the high yield credit market (as measured by the J.P. Morgan US High Yield Index) has experienced roughly half the annualized return volatility of the S&P 500 Index (7.8% vs 14.2%), while providing in-line annualized returns (8.2% vs 9.6%). High yield bonds have also historically outperformed equities during down years. Although past performance is never indicative of future results, this reinforces our belief that the non-investment grade asset class currently looks attractive on a risk-adjusted relative basis versus other investment alternatives.

Correlation metrics are useful both in examining the diversification differences between non-investment grade securities and other asset classes and in examining the market’s relationship to rates. The non-investment grade market has historically had low correlations to many other fixed income asset classes and has been considerably less sensitive to moves in interest rates, as evidenced by the negative correlations of high yield bonds and leveraged loans to 5-year and 10-year Treasuries (Exhibit 5).


Exhibit 5. Correlations (15-years ended 31 Dec 2016)

5-Yr Treasury 10-Yr Treasury BBgBarc. Aggregate Bond Index JPM Investment Grade Index (JULI) JPM Domestic High Yield Index JPM Leveraged Loan Index S&P 500 Wilshire 5000 Russell 2000 JPM EMBI Global Composite Dow Jones World EM Stock Index Gold US Inflation
JPM Domestic High Yield Index -0.24 -0.22 0.18 0.49 0.86 0.68 0.69 0.66 0.70 0.72 0.16 0.17
JPM Leveraged Loan Index -0.38 -0.38 -0.01 0.26 0.86 0.54 0.55 0.53 0.45 0.57 0.03 0.33

Source: J.P. Morgan; Bloomberg. For illustrative purposes only. Past performance does not guarantee and is not a reliable indicator of future results.


Our Strategy for Success: Bottom-Up, Fundamental Selection

Although we believe there are several arguments in favor of the non-investment grade credit market, we fully recognize the non-investment grade credit market is inherently complex—and much of the low-hanging fruit which was readily available earlier in the cycle has been harvested. However, we believe our bottom-up, fundamental strategy is well-positioned in this type of environment.

In situations where investors must be discriminating and diligent in their efforts to find the right balance of risk and reward, we are confident in the merits of our investment philosophy and process. As an active management team with high degrees of freedom, we believe disciplined execution of our process will enable us to build a focused portfolio of non-investment grade securities that can perform well in any market environment. Our portfolio is built from the bottom up without regard to a benchmark. We have no preconceived allocation targets embedded in our process: We take an agnostic view of the capital structure and believe this is a key advantage of our strategy. We have the expertise to identify attractive relative value opportunities across the capital structure and the flexibility to act on these ideas with high conviction, allowing them to have a meaningful impact on the portfolio.

At the core, we seek to invest in securities of issuers with high quality business models that have compelling risk-adjusted return characteristics. We have several foundational beliefs that guide our decision-making. First, we believe that the non-investment grade market has cyclical, industry and company-specific dislocations which we can exploit. Second, we believe we can identify relative value across the capital structure using deep, fundamental analysis. The market is large and growing—we believe there is no shortage of inefficiencies on which we can seek to capitalize. We believe the market is innately complex, and securities are frequently mispriced, which benefits those investors who are willing to roll up their sleeves and perform detailed, bottom-up analysis.

Opportunities to exploit inefficiencies are generated in several ways. First, many non-investment grade companies and securities are thinly (or poorly) covered by research teams at sell-side firms, limiting the amount of broadly accessible information. Second, the buyer pool can be limited according to credit ratings. Similarly, money flows can create inefficiencies. For example, the downgrading of a security’s credit rating from investment grade to non-investment grade can create forced sellers. A fund with a mandate to hold only investment-grade securities may need to immediately sell the downgraded security regardless of market conditions, thus creating inefficiencies.

In our view, individual security selection is the best way to take advantage of the potential opportunities presented by these inefficiencies. Finally, if we execute our repeatable, high-conviction strategy well, we believe we can achieve attractive risk-adjusted returns over a full credit cycle.

We have a firm belief that margins of safety should not be compromised in the search for yield—after many years of experience in this market, we have an unwavering focus on risk-adjusted return potential and upside capture. Our research process has four primary pillars:

Business Quality

We use a variety of sources to understand an issuer’s business model resiliency. We analyze the general health of the industry in which an issuer operates, the issuer’s competitive position, the dynamics of industry participants, and the decision-making history of the issuer’s management team.

Financial Strength and Flexibility

We believe that analyzing the history and trend of free cash flow generation is critical to understanding an issuer’s financial health. Our financial analysis also considers an issuer’s capital structure, refinancing options, financial covenants, amortization schedules and overall financial transparency.

Downside Analysis

We believe that credit instruments by their nature have an asymmetric risk profile. The risk of loss is often greater than the potential for gain, particularly when looking at below investment grade issuers. We seek to manage this risk with what we believe to be conservative financial projections that account for industry position, competitive dynamics and positioning within the capital structure.

Value Identification

We use multiple metrics to determine the value of an investment opportunity. We look for credit improvement potential, relative value within an issuer’s capital structure, catalysts for business improvement and potential value stemming from market or industry dislocations.

 

Artisan High Income Fund: Our Differentiators

Business Quality: An adherence to business quality as a primary driver of value, without compromising for yield

Capital Structure: A strategy that invests across the debt capital structure in both high yield bonds and bank loans, as dictated by relative value

Identifying Value: A preference to act as a cash flow lender at par and asset-backed lender in times of market, sector or company-specific stress

Ratings Agnostic: A philosophy that is ratings aware but agnostic, resulting in atypical and idiosyncratic sector exposure

Risk Management: A differentiated risk-adjusted approach to portfolio construction tiered in three distinct risk profiles

High Conviction: A high-conviction portfolio built upon deep, fundamental analysis and thoughtful credit selection

 

Fixed income investments entail credit and interest rate risk. In general, when interest rates rise, fixed income portfolio values fall and investors may lose principal value. High income securities (junk bonds) are fixed income instruments rated below investment grade. High income securities are speculative, have a higher degree of default risk than higher-rated bonds and may increase the Portfolio’s volatility. The Portfolio typically invests a significant portion of its assets in lower-rated high income securities (e.g., CCC). Loans carry risks including the insolvency of the borrower, lending bank or other intermediary. Loans may be secured, unsecured, or not fully collateralized, and may infrequently trade, experience delayed settlement, and be subject to restrictions on resale. Private placement and restricted securities are subject to strict restrictions on resale and may not be able to be easily sold and are more difficult to value. International investments involve special risks, including currency fluctuation, lower liquidity, different accounting methods and economic and political systems, and higher transaction costs. The use of derivatives may create investment leverage and increase the likelihood of volatility and risk of loss in excess of the amount invested.

1Based on historical examination of 5-year Treasury yields that rose by 70bps or more in a 3-month stretch from 1987-2013. We considered the 5-year note because it has similar duration to the high-yield bond market. Performance over expanded time periods will vary.

This material represents the views of the portfolio manager as of 30 Sep 2017. The views and opinions expressed are based on current market conditions, which will fluctuate and those views are subject to change without notice. While the information contained herein is believed to be reliable, there no guarantee to the accuracy or completeness of any statement in the discussion. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

This material is provided for informational purposes without regard to your particular investment needs. This material shall not be construed as investment or tax advice on which you may rely for your investment decisions. Investors should consult their financial and tax adviser before making investments in order to determine the appropriateness of any investment product discussed herein. We expressly confirm that neither Artisan Partners nor its affiliates have made or are making an investment recommendation, or have provided or are providing investment advice of any kind whatsoever (whether impartial or otherwise), in connection with any decision to hire Artisan Partners as an investment adviser, invest in or remain invested in any funds to which we serve as investment adviser or otherwise engage with Artisan Partners in a business relationship.

The J.P. Morgan Domestic (US) High Yield Index is designed to mirror the investable universe of the USD-denominated domestic high-yield corporate debt market, including issues of US and Canadian domiciled issuers. The J.P. Morgan US Liquid Index (JULI) measures the performance of the investment grade USD-denominated corporate bond market. The J.P. Morgan Leveraged Loan Index is designed to mirror the investable universe of the USD-denominated institutional leveraged loan market. The J.P. Morgan Emerging Market Bond Index Global (EMBI Global) includes USD-denominated emerging markets sovereign bonds. The Lehman Brothers (Barclays Capital) Global Aggregate Bond Index provides a broad-based measure of the global investment-grade fixed-rate debt markets. The S&P 500 provides a measure of large-cap US equities. The Wilshire 5000 Index provides a broad measure of the US equity market, measuring the performance of all US equity securities with readily available price data. The Russell 2000 Index measures the performance of small-cap US equities. The Dow Jones Emerging Markets Total Stock Market Index includes equity securities with readily available prices that trade in emerging markets. The Barclays Aggregate Index represents securities that are SEC-registered, taxable and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities and asset-backed securities. The Bloomberg US MBS Index covers agency mortgage-backed securities (both fixed-rate and hybrid ARM) issued by Ginnie Mae (GNMA), Fannie Mae (FNMA) and Freddie Mac (FHLMC). BofA Merrill Lynch US High Yield Master II Index measures the performance of below investment grade $US-denominated corporate bonds publicly issued in the US market. An investment cannot be made directly into an index.

Non-Investment Grade refers to fixed income securities with lower credit quality. Leveraged Loans are extended to companies or individuals that already have considerable amounts of debt. Spread is the difference in yield between one fixed-income security or index compared against another. Duration is measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Yield to Worst (YTW) is the lowest potential yield that can be received on a bond without the issuer actually defaulting. Correlation is a statistical measure of how two securities move in relation to each other. A perfect positive correlation is represented by the value +1.00, while 0.00 indicates no correlation and -1.00 indicates a perfect negative correlation. Margin of Safety is the difference between the market price and the estimated intrinsic value of a business. The concept was developed by Benjamin Graham and is believed to be an important measure of risk and appreciation potential. A large margin of safety helps guard against permanent capital loss and improves the probability of capital appreciation; however, a margin of safety does not prevent market loss. All investments contain risk and may lose value. Free cash flow is a measure of financial performance calculated as operating cash flow minus capital expenditures. Financial covenants are agreed upon conditions that must be met to fulfill a loan agreement. Dividend Yield is a financial ratio that shows how much a company pays out in dividends each year relative to its share price.