Go with the flow
High yield bond and senior secured loan prices continued to improve, benefiting from investors’ ongoing search for yield and generally low levels of volatility. A weaker-than-expected Institute for Supply Management non-manufacturing report coupled with last week’s disappointing nonfarm payrolls report further reduced the market’s expectation of a rate hike at the U.S. Federal Reserve’s September 20–21 meeting.1,2,3 Alongside a rise in oil prices and a low probability of a September rate hike, inflows into corporate credit resumed in the shortened holiday week.4 Following a mild outflow to end the month of August, high yield bond mutual funds experienced inflows of more than $610 million in the week ended September 7, bringing the year-to-date net inflow to approximately $10 billion.5 Senior secured loans saw yet another weekly net inflow, as bank loan mutual funds extended their positive net inflow streak to six weeks. Over that span, bank loan mutual funds have recorded nearly $961 million of net inflows, erasing a portion of the outflows posted so far in 2016.4 Following this week’s gains, high yield bonds are providing year-to-date gains of approximately 15.0% and remain one of the better-performing asset classes of 2016.6 Of course, the rally in high yield bonds that has occurred since mid-February has been accompanied by significant yield compression. From a high of 10.09% in February, high yield bond yields have since declined to a 2016 low of 6.30%.7 Following 10 straight weeks of positive returns, senior secured loans have generated year-to-date returns of approximately 6.8%.8 As a result of the collapse in high yield bond yields, senior secured loan yields, at 6.12%, are just 28 basis points below high yield bonds.9

Paid to borrow
After staging a strong rally to begin the week, U.S. Treasury yields rose across the curve toward week’s end after the European Central Bank (ECB) failed to announce fresh stimulus measures at its Thursday meeting.10 By Friday morning, the yield on the 10-year U.S. Treasury note had risen to 1.67% from below 1.54% earlier in the week.11 Despite signaling that the ECB remains committed to continuing its monthly asset purchases of €80 billion until March 2017 “or beyond if necessary,” ECB President Draghi appeared to disappoint investors by adopting a wait-and-see approach instead of announcing an extension of the program.12 With euro-area inflation sitting near zero, most economists continue to predict the ECB’s quantitative easing program will be extended.13 Nevertheless, government bonds sold off around the world, with the yield on the 10-year German bund turning positive for the first time since June.14 Despite the shift in tone toward week’s end, the ECB’s bond-buying program has already proved to be a boon to borrowers and has intensified the global search for yield. Case in point: this week German multinational Henkel AG and French drugmaker Sanofi SA joined a small rank of corporate issuers selling negative-yielding bonds by issuing bonds that paid -0.05%.15

Highly credible
Despite a rise in the probability of a September rate hike toward week’s end, federal-funds futures still show only a 30% chance that the U.S. Fed will raise rates at its next meeting.1 Nevertheless, U.S. Treasury yields rose across the board Friday. This followed comments from Federal Reserve Bank of Boston President Eric Rosengren that were viewed as hawkish by some and on news that Fed Governor Lael Brainard is scheduled to speak on Monday.16 The theory is that Brainard, considered one of the most dovish FOMC members, would be well placed to deliver a more hawkish message.17 To date, the U.S. Fed has not substantially pushed back against the low probability that the market is currently placing on a September rate hike. With the central bank likely hesitant to catch the market wrong-footed, a case for moving soon would need to be highly credible in order to give the FOMC room to maneuver at its next meeting. With the U.S. Fed continuing to signal that it remains data dependent, recent data would seemingly suggest that it will remain patient. This week’s ISM non-manufacturing data took on greater importance following last week’s weaker-than-expected jobs report and ISM manufacturing data. Coming in below expectations, the ISM non-manufacturing index fell to 51.4 in August from 55.5 in July, indicating that the U.S. service sector activity continued to expand, but at a much slower pace than the month prior.2

Chart of the week: Manager performance gaps by strategy

Average return dispersion since 2001(top vs. bottom quartiles) 0% 5% 10% 15% 20% 25% Corporate bonds High yield bonds Large cap Mid cap Small cap Private equity Alternatives PERFORMANCE DIFFERENTIAL BETWEEN TOP- AND LOWER-TIER MANAGERS ACROSS STRATEGIES Sources: Fund categories filtered by Morningstar, as of June 30, 2016. Fund performance data from Bloomberg, as of June 30, 2016. The chart represents the difference in annualized returns over the 2001–2014 time period between the top (75th percentile) and bottom (25th percentile) quartile.

  • An alternative manager’s ability can have a more significant impact on returns when compared to traditional investment strategies.
  • As the above chart highlights, the average annual difference in returns between the top- and bottom-quartile traditional investment strategies, such as domestic investment grade bond and stock funds, is just 4.4%.18
  • Investing in alternative asset classes, however, relies less on publicly available data and more on a manager’s ability to analyze and underwrite its investments.
  • Perhaps as a result, the average annual difference in returns between the top- and bottom-quartile private equity managers is more than 16%. For alternative asset fund managers more broadly, the average annual dispersion is nearly 23%.18

1 Bloomberg based on CME data
2 Institute for Supply Management, http://bit.ly/1OVnkqn.
3 U.S. Department of Labor, http://bit.ly/1gck641.
4 Federal Reserve Bank of St. Louis, http://bit.ly/292Tgue.
5 Thomson Reuters Lipper via S&P Global Market Intelligence: http://bit.ly/2bYmThl.
6 Bank of America Merrill Lynch High Yield Master II Index.
7 Bank of America Merrill Lynch High Yield Master II Index, yield to worst.
8 Credit Suisse Leveraged Loan Index.
9 Credit Suisse Leveraged Loan Index, based on a three-year maturity.
10 The Wall Street Journal, http://on.wsj.com/2bWfKCZ.
11 Federal Reserve Bank of St. Louis, http://bit.ly/29ecBfp.
12 European Central Bank, http://bit.ly/2bXWLDj.
13 Bloomberg, http://bloom.bg/2cbjdOE.
14 MarketWatch, http://on.mktw.net/2czvzfM.
15 Financial Times, http://on.ft.com/2c3NtZJ.
16 CNBC, http://cnb.cx/2c3gvsp.
17 Barrons, http://on.barrons.com/2cfl5Uf.
18 Fund categories filtered by Morningstar, as of June 30, 2016. Fund performance data from Bloomberg, as of June 30, 2016. The chart represents the difference in annualized returns over the 2001 – 2014 time period between the top (75th percentile) and bottom (25th percentile) quartile.

The Alternative Thinking Week in Review market commentary and any accompanying data (“Market Commentary”) is for informational purposes only and shall not be considered an investment recommendation or promotion of FS Investments or any FS Investments fund. The Market Commentary is subject to change at any time based on market or other conditions, and FS Investments and FS Investment Solutions, LLC disclaim any responsibility to update such Market Commentary. The Market Commentary should not be relied on as investment advice, and because investment decisions for the FS Investments funds are based on numerous factors, may not be relied on as an indication of the investment intent of any FS Investments fund. None of FS Investments, its funds, FS Investment Solutions, LLC or their respective affiliates can be held responsible for any direct or incidental loss incurred as a result of any reliance on the Market Commentary or other opinions expressed therein. Any discussion of past performance should not be used as an indicator of future results.