Over the past 24 months if you’ve been in yield investments there’s a pretty good likelihood you’ve been shellacked. If you’ve run a more diverse portfolio, particuarly one with some Tech exposure, then you’ve had a good hedge against the yielders plunging. But that may be about to change, at least in the intermediate term.
If the yield bet had been that we’re in a slow growth environment for the foreseeable future, well, that was actually right as GDP growth has averaged at 2% and below. What may have been expected in such an environment was lower equity returns and higher risk adjusted returns accruing to capital that was placed “higher in the stack”. This is subordinated debt and other mezzanine type instruments that typically come with higher yields, greater safety, albeit lower total returns than straight equity. And many investors, like this one, would always trade away a few points of equity return for greater safety particulary when a diversified high yield strategy can still generate in excess of 11% total returns which beats most multi-strategy hedge funds. It’s also well in excess of even the 15 year average return from the Venture Capital and Private Equity segments.
Though something interesting has happened these last 24 months. The oil crash from the mid-$90s to the high $20’s per barrel (WTI) in company with the tantrums associated with expected hikes in interest rates have created fairly dramatic downdrafts in yield investments including BDCs, MLPs, and REITs. A very chaotic time indeed during which the IPO market has been open and closed several times, the S&P 500 has returned low single digits, and rates have been hiked, get ready for it, once by 25 basis points. Valuations for fixed income and quasi-fixed income assets have been down dramatically departing from a yield thesis that may have expected less volatility in owning securities more senior in the capital structure than straight equity.
I think the markets are finally beginning to figure this out. And what’s “this”? Well, that the individual assets held within a BDC are not going bankrupt. That a BDC holding senior debt and mezzanine securities in middle market companies shouldn’t be trading at a 25%-30% discount to the NAV of portfolio. Similar story with REITs and mREITS. The assets, the hedging, the leverage, and the shape of the yield curve simply don’t justify the large discounts at which they’ve been trading. MLPs have been pounded by the dramatic drop in the price per barrel of oil, this on the basis that there is too much supply and not enough demand with no OPEC leadership. This too will adjust in the coming 9 months as the amount of drilling capacity taken off-line globally is dramatic and will take years to reconstitute. The oil market is sentiment driven, if there ever was one, and the facts/reality tend to trail the hurd, not the other way around. Unless an MLP was over-leverage, many are/were, they’re under-valued materially particularly those in the mid-stream sector though even a number of the upstream E&P guys are trading at unjustified discounts given the quality of their assets and reserves.
Tech may be ready for a significant revaluing though I’d say avoid it at one’s own risk. I think much of the noise in the employment numbers these past 24 months has been related to the Fed’s difficulty in measure the uptick in productivity associated with the impact of Tech on how business is run across industries. Said another way, Tech is crushing it and owning great growth names in the sector is likely to keep paying investors for the foreseeable future. Could the valuations come off some here in the balance of 2016, yes and that’d probably be a good thing but I think the core Tech thesis is still in place and I own plenty of it.
In summary, patience not panic with the yield thesis is likely to pay off here in the intermediate term with signs of rationality and recovering returning to those segments. We are in a slow growth environment but defaults and bankruptcies don’t spike dramatically in the midst of a malaise like 2% GDP growth. Companies just don’t growth that much much they pay their bills, their employees, and their interest payments pretty steadily. And if people are getting paid, they make their mortgage and lease payments, they buy cars, etc, etc. and owning securities senior in the capital structure is a good place to be. Some times it just takes markets 24 to 36 months to deal with new realities. I think we’re getting there now.