The Manager's Commentary - September 2011

Volatility is like Kryptonite

During periods of volatility it is important to know the risks in your portfolio so they can be deflected to minimize investment loss. If unprepared, volatility, like Superman’s Achilles heel kryptonite, can affect investors’ ability to make calculated unemotional decisions. The acknowledgement of risk and an honest assessment of its potential impact are critical to long term investment success.

With that in mind, let us turn our attention to the 3rd quarter of 2011 which marked the 4th worst quarterly performance ever for the high yield market at negative 6.3 percent. Yield spreads on high yield bonds increased 300 basis points during the quarter to reach a yield to maturity of 9.6 percent and yield spread of 841 basis points over treasuries.

As a comparison, the 3rd worst quarterly performance in high yield history was the 2nd quarter of 2002 at negative 7.0 percent which was then followed by a negative 3.0 percent performance in the 3rd quarter of 2002. All told, the yield on high yield bonds at this time was 13.5 percent for a yield spread of 1,033 basis points.

The difference between yields today and 2002 is almost 4 percent. In 2002 the increase in yields was driven by the unraveling of debt laden telecommunication and technology companies. Today, yields have increased due to concerns over the ability of nations to pay their debts and the potential negative implications on global growth.

Despite the recent increase in high yield spreads, we think it is possible for high yield to widen further given today’s relatively low historical level of yields in the context of economic uncertainty that the modern world of finance has never experienced before. The level of coordinated political will power required to execute a solution is very high and, in our opinion, ripe for failure.

Due to this concern we continue to keep hedges in place, which includes keeping a cash balance in excess of 10 percent. While we want to maintain cash for further price reductions we are seeing some very interesting opportunities in short dated securities, 6 months or less, where yields of 5 to 12 percent are achievable.

While volatility can cause a great deal of stress, it also creates opportunities. Over the months ahead we intend to execute on those opportunities where for reasons unrelated to the fundamentals of the bond, a disproportionate high level of yield is provided.

Matthew Shandro
September 30, 2011