Finding Value in Active High Yield Debt Investing

We have spent our financial careers in the high yield bond market, actively managing various portfolios and vehicles over our history.  The consistent theme of our active strategy is to focus on where we see value, via high tangible interest income and/or potential capital gains opportunities. This involves looking for securities in which we see attractive yield relative to the risk and not subjecting ourselves to arbitrary restrictions such as ratings or tranche sizes, the latter of which is a primary restriction in the underlying indexes of the largest index-tracking high yield ETFs.  If investors or fund managers put on blinders and subject themselves to arbitrary restrictions such as tranche size, there is a huge portion of the market that they are overlooking, and historically it has often been in these overlooked securities that we find value.

We also look for value in securities that we see as misunderstood by investors.  This involves paying attention to industry trends and credit specific issues, as well as undertaking detailed financing and credit analysis to determine if a specific challenge a company faces is being overblown or temporary, or a potential upside is ignored and overlooked.

Additionally, our strategy includes a deliberate new issue allocation, whereby we include new and newly issued high yield bonds.  Our goal with this allocation is to improve the strategy’s stability and liquidity as the data we have seen and our experience indicates that securities are often more liquid immediately after issuance.  Furthermore, in today’s rising rate environment, we see the higher Treasury rates translating to higher coupon levels on some new issues, which can help further an active manager’s yield/income generation.

Focusing on value also involves looking at where in the capital structure we see the best place to be positioned.  For the most part we find that value in bonds, but in some cases, we see value in the bank loans.  The flexibility within our active strategy to access the loan market expands our opportunity set and allows us to take advantage of the additional yield opportunities.  These loans are based on a spread over LIBOR and we have seen a significant increase in LIBOR rates over the past year, meaning the total coupon rates on these securities are increasing, adding to income generation.  However the caveat here is that given the increased demand for floating rate loans by those investors concerned about higher rates, we have seen a massive wave of repricings on loans pushed through over the last year plus, leading to lower spreads over the base rate in many cases.  This can mean that the total interest rate could actually be falling or going up much less than the LIBOR move would indicate (for further detail see our writing “Floating Rate Bank Loans: Rising Rates, Re-pricings, and the Real Income”).  We believe this dynamic also puts active managers at an advantage as they can focus on loans where coupons are not decreasing and where what we would see as attractive income can still be had.

But that is not to say that floating rate loans are the only place to be positioned in a rising rate environment, rather we see them as a complement to a high yield bond strategy.  Because of the larger coupons and lower duration in the high yield bond market versus certain other areas of the fixed income market, such as investment grade corporates, we have historically seen much less interest rate sensitivity (see our piece, “Strategies for Investing in a Rising Rate Environment”).  The chart below also demonstrates that the high yield bond market has consistently had a notable yield and coupon advantage relative to the 5- and 10-year Treasury yields.1

Even with rates increasing, we expect that notable yield advantage to persist. But again, we believe that active management is important in this environment because within in the high yield indexes and the products that track them, there are a number of securities with yields sub-5% and spreads over comparable maturity Treasuries of 250bps or less.  For instance, 32.5% of the US high yield market trades at a spread of 250bps or less.2  We would expect there to be much more interest rate sensitivity, and thus the potential for price declines, in these securities trading at low yield and spread levels.  However, this is only a portion of the high yield bond market and we still see plenty of attractive, higher yielding, less interest rate sensitive securities in the high yield market that active managers can focus on.

Whether rates continue to increase or not, we believe the active strategy within high yield debt market can make sense for investors, especially those that are looking for attractive  income generation.

1  5-year Treasury yield, 10-year Treasury Yield, data sourced from Bloomberg.  The Bloomberg Barclays U.S. Corporate High Yield Index covers the universe of fixed rate, non-investment grade debt, sourced from Barclays Capital.  Yield, yield to worst and coupon data is based on the month ending levels from 5/29/1998-4/30/18, with the final period intramonth, 5/24/18.
2  Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 4/27/18, https://markets.jpmorgan.com.
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