The high-yield outlook on the road to normal
- It is difficult to define “normal” in the current environment.
- Spreads may tighten but we expect lower-rated credits to remain attractive.
- Credit selection will remain at the core of what we do
William M. Nelson
The credit market
Heading into a new year, the biggest concern facing fixed income investors has not really changed from what it was 12 months ago: what is going to happen with interest rates. Although Fed officials have tried to calm the markets about the potential for policy tightening, inevitably we believe there will be a return to “normal.“ That said, the protracted low-rate environment since the financial crisis has made it difficult to determine what is “normal.”
Although the credit analysis process is at the center of our portfolio construction process, the macro environment also plays an important role. In this regard, the portfolio management team thinks in terms of three-year increments. About 18 months ago I moved the portfolio into a more defensive position, with a significant underweighting versus the index in BB credits, but with higher B and CCC exposure to capitalize on the yield opportunities there and to also mitigate Treasury market impact of the type we saw in 2013.
Given the focus on rate fears, we find it surprising that we have yet to see substantial evidence that our peer group in the high-yield space has fully considered what a return to “normal” might mean to their holdings. Specifically, we would note that there has been a 900 to 1,000 basis point difference in total returns generated by the B and CCC category compared against the BB, which are more heavily influenced by Treasury rates. This spread, was a key factor in the past year’s performance.
We believe that, barring an unexpected event, the environment we have seen over the past year may foreshadow what we are going to see for the next year or two. We expect we will remain underweight on BB credits in our funds with more of a focus on the B and CCC quality. However, we want to stress that we don’t expect that the degree of performance we saw in the spread versus BB credits is going to occur again in 2014. That 1,000-point spread was this year’s investment story.
We expect that spread is going to be compressed in 2014, but should still provide attractive yields relative to the higher-rated credits. Our mantra has been and remains that we would prefer to take credit risk than Treasury risk in this environment.
Depending on what happens in the months ahead we could see a situation where we might consider reducing CCC exposure in favor of higher-rated credits. However, that move would be influenced by several factors that could weigh on the market. We would not be surprised to see an environment where CCC stays strong for a longer period of time than some expect, but it will depend on such developments as available supply and if the market shifts into a diversification mode. Price certainly plays a role in this equation as well and cannot be overlooked.
Finally, as we consider the eventuality of a Treasury interest rate climb, we believe the market is going to undergo a transition from a yield-to-worst or a yield-to-first-call market to a yield-to-maturity market as the cost of funds faced by companies in the future could be higher than what is currently in the market. The result is that the market will push out duration.
The core of our high-yield fund has been and will continue to be credit selection. The analyst team is responsible for making recommendations related to our high-yield strategy by using established templates and metrics as a starting point. Although we weigh a number of factors, we place particular emphasis on free cash flow generation and the ability to deliver a balance sheet. We prefer companies that have the cash flow to pay down their debt absent top-line growth and focus particularly on unorganic growth in cases of mergers and acquisitions.
Our goal, of course, is to find the opportunities early. For example, we want to own a CCC name – which some cannot purchase because of the credit rating – before it moves to B and has the related price appreciation as it becomes available to a wider range of buyers. Because we have the flexibility to invest across the capital structure, we also may invest in opportunities where we may own both the bank debt and the bonds of a particular issue when we believe we are appropriately compensated.
It is important to stress that while we often explain fund performance in terms of owning credits with lower agency ratings, in terms of credit buying decisions we place very little value on the ratings from Nationally Recognized Statistical Ratings Organizations such as S&P and Moody’s. The agency ratings are not only backward-looking, but we believe fundamental flaws in the ratings process may result in undervalued credits. We believe very strongly in our analyst team and their ability to uncover attractive investment opportunities and make decisions based on their findings.
Given the emphasis we place on our proprietary credit research and its ability to uncover value, it is probably not surprising that we usually hold only half or less of the top 30 high yield credit issuers at any one point.
Although the reasons may vary on why we do not own individual credits on that list, overall it is important to remember that you cannot outperform peers if you are all holding the same thing. The only way to succeed in that model is to be a better trader, which often requires a good amount of luck with the timing since the trade often moves in one direction: everyone is either trying to buy or sell the same basket of securities at the same time. Similarly, we usually do not own what we like to think of as the “exchange-trade fund (ETF) bonds” or the roughly 20 names that regularly move when high-yield ETFs are forced sellers on the market.
However, we do try to take advantage of a contra approach where it works within our strategy or presents an opportunity on a credit we find attractive. For example, if an ETF is liquidating under pressure, we may seek to capitalize.
In addition to what we believe to be the return benefits of not holding many of these heavily-traded names, we also feel that it creates the potential for a lower level of volatility than might be created amid market swings.
In closing we think that 2014 will be another year where the interest rate levels may determine total return for high yield funds as the market potentially reacts to Fed action.
Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through January 3, 2014, and are subject to change due to market conditions or other factors.
Investment return and principal value will fluctuate, and it is possible to lose money by investing.
Risk factors. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Loans (including loan assignments, loan participations and other loan instruments) carry other risks, including the risk of insolvency of the lending bank or other intermediary. Loans may be unsecured or not fully collateralized may be subject to restrictions on resale and sometimes trade infrequently on the secondary market. These and other risks are more fully described in the Fund’s prospectus.