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The high yield bond market has had a rich, storied past and has taken an interesting journey over the decades through scandal, high interest rates, and default rate concerns – from “junk” bonds to “fallen angels” to “original issue” high yield bonds to “high opportunity” bonds. The asset class has weathered the turmoil and vagaries of the markets and investor biases.
Today, the US high-yield bond market represents a $1.4 trillion market - up from $500 billion in 2002 - which represents roughly 15% of all outstanding corporate debt. According to Debtwire figures, US high yield issuance climbed 26% year-on-year, up from US$64.3 billion in H1 2022 to US$80.9 billion in H1 2023.
To better understand what we should know about the high yield market today, we were introduced to Bruce H. Monrad and Chapin P. Mechem co-Portfolio Managers of the Northeast Investors Trust – a no-load, fixed income, high yield mutual fund launched in 1950 making it one of the oldest bond funds in the country. We asked them questions to learn from their unique perspective which employs a nimble and flexible active management style. While the fund is concentrated, they take an unconstrained value-oriented approach which allows them to look in the deepest corners of the high yield space.
Hortz: With your decades of experience with high yield bonds, how would you characterize the high yield bond market today versus its historical past?
Monrad: Indeed, we have seen numerous cycles affecting the high yield market. Prior to the 1980s, the market was exclusively a “fallen angel” market, made up of former high-grade bonds that had been downgraded to BB or below. The new issue high yield market dominated by Drexel Burnham Lambert was characterized by coupon rates starting at 13%, but the ultimate criticism was that too much leverage was used in the leveraged buyouts of that era. “Good companies, with bad balance sheets”, so went the mantra. After nearly a decade of smooth sailing, the high yield market once again came under pressure, having financed waves of telecom issuers in the so-called “tech bubble”. The pithy remark then morphed into, “In 1990, it was good companies with bad balance sheets; in 2000, they were just bad companies with bad balance sheets.” By the way, Northeast did not buy any telecom bonds during that bubble.
None of the above should detract from the above-average interest rates that benefit high yield bondholders, year in and year out. Moreover, the high yield market currently seems more resilient than in those prior periods. The ratio of BBs in the market is higher than before, and as is typical and should be remarked upon, the average maturity within the high yield market is lower than most other fixed income subsectors. To be sure, all debt issuers are confronted with the higher repricing of their balance sheets as old debt comes due in a higher interest rate environment, but observers point out that the leveraged loan and direct lending segments are more exposed to that risk.
Mechem: As the high yield market has grown over the past 30 years it has become much more mainstream. Over the past 15 years we have also seen an improvement in overall credit quality. In 2007, 36% of the market was BB and 19% was CCC, while today those numbers are more like 50% BB and 10-11% CCC. The leverage ratio of the market is also at historical lows, hovering below 4x. This will bode well in the event of an economic downturn. The historic low rates of the past 5 years, before the most recent rate hikes, allowed companies to pay down debt and push out maturities at historically low coupons, which has created stronger balance sheets across the market.
Hortz: What do you see as the biggest challenges for fixed income managers and investors today and how are you addressing them? How do high yield bonds help in these challenges?
Monrad: Perhaps the biggest challenge for fixed income portfolio managers is hiding in broad daylight. We have exited a decade-long period in which fixed income benefitted from the tailwind of price-insensitive buyers in the form of central banks. With the exception of the Bank of Japan, that era has come to a close and even that may change soon enough for the Bank of Japan. Today, the fixed income markets may now be seeing the headwind of not one, but two price-insensitive sellers - the central banks and deficit-running government issuers. To make the point on the latter, consider this thought experiment. What is easier for a sovereign country issuer of bonds - to cut government spending to reduce its budget deficits or to pay a little more on its borrowings from the bond markets?
More granularly, we are finding that issuers, their sponsors, and even fellow bondholders can provide challenges that sometimes reduce value in the high yield market. An example of this would be a private-equity backed leveraged buyout attempting to transfer assets out of the reach of bondholders. We have long been concerned about this phenomenon, and we strive to avoid credits where this risk is elevated. Generally speaking, these are risks that are positively correlated with financial stress, and so healthy credits are less likely to be affected by these risks. For this and other reasons, we have in the last half decade concentrated our purchases on BB issues at the top of the high yield credit spectrum.
Mechem: In the short term, the biggest challenge from an investing perspective is in predicting the future of interest rates. There is direct action on the fed funds rate, but we are also trying to determine what is the proper ‘Neutral Rate’ or long-term rate. We have not seen “term premium” – the extra yield bond investors get for owning longer-term bonds compared to owning and rolling over short term bonds - in years and that has returned, so just trying to predict where long rates land and managing the portfolio appropriately is an issue. High yield keys more off the longer rates than the fed funds rate. I do think the rate increases are basically done, but what sort of cuts lie ahead?
Hortz: Can you please walk us through your investment approach and process?
Mechem: Our process begins on a macro level, as we assess both the current and forward-looking dynamics of the fixed income market. Given that backdrop, we identify key market drivers and narrow our focus on a particular set of sectors or industries. From there, we lean on decades of experience and qualitative research to lead us to the best relative value opportunities within each industry/sector. Because we are not limited to ‘index’ securities, we are able to expand our search to lesser-known areas of the high yield market, which we believe gives us an advantage over our peers when trying to identify and capture relative value. The end result is a unique, concentrated collection of high yield investments that aims to generate income at an attractive level of risk/reward.
Since high yield investing has asymmetrical risks, with outsized downside risk, that also causes us to prefer the higher quality high yield issuers. We are currently positioned at the short end of the curve and at the relatively high end of the high yield credit spectrum. The higher credit issuers should outperform in the event that we see an economic downturn and the high yield spread widens (the premium high yield issues have to pay vs. treasuries). However, if the economy perseveres and we achieve the ‘soft landing’, some of the rate cuts that are priced into the market will reverse and the short end will outperform from a rates perspective.
Monrad: At Northeast, we are essentially value investors within the high yield space. We take a long-term perspective when evaluating credits, and we believe this provides a competitive advantage and that it is inefficient and suboptimal to invest otherwise. Value investing in high yield involves evaluating credits on a hold-to-maturity basis and removing from the analysis anticipated short-term, temporary wiggles.
On this basis, there is a similarity with private credit. However, private credit is essentially a new issue, buy-at-par market, and in the public markets we have the opportunity to take advantage of dislocations and buy bonds at discounts if we feel the opportunity is attractive. In this sense, volatility is a feature, not a bug. The management of Northeast owns a meaningful percent of the fund, and so this leads us to invest with this buy-and-hold approach, which again we think is a structural advantage.
Hortz: What research and analysis do you do to determine risks and opportunities and the underlying fundamentals in the high yield market? What trends and opportunities do you see right now?
Mechem: With our decades of experience, we have been through all types of cycles, so I think we do a very good job understanding the cyclical and secular nature of downturns or changes. We spend a lot of time understanding the macro environment, as well as deep dives into industry specific dynamics and challenges. We then do a bottom-up analysis of individual issuers by focusing on balance sheet strength, cash flow generation, and project level IRRs.
Being generalists also allows us to analyze relative value across industries. For example, chemical companies have been extremely pressured the past four quarters, which has come as a surprise to many given the relative strength in GDP. We are able to understand the cyclical challenges allowing us to see bottoms and buying opportunities. We also like US energy companies based on our views of global oil supply/demand dynamics.
Monrad: High yield is an outstanding space to be in because it overlaps with so many investment classes and themes. We need to take into account the macro aspects of the Treasury market, the credit quality of the individual issuers evaluating both quantitative and qualitative features, and also a reasonable dose of legal analysis - starting at the top of the market with simple bond covenant analysis and going all the way down to understanding the legal intricacies of the bankruptcy code. If a portfolio manager competitor is short of any of those skills, he or she might misallocate capital and that is an opportunity for competitors.
As to trends, there are always opportunities in the seams of the high yield market between new issues and discounted bonds, and between discounted bonds and explicitly distressed bonds because some of the aforementioned human capital skills I mentioned are in human silos and not integrated, like they are in our research.
Hortz: From your experience, why would you argue that active fixed income management is needed over passive management and bond index funds?
Monrad: We firmly believe that fixed income is better managed actively, rather than passively – particularly in the high yield market which is almost by definition an active market. Who makes the decision in a passively-managed fund whether to accept a tender offer or a consent payment for modifying a bond covenant? Who determines whether to accept an exchange offer that extends your maturity?
Active portfolio managers also have the opportunity to take advantage of market dislocations. As we mentioned before, whenever there are price-insensitive forced buyers or sellers, that creates opportunities and the ability to make judgements and act in a nimble manner, providing the chance to add alpha over the index.
Mechem: The fixed income market is very different from the equity market in terms of the importance and impact of active management. Managing interest rate risk and credit risk, based on where we are in each cycle is critical and this can only be done with active management.
Hortz: What is your perspective on what is next for the high yield bond market?
Monrad: Much akin to the overall fixed income markets, investors will take their cue from developments in inflation, the strength or weakness of the economy, and the Fed’s reaction function to those factors. We have long downplayed the impact of rising interest rates on the economy when starting from the zero percent lower bound, which represents a contrarian view. Accordingly, we have been more sanguine when others have been more concerned about recession risks.
Moreover, we also tend to think that an underappreciated opportunity is the chance of a manufacturing rebound in 2024, which is also not a consensus view. However, the downside to this view is that we are somewhat wary of current predictions that the Fed will aggressively cut interest rates in the 2024-2025 period.
More prosaically, we think the high yield market will nonetheless see slightly higher default rates in 2024 (although nothing like that seen in the Asian high yield market). Still, we believe that the relatively short-duration nature of the high yield market, coupled with most bonds’ trading at discounts to par, provides both structural and idiosyncratic opportunities for bondholders to benefit from the natural “pull-to-par” of their discounted bonds.
Hortz: What thoughts or suggestions can you share with investors looking at the high yield market today? What should investors in this space be aware of?
Monrad: We believe potential investors in the high yield market should take stock of the basic valuation relationships between high yield and other asset classes. A starting point includes the potential value of relatively short-duration assets and asset classes, especially with the yield curve inverted (short-term bonds yield more than long-term bonds).
If we had to distill it down to an anecdote, we would invite investors to compare the risk-reward attractiveness of a 2-year BB high yield bond (priced perhaps 2.5% over the 4.5% 2-year Treasury for a yield of 7%) against the 10-year Treasury currently yielding 4.3%.
An additional comparative data point would be the 5% earnings yield of the S&P 500 (i.e., the inverse of the 20x P/E multiple). When measured this way, the so-called equity risk premium is on the historical low end against long-term Treasuries, and it is even negative compared to the yield on the high yield market. We would accordingly conclude that the relative risk-reward tradeoff appears favorable for high yield at this time.
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