Investment Insights Series: Down but not out – Opportunities in High Yield Bonds

On 27 October 2022, David Rosenberg of Oaktree Capital, co-manager of the St. James's Place Global High Yield Bond fund, was joined by Martin W. Hennecke, Head of Asia Investment Advisory and Zoe Pearson, Head of Location – Asia Marketing, St. James's Place Asia. He shared his insights on the risks and opportunities in high yield bonds going forward and what his team does to achieve resilience in uncertain times.

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We have seen an interest hiking race not just in the US, but for many other countries as well. When do you think the Federal Reserve will potentially stop raising rates?

All eyes seem to be on the Fed — when you watch bond markets and equity markets, volatility is driven by people trying to predict what the Fed's going to do. However, I would argue that even the Fed doesn't know what the Fed is going to do yet, so it's very difficult to predict.

If you looked back a few months ago, there was a fairly strong rally in the high yield market as the market had come up with a determination that inflation had peaked — if inflation had indeed peaked in 2022, then we were going to manufacture a soft landing, and rates were going to go down in 2023. That would be very bullish for equities and bonds, so everything rallied.

However, when you think about what that means, it doesn't really make a lot of sense. The Fed is not in the business of propping up equity markets. Despite everyone's desire for that to be part of their mandate, it's not. If the Fed is going to lower rates, there needs to be a crisis - a pandemic or a global financial crisis – for the Fed to step in and save the economy.

The reality is if inflation had truly peaked in 2022 and we had a soft landing, there would be no reason to lower rates. If the Fed lowers rates in 2023, that means there is a crisis in 2022, and there is no soft landing. You cannot have the two coexist.

Now, we've got to the part where the market really wants something to happen, and we are in a world where bad news is good news. When things are bad, that means the Fed can't raise rates, and somehow that becomes good, and everybody goes to buy.

 

Have we been here before? Is there anything different this time?

What's really important is that for the first time in decades, we're fighting inflation. In the US, we've gone through multiple decades of rates just going straight down and now, with rates starting to go up, that has a lot of implications for many different things.

When I talk to clients, I always start out to tell people that this is below-investment-grade investing. When you're investing below investment grade, first and foremost, you must have a handle on your default risk. But for years, people have told me that they don't have to worry about credit. That was quite frustrating because it was true — generally, if you didn't sell in the first two weeks of volatility and held your breath, the Fed would come in and bail you out whatever you owned, and things would go back up.

But now, we're in a period where the Fed wants to bail you out, but it can't. Now, the Fed has to choose — you cannot support a market on the one hand and fight inflation on the other. Those are in direct contradiction of each other because supporting markets is inflationary, and the Fed has picked to fight inflation.

Now, we're starting to separate the market from those who have done their credit work, and those who have just been hoping for the Fed to bail them out.

Most people think we're heading into a recession, but what's different this time is that the recession isn't necessarily being driven by excesses in the market — a bubble that's bursting, subprime lending or some other market that has gone out of control, causing an unwind in the economy. Instead, it is policy driven, and the concern most people have is that the Fed is going to push too hard on inflation and slow the economy down.

If you look back over the entire history of the Fed, there have been periods when the Fed was trying to slow inflation, i.e., letting inflation grow at a slower rate, and they have manufactured a soft landing from time to time. However, when the Fed had been trying to bring inflation down, they had never been able to manufacture a soft landing. Inflation is effectively the growth rate of the economy. To take an entire economy and slow it down, not too much but just enough, is very difficult to do so, and I think it's very likely you will end up overshooting and pushing yourself into recession.

 

With a possible recession round the corner, do you still have confidence in the high yield market?

People think about defaults when thinking about recession. However, I do think that we are going into a period of defaults that is likely much more benign in this recession than the previous. This is because all the weak companies that would have defaulted in the next recession had already defaulted during COVID. This explains why we had a spike in defaults up to about 5% in the US and so, that cleared the decks.

Let's look at what the Fed did in the US and other central banks around the world — when they were trying to bail the economy out of the pandemic, they flooded the market with liquidity. When they did that, any CFO with the pulse saw how cheap money is and quickly went to refinance their debt. This brought down their cost of capital, and the ancillary benefit is they had extended their maturities.

So right now, if you look at the high yield market, I think less than 6% or so of the market matures within the next two years. This means 94% of the companies don't have to answer anything for a couple of years now, which gives them flexibility, and that means it's unlikely that they will hit a wall and go into default in the near term.

Hence, while I think we are headed into a recession because the Fed is likely to overshoot while fighting inflation, we have companies that have cleared their balance sheets, which allows them to manage through this.

 

If the markets hit a pocket of illiquidity, are you confident that you can sit on your bonds and the underlying companies will generate enough free cash flow to pay you back at maturity, or are you making some changes to your portfolio?

l am very confident in our credit work and firmly believe we're in a credit pickers' market now, which is going to separate out the good from the bad.

When you do your credit work, you get two things out of it. One, while everyone else is having problems, you're having fewer problems, and you outperform on the way down. Two, when everybody's panicking and looking to sell because they have more risk than they thought they did, we're looking to buy and take advantage of this dislocation.

For example, I didn't see COVID coming. But we had the portfolio built with each credit underwritten, saying if something unexpected happened, which tends to happen, the bond has a cushion to absorb it, make it through and pay you back.

Today we're quite happy with what we own. During COVID, many people asked me what I'm doing to make my portfolio more defensive, and I've always told them if I'm doing it now, it's too late — it's very expensive to make things defensive in periods of panic.

I'm not alone in my view that the Fed will push us into a recession, and if you sell CCC-rated bonds (the riskiest segment of the high yield market) today, you have to sell it at a very deep discount. What we have done is exit during 2021, when the market was strong and CCC securities were the best performing — the world was reopening, everybody wanted exposure to this, and it was in fact, coined the reopening trade. But I've always had a rule that whenever a trade gets a name, it's time to get out. So, while everybody was chasing opportunities in the reopening trade, we were selling risk.

We also bought the bonds of an airline during COVID. It was a secured bond with great collateral — even in the case of bankruptcy, we know we can come out without losing money. While we liked the bond, when we entered mid-2021, it became a business that needed the reopening to go very smoothly, but nothing ever goes in a straight line in our business. Hence, we sold that bond at 117 cents on the dollar and bought into a food distribution company instead, which offered the exact same yield and yet doesn't need the reopening to go very smoothly.

And now, we have built a portfolio that we are very confident of. If things go down, we will be looking more to buy than to sell.

 

Most people associate high yield with high risk, but it’s not always the case. Can you take us through a case study of how you’ve managed the risk down when investing in high yield securities?

When we were in the depths of COVID in March and April 2020, it was uncertain how long the quarantine was going to last. There are a lot of companies in the crosshairs of COVID that were really at an existential moment of whether they were going to survive. They came to high yield for a liquidity bridge. What we found interesting was that they offered security in return, which is quite rare in the high yield market and is usually reserved for the loan market.

You're already getting paid more by being in high yield, but the job number one for us is to bring you into that asset category but manage down the risk. While COVID was clearly very scary with lots of uncertainty, there's got to be safe ways to invest in these businesses.

One of the businesses that came along was a large cruise ship business. With cruise ships not operating, it's very expensive to have a business like that — you're burning close to a billion dollars a month and you need to raise liquidity. When it came to the bond market, we got together with a few other investors to structure a deal, and we took a deep dive into the business. While everybody was saying no one's going to go on a cruise ship ever again, we dug into the data and found that over 50% of the people who received cancellations were choosing to rebook instead of getting a refund. It was our view that there was real business to underwrite here, and more importantly, this business was a fallen angel who came down from investment grade into high yield.

We offered liquidity on the basis that we are the first lien, even ahead of its revolving line of credit, and took all unencumbered ships as collateral. The analysis we did suggested that the loan-to-value was effectively 25%, which means we could fire the sale of the assets and still get our money back.

Our thesis that the business will make it through turned out to be true. However, if we were wrong, we had a second way out because we were so well over-collateralised, and essentially, we had two chances to survive. We bought that bond with a double-digit yield, and when the reopening trade happened, those bonds traded at very high prices, and we happily let them go. It was a good way to use structure and collateral to get yourself comfortable in a business that was clearly going to go through a very difficult time.

 

Some of these examples you shared have demonstrated the thoroughness of the credit work Oaktree has done. Could you share more about the process that guides you through the selection of high yield bonds?

In Oaktree we have a proprietary framework called the Credit Scoring Matrix. It refers to the eight factors we analyse with every credit before we buy it — the industry, company, management, financial cushion coverages, capital structure, amount of flexibility the business has, the value of the company if things go wrong, and the terms of the deal.

You would notice that none of these eight factors was price, yield, or spread. It's all credit first. The rule at Oaktree is that credit must be acceptable, and only if credit is acceptable then can we talk about relative value. I do believe that this discipline allows us to focus on what's important and over 30 years, with the market default rate around 4%, we have a default rate of only around 1%.

The other thing that's unique to Oaktree is we are a very large, distressed debt business and that in the event of defaults, we have the expertise in-house to go through the company's bankruptcy and maximise our recovery.

With a combination of a default rate below the market and a recovery rate above the market, I find that to be very powerful.

 

Looking forward, do high yield bonds still have a place in portfolios?

For a long time, the risk in high yield has not materially changed. These are still junk, high yield rated companies that have an equity-like risk to them, but the reward has materially changed.

When rates are low, everyone was leveraging up to get as much as they could at 4% or 5% for high yield, or around 3% - 4% if you were buying into higher quality. People always say it has got to be so painful investing in fixed income while rates are rising, and I would agree it's no fun to go through it. However, when you get to the other side, it is very healthy for the market. The central banks were purposely pushing people into unnatural risk in order to stimulate the economy, but they don't need to do that anymore.

Now, you can earn 9% or 10% for a high yield company where the risk hasn't materially changed, but the reward has because rates have risen — it just changes the math of fixed income. Looking forward, what you'll get out of fixed income is very different over the next five years compared to what you've gotten over the last five years.

Another way to think about it is that bonds mature at par. Today, the average bond is at 85 cents on the dollar and there's this upside built into the market that's quite rare. I've been doing this for over 18 years, and at the beginning of my career, bonds priced in the 80s were considered no man's land — no bond ever traded in the 80s for very long. It was either going all the way to distress, or it was mispriced.

Now the average bond is in the 80s. You could go to par quicker than maturity and earn a better return with less downside. But if a company does go into bankruptcy in restructuring, it doesn't need to be worth 100 cents on the dollar — if it's only worth 85 cents on the dollar, I still get my money back.

It's not every day you can buy something with less downside and more upside.

 

Is now a good time to invest in bonds?

People like to look at spread, which is how much additional yield you're getting over the risk-free rate to bear the risk. If you look over the last 30 years for a B-rated bond, which is the core of what we like to buy, the normal range of spread tends to be 300 to 500 basis points (bp).

Right now, spreads are around 500 bp, right outside the wide end of normal. However, people are saying that in previous recessions, spreads have always gone to 1,000 bp, so they should wait further. But the truth of the matter is that things are different now, where defaults are likely going to be much lower, and the quality of the bond market is much higher.

The percentage of BB-rated bonds (the highest quality in high yield) is higher than they have been in over a decade, while the percentage of CCC-rated bonds (the lowest quality) is lower than they have been in over a decade. Therefore, we have a very high-quality market. Mathematically, for bonds to get back to the 1,000-bp spread, the average price has to be down in the high 60s or 70s, and the odds of that happening before people like myself step into buying is very low. If you sit and wait, you'll likely miss the opportunity.

When a recession hits, spreads could go wider, but I always say if you wait till the bottom, no one will sell to you.

 

What’s your outlook on the high yield market?

For the long term, I expect you'll earn 9% or 9.5% based on today's yield, and I'm quite confident we're going to manage the default risk down.

In the short run, I do think that things are getting weaker in the economy and inflation is still real, as we haven't quite seen that flow through earnings just yet. When we talked to the management team of the companies, the tone has very clearly shifted. A year ago, they were passing the inflation through to the customers, and there was government support running through the system. Now, consumers have already absorbed whatever they can absorb, and our companies are talking more about cost cutting — finding other ways to absorb the cost themselves.

With that said, I expect things will get a little more attractive in the near term when there will be a tremendous buying opportunity. Eventually, the central banks are going to back off the constant pressure on the economy, and there will be a bit of a retracement.

As for how much yield you get to keep, to me, that's the art of this business — managers who know what we're dealing with will be able to artfully pick the companies that will not default. They'll earn the yield, and those who are just trying to ride the tide with everybody else is going to step on a few land mines.

 

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