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A different approach to US high yield

Wall_StreetAn ongoing environment of low or even negative interest rates and low yields means investing in bonds continues to be challenged. In a recent Funds Europe webinar, Roman Rjanikov, portfolio manager at US-based DDJ Capital Management, discussed how to generate sustainable returns by adopting a different approach to US high yield.

High Yield – once known as ‘junk bonds’ – is often considered a riskier asset class. It is known for higher volatility and increased risk of default. Investors can be hesitant to buy into the US high yield market because of concerns over limited upside versus equities and stocks.

Yet many investors who have these concerns are often invested in small and mid-cap equities which have the same, if not even riskier profiles and less downside protections, according to Roman Rjanikov, portfolio manager at US high yield specialist DDJ Capital Management. Speaking at a recent Funds Europe webinar, Rjanikov highlighted that many of these small and mid-cap names are the very same companies that issue high yield paper.

“These equities are, by definition, riskier as they are lower in the capital structure,” he said.

From April 1998 to September this year, US high yield has only slightly lagged equities and this includes a year to date where equities have effectively bounced back to pre-Covid market levels whereas US high yield bonds and bank loans are yet to do so, according to research by DDJ Capital.

As Rjanikov pointed out, US high yield can generate sustainable cash returns, through their coupon, that compound over time. To draw a comparison, for equities to appreciate investors need to believe they are undervalued – “equities can stay undervalued for years or even decades”. “Meanwhile the price of a bond or bank loan can go up or it can go down through its life, but if it matures or gets refinanced you will get your return through the coupon regardless,” Rjanikov highlighted.

Changing sentiment
A recent change in monetary policy sentiment saw investors rush to US high yield, sinking $3.3 billion (€2.8 billion) into the asset class through the week ending November 11, according to EPFR Global data.

Fiscal and monetary stimulus is, as Rjanikov said, one of the biggest variables affecting the US high yield market, alongside the duration of the pandemic, and the direction of interest rates and politics – especially the aftermath of the US November elections.

“The wind of sentiment on all these issues shifts daily. All these things are interlinked. One thing we can count on is that there will be more volatility in the second half and beyond because this is certainly not business as usual,” he told our audience from his office just outside Boston on the day of the presidential vote.

The High Yield index is currently at about 500 bps spread – a long way off from the wide spreads  seen in March of over 1000 bps. It is also still much wider than the record low of 326 bps seen at the end of 2018. “The data is in line with the historical average. Under certain conditions, it would be no surprise to see the market tighten further or possibly even widen,” said Rjanikov.

In 2019 and this year, lower-grade credits underperformed their higher-grade counterparts dramatically, data from the International Exchange (ICE) shows.

“Whenever that happened in the past, historically the lower grades would eventually catch up and then some,” Rjanikov said. When market conditions normalize, stronger performance from single-B and triple-C credits can be expected. Whatever happens, the portfolio manager argued, markets are not going to be moving forward in a straight line.

A more traditional approach adopted by larger high yield managers is to run “closet” index funds which own hundreds of issuers spread in tight positions. With this method, investors tend to look at each issuer index weight and make their decision based on that.

Despite a challenging environment, Rjanikov believes that superior returns in US High Yield can be generated by building a concentrated portfolio of bonds with safe principal protection but paying slightly more yield than the market.

Navigating volatility
Evaluating the risk/reward of each company individually, regardless of how big the name is in the index, can generate better returns in US high yield.

“There has to be a yield advantage over the benchmark because income is the most consistent, reliable, and sustainable source of outperformance,” Rjanikov explained.

But using this bottom-up approach alone can have the potential downside of “unintended” risks. This is where some top-down analysis is also crucial. A big part of this research involves legal analysis and restructuring expertise, according to the portfolio manager.

One credit of interest in DDJ Capital’s Upper Tier High Yield strategy is land development company, Five Point Holdings.

“This is a great example of an off-the-beaten-path credit,” Rjanikov said. “Land developers buy land, perform all necessary permissions, and then employ engineering and construction companies to build infrastructure, such as water pipes, electricity etc.  They do not build houses, instead they sell developed lots to the home builders.”

When investing in US high yield, it’s all about having the long-term view for Roman and DDJ Capital. The reason why businesses such as Five Point are interesting from a high yield point-of-view, are because of their potential and downside protection.

“While the company does not generate cash right now because the land plots have not been sold yet, based on our analysis, the value of the land covers the value of debt several times over,” said Rjanikov.

More importantly, he noted: “there is a clear path and timing as to when the company will start generating cash.  It is a B- credit today, but it is substantially underrated based on the net present value of those cash flows.”

You can watch the full webinar on sustainable income in US high yield on our Webinars Channel.

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