High Yield Bonds Explained | Portfolio Manager Views Podcast

Transcript:

Alexandra: Hello everyone, and welcome to Portfolio Manager Views. My name is Alexandra Gorewicz and today I am joined by Anthony Imbesi, the lead of our high yield portfolio management team at TD Asset Management, which we affectionately called TDAM as lead Core Plus manager at TDA M. I can safely say that high yield is the most important plus lever when it comes to generating income.

And so, my teammates and I rely a lot on Anthony and his team to invest in a space that has both higher risks and higher rewards than other fixed income asset classes. And so, Anthony, welcome. Thank you. I'm here to talk to you about all things high yield. What is high yield? Why is it misunderstood and how can it play a role in traditional fixed income portfolios?

So, let's start simple. What are high yield bonds and are they different from other bonds?

What high yield bonds are and how they differ from investment grade

Anthony: Well, high yield bonds are just simply bonds or debt issued by companies with below investment grade ratings. So, they tend to have higher coupons because of the ratings. They are fixed coupons like regular bonds, but they differ in other ways. For example, they have - they're callable. Not only do they have shorter maturities, but they're also typically 5-to-10-year maturities, which is typically shorter than investment grade bonds.

But the call ability feature means that duration is even shorter because the bonds can be paid down earlier or called once a non-call period expires. But the companies have to pay you a premium for doing so. So, the bond holders will get compensated for having their bonds called earlier. The other thing about the high yield bond market or bonds in particular, that I should point out are the covenants.

They tend to have fewer covenants or fewer protections than investment grade bonds do. And as a result, investors have to be aware of that when they are making a decision whether or not to invest in high yield. And the other point I would say is the high yield bond market in general, if you think back, it kind of started off in the mid-eighties when it was a small 50 billion size market and it was mostly made of fallen angels.

That was the majority of the bonds that's making bonds like it downgraded - it downgraded to high yield and that's what constituted it over the years and decades. This market's growing into 1.4 trillion size market. And if you throw in leverage loans, euro market and emerging markets, the size, this market is about 4 trillion in size. And that's a pretty hard market to ignore.

Alexandra: Why the lower ratings then? I mean, it's grown a lot over time like what's the reason there.

Anthony: Yeah, the low ratings is really a function of higher risk. And if you think about ratings, the rating agencies, what they do is they provide this rating, which is essentially a score or an opinion on the credit worthiness of the companies or the issuers of these bonds. And it can be companies, governments or other entities that issue this debt.

And essentially, it's an assessment of how can they how good are they paying their interest payments when they come due and the principal when it matures. So essentially, they're talking about default risk. So, the higher the perceived credit risk, the lower the rating is essentially the way to look at it. But one of the caveats about ratings is really they're not perfect. Investors.

Be mindful if you rely on ratings alone because they don't react in real time the way markets do. So, if there's an event, let's say a negative credit event or positive credit event, rating agencies will take time to reflect that and to upgrade or change or downgrade and change the ratings to reflect that information. The markets are much faster.

So, when there's a negative news event happening, the markets will reprice that quickly in the bond. So that will reflect the true risk of the bond versus the rating that agencies provide. So that's something to be to be mindful of when you're looking at that. And it's part of the reason why you hear words like speculative grade, you know, below investment grade junk and things that you may have been familiar with.

Defaults explained and why they don’t always mean full loss

Alexandra: I mean, I put myself in the shoes of someone who doesn't get to speak with you as often as I do. And I'm going to latch onto some of the words you just said that I noted here. And I'm especially putting myself in the shoes of someone who perhaps advises people on all thing's financial matters. When you say higher credit risk, I might hear my clients fall asleep at night, or I'll have a lot of handholding to do with my clients in this asset class.

You mentioned default, right? When I hear that, I'm hearing my clients won't get their money back. Junk. That's the word I latched onto. I'm hearing where's the value for my clients then? Now I know you live and breathe high yield bonds. So, you know, you're saying these terms with, you know, a lot of likes, you know, nonchalance.

You're very casual about it. But, you know, shouldn't investors be worried about, you know, everything that you just said?

Anthony: That's a common reaction we get whenever we talk high yield. Yeah, exactly. What you said is what is on top of investors' minds. Yeah. And we have to understand it first of all. So, when you talk about bankruptcies and defaults and you know, the term junk, it is part of the asset class. Unfortunately, it does have that sort of negative perception from investors.

But if you get down to it and understand what it means when you do have a bankruptcy or a default, first of all, there are only about two or 3% default. That's the long-term average default rate. Call it three, three and a half percent. So, it is low and that's over four cycles in the history of high yield.

But when you break it down, a default doesn't mean 100% loss because, if you do your work right, you have protection and you've got that protection to protect your investment. But essentially, a default is really I mean, you can have a technical default, which is just when a company breaches a covenant, maybe the leverage level rises above what their covenant allows it to rise to or a more serious default or a breach is when they miss a coupon payment.

And that says when they run out of liquidity, that's a true and proper default. Right. So, what happens in that situation is it will depend on where you sit in the capital structure, whether you're first lane, second lane, unsecured, subordinated, that will mean where you rank in terms of getting your money back. And the other thing is it's what is your recovery value?

So, if you've done your homework right, if you've assessed the credit and said, okay, I've got a huge cushion of assets underlying my investment, then you will probably come out okay. You can buy a bond and be first lane in a default scenario. You can come out with pretty much almost a full recovery value, if not a full recovery value.

In some cases, you can get more because remember, you can buy these bonds at a discount. There are investors that invest solely in distressed bonds. That's their specialty. Or they look for distressed bonds that are perhaps the market is being overly pessimistic on the outcome of the restructuring. So, you can buy these bonds at $0.50 on the dollar or less, and all you need is a recovery of $0.60 or high or whatever.

And not only have you made your coupon, but you've also made a nice capital gain. So, default is not the end of the world in the context of a portfolio. Think about it. If you have a 50-basis point weighing in a position, even a hundred basis point weight and you have a 50% loss, that's a 50, that's a 50-basis point hit to your portfolio.

It's not the end of the world. I mean, it's not pleasing to have a loss, but it's not it won't implode your portfolio, especially if it's diversified.

Alexandra: Okay. So, I think your clarification on defaults is important. I wrote not the end of the world, but if I had to use an analogy, it's a little bit like potholes, if you will, when you're when you're driving. Right. With careful driving, you know, you can avoid them, but even if you hit one, you might not get a flat tire.

And under your trip that might just be a bump in the road. And I've heard you use the, you know, expression that high yield bonds are like the equity of fixed income. Can you explain that a little bit?

Why high yield is called the “equity of fixed income”

Anthony: Sure. Sure. I tend to say that because when you think of high yield, there are similarities that relate to equities. Okay. For one, I mean, what drives higher performance? It's fundamentals. It's more fundamental than it is interest rates, which is similar to how equities perform. If you're an equity investor and you're looking at a company, what are you looking for?

Earnings growth margins. You know, you do look at the balance sheet. All of these things are similar to what you see in high yield. So, when we look at high yield, it's credit risk. But what drives credit risk while fundamentals and fundamentals drives fundamentals, it's revenues, a cash flow, how leverage is the balance sheet. So, all these things, all these factors, companies, fundamentals go in determining or assessing the risk.

So that's one thing. The other thing I would say is look at the performance of high yield. So, you compare that to other asset classes, and you've got pretty high returns historically. You can go back to even 30 years. You're getting mid to high single digit annual returns, and that includes recessions, defaults, bankruptcies. I think Tech bubble, GFC, 2022, COVID, all of these cycles and events in the markets are all captured in those returns.

So that is another attractive part of high yield that kind of equates it closer to two equities.

Alexandra: What drives that? It sounds like what you're saying is risk adjusted return is higher than perhaps other asset classes. Why?

Anthony: It is. Well, well, just risk adjusted return. Think about the returns of the asset class over the volatility. It's just the ratio of comparing it. So high yield gives you high coupons. Yeah. Therefore, high income. So, the numerator, the return component, is larger than it would be, let's say, for investment grade or government bonds. And that's just the nature of the asset class, higher risk, higher coupon.

Then you look at the denominator, the volatility, and because high yield has lower duration or is less sensitive to interest rates or is more driven by credit fundamentals odds than it is interest rates, it's a lower number than you would get with a more interest sensitive asset class like investment grade or government bonds. And then if you compare it to equities, equities have absolutely the higher return on the numerator.

That's a given. But because they have a disproportionately more volatile performance, I mean.

Alexandra: During a recession.

Anthony: A 20% drawdown is not unheard of in equities. Yeah. So that ratio, when you calculate for equities still comes under high yield. So, on a risk adjusted basis or when you compensate for volatility, high yield actually comes out ahead of other fixed income asset classes and equities.

Alexandra: Okay. So, I'm going to use another like car analogy here. High yield bonds are like I'm going to call it a super charged Honda Civic. Okay. So, okay, follow up. Follow the thought process here. So traditional bond and, you know, it pays you like a traditional bond, right? So that's the good old reliable Honda Civic. But then when you look under the hood, they behave like equities because it's really just a race car.

It's supercharged. So how do you how do you deal with the high speeds? Okay. How do you and your team think about what you need to manage to invest and to lend to high yield issuers, high yield companies?

Anthony: Yeah, I would say good analogy. It. When we're looking at high yield, it's about the credit fundamentals. So, the credit analysis is really what's going to make the difference. Okay. Because we're not dealing with, you know, what we're dealing with companies and their performance, the operations of the companies. So, you have to really get into the financials. You have to model the forecast how the company is going to perform going forward.

You look at things like free cash flow generation. Can they generate cash flow through a cycle? If they do get stressed, which we model for, we stress test our investments, then do they have enough liquidity to weather that storm, whether it's a year or two years or however long we think it could last? How leveraged is their balance sheet given the industry that they're in?

If they're in a cyclical industry like commodities or energy, you probably can't tolerate as much leverage than a company that's probably more in a stable, more mature market. You know, we look at margins, we look at all kinds of factors that, you know, how diversified are their revenues are. They rely on just a handful of customers that if they lose one, it would be a pretty significant event.

Or are they diversified? Do they have a moat or all these sort of things? Is it a good business or a good company? Would you look at the equity and then we look at the capital structure? Are we where do we invest in the capital structure? We first lean secure. Do we go subordinated or unsecured? How much equity or cushion to absorb losses is below us?

Because that's important, especially when it comes to restructuring, like I mentioned. One other thing I would say is management teams. That's very crucial to our analysis. We spend a lot of time on it. It's important because these are these are the people that are managing the company that you're lending money to. So, are they good operators? Do they know the business, the industry?

What's their experience like? Are they good allocators of capital? What kind of return do they get on their capital? Remember, we are lending money. We want them to earn a satisfactory return on their capital. And then, for example, last year we had over 100 interviews with management teams in our analysis. And of those interviews.

Alexandra: And…

Anthony: About 70% were face to face were in person. And we've owned over we owned about over 50% of the bonds of the companies that we actually sit and meet with. And we even look at their competitors. That's part of the analysis. So, it gives us insight into what their competitors are doing, what the industry's like. It's all it all that goes into the analysis.

And then once we do the analysis, it doesn't stop there. We have to keep revisiting the thesis. Has anything changed? Our fundamentals are the same as they were when we first looked at it. For example, do we? Where's our exit value? Like what value do we exit the position at? Because we have to be disciplined not just how we buy things, but when we sell.

Right. So, valuations change and that's how we constantly go through the portfolio and upgrade it.

Alexandra: So, I have to say, look, everything that I wrote down here about how you and your team do what you do. Okay. I'm going to sum it up this way. You're investing like an equity manager, but you're protecting the downside like a bond manager. So, if you ask me as an allocator, I think you've just solved a, like, centuries old investment code.

You've broken it. Okay. But if I go back to the person that advises other people on financial matters and how would you advise them on how High yield compares and contrasts with others, let's say, yield enhancing strategies, things like short credit strategies, dividend equity strategies? I believe that you've compared and contrasted with equities quite a bit or option-based income generating strategies.

You know, help somebody understand those differences.

Comparing high yield to dividend stocks and other income strategies

Anthony: Yeah. Sure. Let's start with the short credit strategy. In that strategy, you're probably you're focusing more on safety and liquidity and you're giving up the sort of credit upside you're sacrificing return for the safety and liquidity of things short and low credit risk; high yield is kind of on the opposite side of that spectrum. It gives you higher credit risk but a higher return.

So that's one difference, I would say, or that's how I would contrast it to the short credit strategy. The other one was a dividend ... Dividend equity, you know, it's great. It's growth in income. So, you're here, you're looking for you're getting more equity risk. In fact, you are getting equity risk with the income component. So, you're getting more volatility.

High yield, on the other hand, gives you the high-income component with lower volatility. And the one difference I would say between the dividend strategy and the high income, high yield is that coupons are contractual. You can't cut them, you can't defer them, you can't pause them. You have to pay your coupon. That is a contractual bond between the lender and the borrower.

Dividends can be cut if things go badly or downturn in the economy. Companies can always do that. So that's the difference between those two strategies. And then finally, the option.

Alexandra: In space one.

Anthony: Yeah, that one is probably more I would say you're it's more about volatility than it is credit. There's no credit involved or very little credit. Hight Yield gives you the credit performance spread tightening, right. With the volatility strategy. It's sort of a call on the value of volatility. You're pricing in volatility, you're giving up some income or some upside to you to your underlying assets, because you're obviously putting options in place because of that.

That's probably the difference between those two strategies. I would say that make up the most obvious comparison. Okay.

Alexandra: So, I definitely noted coupons are contractual and now all I can think about are like contractors and, and rental projects and our audience probably I probably doesn't know as well as I do. And my teammates know that you're actually an amazing craftsman. Your high yield bond manager is extraordinary by day, and you are a craftsman by night. So if you think about and I'm pretty sure you know where you're going with this, like think about all those do it yourself rental projects, those amazing projects you've completed at home, and compare and contrast that with an investor who's looking at high yield bonds.

Would you recommend them to do it themselves or would you tell them to get a contractor to get a high yield bond manager?

Anthony: With respect to high yield, it's actually it's a good point because investors that try to do it some it tends not to work well sometimes. There's a lot involved. I mean, first of all, you need capital. Half the ... a big portion of the high yield market is only available to qualified institutional buyers. So that means you need to have 100 million U.S. dollars in assets to buy some of these bonds because they're not registered.

So that kind of removes a lot of the market from the typical retail investor can access. The other point is you have to kind of trade in size. You can't just buy small, you know, really odd lots. It just doesn't trade in those kinds of quantities. And then you also have the fact that you won't get the same pricing that we as institutions can get when it comes to buying high yield directly.

Right. You will really pay through the through the nose on the bid. I spread and that's going to really erode your returns. So, it'll be hard to diversify portfolios or create a portfolio that's diversified enough. You don't want to just hold a handful of bonds because you can get hurt badly. You won't get the same pricing that we do.

You can't access the same the same span of the market that we can. And I would say also the fact that you're probably constrained to a handful of names that you're not going to really want to buy anyway. So, yeah, that's I would probably recommend you look for a manager. Okay. Because think about it like you need a team of analysts and, and it's a really look at all these companies.

You have to really do your credit work. Yes, I understand. Covenant. That's you got to understand the legal jargon. You've got to get through all that. Where you are in the capital structure. What are the risks? Price it. It's a lot of work and it's hard work. So, I would recommend, as you suggested, probably look for a manager that has a discipline that you like or suits your investment style that you can trust and has a good track record.

Alexandra: So maybe my analogy with the Reno projects wasn't quite appropriate. Maybe it's akin to building a house, which I think even you would get a contractor to do it. My prepared to say Yeah. Okay. Okay. So, before I ask you to summarize you know, why high yield. Let's talk a little bit about private credit. It's been on the news a lot.

We've had a lot of questions about that asset class. And rightly or wrongly, it's been compared to high yield at times as a high yield. PM You know, what are your views there and maybe compare and contrast private credit with high yield and then you know, what are your views on the space?

High yield vs. private credit and key differences investors should know