Ten Years of Seeking to Exploit Inefficiencies in High Yield

The US High Yield Composite outperformed its benchmark, the ICE BofA US High Yield Constrained Index, and returned 4.91% annually over the 10 years ended April 30, 2023.¹ Over this same time period, the Composite annualized total return ranked in the top 8% of the 226 funds in eVestment’s high yield fixed income universe and offered strong relative risk‑adjusted returns.¹

In this Q&A, Kevin Loome discusses the team’s investment process and how in‑depth research into individual companies and industries gives him conviction to actively position the Strategy in the team’s best ideas through a concentrated approach. Additionally, he shares his insights on the evolution of the U.S. high yield market over the last 10 years and key factors that he expects will influence the market in the future.

How would you describe your investment approach?

I think of our approach to managing high yield debt as flexible and nimble. The core of our team has been together for over 15 years and has managed together through multiple market cycles. Our flexibility, in particular, is a key differentiator versus competitors, in my view. As a relatively small portfolio, we can rapidly pivot to become more defensive or to take advantage of opportunities when the market environment changes.

For instance, when oil prices began to drop in 2014, pressuring the energy‑heavy broad high yield bond market, this flexibility allowed us to quickly reduce risk in the portfolio. Some of our larger peers were not able to sell all of a particular holding if they needed or wanted to.

In an example of pivoting to offense, we expeditiously moved to add risk exposure at the onset of the coronavirus pandemic when certain bonds became available at dislocated prices that did not reflect their true credit quality. We believe our ability to recognize and take advantage of these opportunities serves as a sustainable long‑term advantage of our investment approach that can lead to meaningful alpha² generation over time.

Your Strategy takes a concentrated, best ideas approach, typically investing in just 100 to 200 issuers. How did you arrive at these guidelines?

As we have written about recently, we are strong believers in the benefits of active management in high yield. With around 100 to 200 issuers typically in the portfolio, our portfolio is significantly more concentrated than the benchmark—the ICE BofA US High Yield Constrained Index has about 1,000 names—and most peers.

We believe this level of concentration strikes an appropriate balance between providing proper diversification and delivering a portfolio of best ideas to our clients. It also reflects the fact that we strive to add alpha primarily through credit selection and, to a lesser extent, through our top‑down macro views. We perform in‑depth bottom‑up fundamental credit analysis to uncover and take advantage of market inefficiencies that may arise due to an issuer’s size, geography, lack of coverage by sell‑side analysts, or general misconceptions in the marketplace. When building the portfolio, we manage individual position sizes based on our level of conviction while taking factors such as liquidity and other risks into account.

What are some of the key features and unique aspects of your team’s investment process?

Our team has a very collaborative culture—the traders, credit analysts, and me all sit in the same location to facilitate easy, rapid information sharing. The entire investment team is dedicated to only this one single strategy, which is relatively uncommon in the industry. All team members actively participate in the investment process, which includes two or three individual credit reviews per week, monthly attribution meetings, and twice‑yearly offsites where we analyze and review every portfolio holding. Our collaborative team in combination with a concentrated approach helps ensure that every name in our portfolio has been heavily vetted and that no name gets overlooked or left unattended. It also creates constant friction for best ideas.

In terms of the credit research process itself, we assign a proprietary credit rating, spread³ target, and environmental, social, and governance (ESG) score to every issuer we assess. These proprietary ratings help us be more forward‑looking so that we can identify inefficiencies, stay ahead of market trends, and anticipate ratings actions before they happen. Our spread and total return targets force us to identify future potential sources of alpha and create a natural sell discipline in our portfolio. We also meet quarterly with T. Rowe Price Investment Management’s team of ESG analysts, who provide valuable company‑specific and portfolio‑level insights from an ESG point of view.

Because new issuance is a huge component of the high yield bond market, our credit analysts review and provide a written analysis, including a proprietary credit rating and spread forecast, for every new deal. This helps us stay on top of key market developments, facilitates access to company management teams, and provides a foundation of research even for deals we did not participate in, which we can later come back to if the relative value of the investment improves.

What do you typically look for in an investment? What common qualities characterize the issuers in your portfolio?

We concentrate on finding bonds that offer attractive relative value compared with issuers in the same industry, weighing credit quality against credit spread to locate value. We focus on finding issuers that generate strong cash flows rather than just earnings growth as we think healthy cash flow is a better indicator of an issuer’s ability to meet its debt obligations in the long term. We tend to be forward‑looking when looking at issuers—often modeling a company’s financials four or five years out so that we can get a better sense of what an investment looks like over the full life of the bond—and time our investment horizon accordingly.

Enterprise value is another measure that we closely examine in order to track an issuer’s credit quality and default risk. By adding an issuer’s total debt to its equity market capitalization and subtracting any cash on its balance sheet, enterprise value not only provides an idea of the company’s value to an acquirer, but it also helps us better understand room for error. It’s worth noting that a large portion of our market consists of small private issuers where access to information can be limited. By comparing and evaluating private companies against public firms in the same industry, we can determine the size of a private issuer’s equity cushion even without readily available data. This method of measuring the amount of equity that would absorb losses before debt in an issuer bankruptcy underscores the importance of our proprietary research efforts.

We also closely examine each bond’s covenants, which define the legal agreement between the issuer and debtholders. Covenants provide legal protection for debtholders against a deterioration in the borrower’s fundamental credit metrics. We primarily rely on our own examination of covenants, though we also use some covenant research from outside providers.

In terms of bank loan analysis, we apply many of the same techniques. We look at loans as a natural extension of our investment universe and primarily consider loans of companies that also already issue bonds in our market. As we analyze a company’s overall capital structure, we will occasionally invest in loans (in vehicles that allow them) if they offer attractive relative value as a result of their higher position in the capital structure or duration⁴ profile.

How do you think about risk management given the Strategy’s concentrated approach, particularly given that defaults are an inherent part of the high yield bond asset class?

Despite taking a concentrated approach, our Strategy is very risk aware. We have had no defaults in our representative portfolio⁵ in the 10 years since the Strategy incepted. One of the key benefits of fewer holdings is that we can more frequently and thoroughly vet our holdings. In high yield, risks are asymmetric—our goal is to mitigate the downside while participating in the upside, in that order.

Our approach to managing risk is dynamic and multifaceted. As you might expect, our overarching focus is on credit analysis. We have a number of different processes in place—including daily monitoring and our monthly attribution meeting—that can help provide us with early warning signs. If we detect a deteriorating trend in credit quality, we can quickly take action to reduce the size of a position or eliminate it entirely if necessary.

In periods of extreme market stress, our concentrated approach grants us the ability to go back and efficiently re‑underwrite our portfolio to regain comfort with positions or right‑size them accordingly. Our collaborative approach allows us to discuss ideas and flag key concerns with the group to solicit feedback and test each other’s thinking. We regularly take advantage of opportunities to meet with management teams, sponsors, sell‑side contacts, and our equity research counterparts to further inform our thinking.

Liquidity is another important risk management consideration. As I mentioned earlier, we actively take liquidity into account when determining the size of individual positions and are more cautious in sizing exposures that may be less liquid.

What are some of the key factors that will influence the high yield market moving forward? How do you expect the market to evolve from here?

Speaking of liquidity, it could become even more challenging in high yield going forward. We continue to feel the impact of post‑global financial crisis regulations that have caused bond dealers to hold fewer issues in their inventory, worsening the liquidity situation for many bond issues.

On a more positive note, I think that ESG will become even more important in the high yield market. In time, we could see high yield mandates that exclude holdings in the energy sector, which would be a major shift from the current high yield benchmarks and their relatively high exposure to energy. But we are not there yet.

From a structural point of view, direct private lending could eventually encroach on the high yield market. This would provide high yield companies with additional sources of funding and could hold down the level of new supply of high yield bonds, providing some technical support to the market.

What do you think is being overlooked by investors in the high yield market today? Where do you expect to see opportunities moving forward?

Many investors are focused on spreads and default rates, generally feeling anxious over what a slowdown in growth and tighter credit conditions might mean for the overall high yield market. While the fundamental backdrop is beginning to erode, corporate fundamentals have entered the current environment from a position of strength. Looking at current default forecasts, the general expectation is that defaults will rise, but only to roughly 3% by year‑end, which puts them back in line with their long‑term historical averages.⁶

Although most high yield issuers do not face a near‑term formidable “wall” of maturities, companies still face significant refinancing risk as interest rates have rapidly climbed. This is something that the market seems to underappreciate, but it is one of the factors that we closely monitor when analyzing credit quality.

While some investors are fixated on credit spreads, others appear to ignore them, as all‑in yields in the asset class also climbed in 2022. We think that our rigorous relative value analysis—which incorporates spreads—presents an opportunity to capture attractive yield while benefiting from our credit research. In addition, the outlook for total returns, which include both yield and price appreciation, in 2023 is much brighter than it was in early 2022 as the Fed began to tighten policy.

As an investor in this approach, what would you tell fellow investors?

We think of high yield as a strategic, long‑term investment. In our view, the best way to invest, both in the asset class and in our approach, is to stay the course—don’t jump in and out. Effectively timing the market is nearly impossible, and staying invested gives you the opportunity to benefit from our goal of outperforming over the full credit cycle. Though we won’t outperform every single quarter, and inevitably we will make some mistakes, over the long term, our time‑tested approach has enabled us to provide strong performance compared to the benchmark.