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Under the Bonnet of US High Yield

Kevin Loome, CFA, Portfolio Manager

PRESENTER: Joining me now is Kevin Loome, Portfolio Manager, US High Yield Bond, T. Rowe Price, so, Kevin, good to have you with us today.

KEVIN LOOME: Thanks for having me.

PRESENTER: So, first up, US high yield, how is this different from other asset classes?

KEVIN LOOME: Well, within fixed income, it’s actually a small part of the overall equation. It’s about a trillion-dollar market. It’s populated by a lot of small companies, a lot of private companies. And interestingly even though it’s been around for 30 years there’s no formal exchange, so it’s an over-the-counter market. For the US high yield market, it’s highly domestic. So US companies doing business onshore. The average issue size of the companies that we invest in is about $500m, so again pretty small. It can be very illiquid at time, and it can go through severe bouts of volatility as well.

PRESENTER: And what makes your investment approach different?

KEVIN LOOME: I think our investment approach is very bottom-up. So we aim to add our alpha through, about 75% is bottom-up credit selection. And that’s been a time-tested approach for this asset class through cycles. The other 25% is flexibility. So we view our strategy as a strategy for all seasons, so up markets, down markets. But in order to do that you have to have a good combination of selecting credits, but also being able to be flexible to switch between the higher quality tier and the lower quality tier, or within industries. So an example would be in 2008 to have been defensive; in 2009 to then have taken more risk; an industry example is in 2015 being very underweight the energy sector was a big part of our alpha generation for the strategy.

PRESENTER: Now, Donald Trump is dominating headlines with his trade war, and this does seem to be escalating, so what sort of impact is that having on US high yield?

KEVIN LOOME: Yes, I think for US high yield the actual direct impact is pretty minimal. So if you take autos, auto parts, metals and mining and chemicals, those are the three main sectors that are going to be impacted for us. They’re only about 7% of the market. The beneficiary would be steel. Steel within high yield is only about 1% of the market. So when you net that all out, it’s only about 6% or 7% of an impact. So the US high yield market is again populated by these small private companies, but a lot of them are onshore self-contained, they don’t trade across borders. So it’s not really going to have a huge impact.

I think what we worry about longer term though is that tariffs in and of themselves are inflationary, and it’s going to affect labour costs – because what does China have? They have cheap labour, and when that goes away labour costs go up for everybody. The other impact we’re thinking is in metals and mining. So China consumes about 50% of the entire copper production globally per year, to the extent that if their growth slows down I think it could have a negative impact on metals and mining. Within high yield, metals and mining is only about 3%. So I don’t want to dismiss the risks, but for our asset class it’s not my main concern right now.

PRESENTER: So then what would you say are the key trends in US high yield at the moment?

KEVIN LOOME: Yes, I think the key trends in US high yield are interest rates. And the effect they’ve had on the market is for the first time in my 25-year career, like a lot of other high yield managers I’m sure where I view my role is managing credit risk, for the first time now I also have to manage interest rate risk, because for the last 25 years global rates have just gone like this (down). So now we’re in a different environment, the next 25 years will be different. This is weighing heavily on investors’ minds, especially in the US where we’re a little bit ahead of the curve as far as raising rates, and the effect has been a huge demand for floating rate leveraged loans. And that market has grown by, anybody’s estimates would show it’s about the same size as the high yield market right now.

So the companies are smart, and they’re well coached by investment bankers. So when they want to issue now they’re being directed toward the loan market. So the net effect for us is the high yield bond market has been shrinking and money has been diverted to loans. The other effect is the demand for floating rate has made CLOs attractive, so collateralised loan obligations, and these are the structures where people buy loans and borrow money, package them together and sell them to institutions around the world that want to earn a little bit extra yield. And these structures are eight times levered, and then the companies they’re investing in are four to five times levered, so in the last credit cycle this became a tightly wound spring and I don’t know when the spring is going to go like this, but that is another concern that’s weighing on our mind right now.

PRESENTER: So finally what then are you seeing in terms of valuations?

KEVIN LOOME: I think valuations are, on a scale of one to ten, they’re kind of a four; five being average, ten being very cheap, one being rich. Traditionally spreads have been 500 as a long-term average that people use; we’re approaching 400 right now. I think one of the headline numbers that seems to be kind of a Mendoza Line in the US is when the yield gets to 7% it creates a lot of attraction for the asset class, and we’re almost there after the difficult October that we’ve had. So I think it’s hard to get excited. I think this asset class is unique though in the sense that in some years it looks like an equity opportunity, so a total return where you have high coupons and things trading at a discount, and your expected return is a price appreciation. Right now it’s an income opportunity. So we have low coupons, even with the selloff things are trading around par. So valuations are slightly rich, and we’re viewing it as an income opportunity this year.

PRESENTER: Kevin, thank you.

KEVIN LOOME: Thank you.

Risks – the following risks are materially relevant to the strategy:

Credit risk – a bond or money market security could lose value if the issuer’s financial health deteriorates.

Currency risk – changes in currency exchange rates could reduce investment gains or increase investment losses.

Default risk – the issuers of certain bonds could become unable to make payments on their bonds.

Derivatives risk – derivatives may result in losses that are significantly greater than the cost of the derivative.

Emerging markets risk – emerging markets are less established than developed markets and therefore involve higher risks.

High yield bond risk – a bond or debt security rated below BBB- by Standard & Poor’s or an equivalent rating, also termed ‘below investment grade’, is generally subject to higher yields but to greater risks too.

Interest rate risk – when interest rates rise, bond values generally fall. This risk is generally greater the longer the maturity of a bond investment and the higher its credit quality.

Liquidity risk – any security could become hard to value or to sell at a desired time and price.

Sector concentration risk - the performance of a fund that invests a large portion of its assets in a particular economic sector (or, for bond funds, a particular market segment), will be more strongly affected by events affecting that sector or segment of the fixed income market.

General Portfolio Risks

Capital risk – the value of your investment will vary and is not guaranteed. It will be affected by changes in the exchange rate between the base currency of the portfolio and the currency in which you subscribed, if different.

Counterparty risk – an entity with which the portfolio transacts may not meet its obligations to the portfolio.

Geographic concentration risk – to the extent that a portfolio invests a large portion of its assets in a particular geographic area, its performance will be more strongly affected by events within that area.

Hedging risk – a portfolio's attempts to reduce or eliminate certain risks through hedging may not work as intended.

Investment portfolio risk – investing in portfolios involves certain risks an investor would not face if investing in markets directly.

Management risk – the investment manager or its designees may at times find their obligations to a portfolio to be in conflict with their obligations to other investment portfolios they manage (although in such cases, all portfolios will be dealt with equitably).

Operational risk – operational failures could lead to disruptions of portfolio operations or financial losses.

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