Playing a high-yield market strategy
There’s been a lot of talk recently about impending weakness in the bond market as expectations climb for higher interest rates.
But investors should remember t hat corporate bonds have a bit of a different cadence than government bonds do, in part because the latter usually have longer terms and tend to be solely an interest- rate call. However, with corporate bonds, and high-yield bonds in particular, there is always the issue of solvency.
So while long- term government bonds are down in the past 12 months, highyield bonds have seen gains in the low double-digits.
“You’ve got that dichotomy because the risk of bankruptcy is perceived as not being high right now,” said Brandon Osten, chief executive at Toronto- based Venator Capital Management Ltd. “The high- yield market is moving with a decent correlation to the stock market.”
Osten runs several mandates with co-portfolio managers Stephen Andersons and Jeff Parks, including the Venator Income Fund.
The majority of the portfolio is made up of bonds, but it always has an equity component, such as higher- yielding names like recent addition Corus Entertainment Inc.
But the most recent significant opportunity the managers spotted was in the fall of 2016, when they went out looking for convertible bonds with positive yields.
“Interest rates are generally low, so we wanted to see if we could get a free call option,” Osten said.
They looked for companies with a very low likelihood of insolvency, and decent odds that the underlying stock would go high enough that the exercise option could be converted.
Tesla Motors Inc.’ s 2021 convertible bonds stood out, with a price of roughly US$93 and a yield to maturity of about three per cent.
That’s not particularly high, but Osten noted that he was trying to exploit an area of the market that appear undervalued.
He highlighted Tesla’s US$ 40- billion market cap, less than US$ 5 billion of debt, and while the company is burning cash, it can easily issue stock to reduce that leverage.
“They are not burning enough money that I’m particularly worried about the debt,” Osten said, noting that with the stock around US$ 250, and essentially a free call option that comes into effect at about US$ 360 per share, Tesla’s volatility could pay off handsomely.
“It has explosive growth, which increases the chances of converting the bond,” he said.
Another high- yield holding in the portfolio is Ceridian HCM Holding Inc.’ s 11-per-cent 2021 bonds.
Currently yielding above nine per cent, it is a bit of an outlier in the market, and one that Osten thinks is misunderstood by investors.
“The nature of the bond market is such that it won’t appreciate a fast- growing software company within a payroll- processing company,” he said. “While they are migrating customers to the software platform, the company just isn’t showing the kind of metrics bondrating agencies want to see.”
The manager believes software is the source of a lot of Ceridian’s value, even though most of its revenues are still associated the legacy payroll-processing business.
On the equity side, much of the fund’s exposure is currently dominated by REITs.
Venator continues to be a significant shareholder in NorthWest Health Properties REIT ( NWH. UN/ TSX), which is the leading medical office property owner in Canada.
However, Osten noted that is only about half its business, as NorthWest also is the largest hospital owner in Brazil, has properties in Germany, and owns more than 20 per cent of two pre- mier publicly listed REITs in Australia and New Zealand.
“It is outside the comfort zone of most REIT investors, largely owing to its international exposure,” he said. “It’s a complex story, as there are currencies flying everywhere, so it is difficult for people to wrap their heads around it.”
Osten pointed out that NorthWest’s leadership team has fulfilled its promises in terms of reducing leverage and growing the asset base, but believes the company hasn’t been getting the recognition it deserves, while at the same time offering a current yield just below eight per cent.
He highlighted the management contracts for the REITs in Australia and New Zealand as one hidden asset, while the Brazilian assets may be discounted even though they are excellent properties leased out with great terms.
Osten expects the market will take notice as NorthWest builds out its strategy in the next few years.
“As the stock goes up, they will have an increasing amount of flexibility in terms of where they invest,” he said.
“They can pull l evers around the world with vastly different borrowing costs, whereas a purely domestic REIT may not.”