DON’T DISMISS HIGH- YIELD DEBT
Portfolio manager points to bond market study after 2013 Taper Tantrum
Predicting which way interest rates are going remains one of the most difficult tasks for investors and economists, but those looking for a source of income that won’t keep them up at night worrying about rising rates should probably take another look at high- yield bonds.
It may sound counterintuitive since much of the bond market is vulnerable when interest rates are rising, but high- yield bonds do pretty well when the U. S. Federal Reserve tightens monetary policy.
Sandy Liang, a portfolio manager at Aston Hill Asset Management, highlighted a study his firm published in the summer of 2013 after the Taper Tantrum caused a sharp sell- off in the bond market. The firm looked back 30 years to find instances when the U. S. 10- year treasury yield rose by one per cent or more within an 18- month period.
During these rising rate environments, high- yield debt matched its historical performance, which is an average annual return of about eight per cent.
More significant is that in 12 of the 13 instances when 10- year yields climbed at least one per cent, high- yield bonds outperformed investment- grade corporate debt.
“That makes a lot of sense, because when rates are rising, that’s bad for bonds that are pure interestrate plays,” Liang said.
The internal yield ( all bonds combined) of the high- yield- focused Aston Hill Strategic Yield Fund is currently about eight per cent. Of that, roughly 600 basis points ( six per cent) is credit spread — the part of the portfolio that benefits if a company’s credit quality is improving along with the economy.
“There is an economic recovery that is pretty clear in the U. S.,” Liang said, noting that consumer confidence is rising and the unemployment rate is dropping — things that are very good for the middle class.
“Since the economy is moving, that credit spread should be coming in, which is good for the price of bonds.”
Of course, it’s not as simple as just being in high- yield bonds. He also wants exposure to companies that will do well as the U. S. economy recovers. This includes names in the retail and consumer space such as restaurants, autos and homebuilding.
One fund holding is 24 Hour Fitness Worldwide Inc., the secondlargest chain of gyms in the U. S. The company is partly owned by the private- equity division of Ontario Teachers’ Pension Plan. As a result, Liang noted that if he were to lose any principal on his bond investment, Teachers’ Private Capital’s equity investment would be completely wiped out.
“Basically, we’re taking less risk than the pension plan in this investment,” he said.
Liang also pointed out that Life Time Fitness Inc., the third- largest U. S. chain, was taken private at a multiple of 10x cash flow, while his investment in 24 Hour Fitness equates to roughly 5x cash flow, and he makes an eight- per- cent coupon on the bonds.
A more concentrated economic play is the fund’s position in Greektown Holdings LLC, which is one of three casinos in the Detroit area.
“Detroit is actually recovering with the U. S. economy and has seen a lot of private investment,” Liang said. “The downtown core is hard to recognize versus five or 10 years ago, and you can get Wi- Fi everywhere, for example.”
The Greektown Casino Hotel is the only casino within walking distance of both downtown Detroit and Comerica Park, where baseball’s Detroit Tigers play. It’s also 100- per- cent owned by highprofile billionaire Dan Gilbert, who owns top- five U. S. mortgage underwriter Quicken Loans Inc. and the NBA’s Cleveland Cavaliers.
Another theme he is focused on is the positive impact that lower energy prices have on various market segments, such as crude shipping, which is capitalizing on the increased cost of storage, and airlines.
But one big debt issue he stayed away from was Bombardier Inc.’ s recent deal that offered investors 5.5- per- cent bonds maturing in 2018 and 7.5- per- cent bonds due in 2024.
Liang felt the pricing of these new issues didn’t reflect some risks in Bombardier’s credit story, especially since carriers and leasing companies have less incentive to buy more energy- efficient planes when jet fuel prices are low and it’s competing with wellcapitalized and high- quality issuers such as Boeing Co. and Airbus Group NV.
As a result, Liang believes Bombardier will have to offer significant price concessions to attract new customers.
From a lending perspective, he expects the company will be free cash flow negative for at least two to three years.
Since the economy is moving, that credit spread should be coming in, which is good for the price of bonds.