COR­PO­RATE BONDS

De­faults are de­clin­ing in the high-yield arena as cor­po­rate is­suers en­joy ris­ing prof­itabil­ity and strong bal­ance sheets

Investment Executive - - CONTENTS - BY JADE HEMEON

Port­fo­lio man­agers of global high-yield bond funds re­main op­ti­mistic.

global high-yield bonds be­gan 2018 in rel­a­tively strong shape, hav­ing weath­ered last year’s se­ries of small in­ter­est rate in­creases with the help of a tail­wind from a buoyant global econ­omy.

Ac­cord­ing to Toronto-based Morn­ingstar Canada, mu­tual funds i n the high-yield fixed­in­come cat­e­gory en­joyed a healthy 4% av­er­age gain in 2017. And Moody’s In­vestor Ser­vice Inc. of New York states that de­faults are de­clin­ing in the high­yield arena as cor­po­rate is­suers en­joy ris­ing prof­itabil­ity and strong bal­ance sheets.

“Fun­da­men­tally, credit is in good shape [for is­suers of debt se­cu­ri­ties],” says Joshua Rank, port­fo­lio man­ager with Prin­ci­pal Global In­vestors LLC in Des Moines, Iowa. Prin­ci­pal GI is sub­ad­vi­sor to NEI North­west Spe­cialty Global High Yield Bond Fund, which is spon­sored by NEI In­vest­ments of Toronto.

(NEI is ex­pected to merge soon with Cre­den­tial Financial Inc. and Qtrade Canada Inc. into a new com­pany called Aviso Wealth.)

Debt is­suers have been con­ser­va­tive f rom a bal­ancesheet stand­point, Rank says. They have not gone over­board on cap­i­tal ex­pen­di­tures and are keep­ing bor­row­ing man­age­able.

“From a macro view­point, all the ma­jor economies are mov­ing ahead, and work­ing in sync for the first time in a decade,” Rank says, adding that this is a good sign for the strength of bond is­suers and their abil­ity to meet in­ter­est and re­pay­ment obli­ga­tions.

The global de­fault rate on spec­u­la­tive-grade se­cu­ri­ties was 2.9% at the end of 2017, ac­cord­ing to Moody’s, which fore­casts that the rate will con­tinue to slide this year to fin­ish 2018 at 1.9% due to strong eco­nomic growth, good liq­uid­ity and low re­fi­nanc­ing risk.

His­tor­i­cally, Rank says, the de­fault rate in the high-yield cat­e­gory has been closer to 5%, mak­ing the cur­rent mar­ket healthy in com­par­i­son.

Cor­po­rate bonds his­tor­i­cally have been neg­a­tively cor­re­lated, for the most part, to 10-year U.S. trea­sury bonds, Rank adds. This char­ac­ter­is­tic makes cor­po­rate bonds a use­ful di­ver­si­fi­ca­tion tool in a fixed-in­come port­fo­lio.

A key strategy for pro­tect­ing port­fo­lios from any dam­age in­flicted by ris­ing in­ter­est rates is to stick to short-term se­cu­ri­ties. The av­er­age du­ra­tion of Rank’s NEI port­fo­lio is about 3.7 years, less than the 3.9 years for bench­mark av­er­ages.

The newly passed U.S. bill on tax cuts, he adds, will fur­ther strengthen U.S. high-yield bond is­suers by in­creas­ing cor­po­rate prof­itabil­ity. With higher cash flow, some is­suers will ex­pe­ri­ence up­grades in their rat­ing sta­tus, which will give them ac­cess to a big­ger pool of bor­row­ers and to money at lower in­ter­est rates.

“The tax cuts should help ex­tend the credit cy­cle,” Rank says. “The cuts give cor­po­rate is­suers momentum and ex­tend the pe­riod of bullish­ness. The big­gest po­ten­tial risks would be a sur­prise on the in­fla­tion side or in the pace of in­ter­est rate hikes, but those are both in check at this point.”

On a ge­o­graph­i­cal ba­sis, the NEI fund has 76% of its as­sets un­der man­age­ment (AUM) in­vested in the U.S., 8% in Canada and about 15% in Western Europe, along with a min­i­mal cash hold­ing. The fund is in­vested en­tirely in cor­po­rate bonds.

Rank is leery of re­tail­ers’ debt, point­ing to the bank­ruptcy fil­ing last year of Toys “R” Us Inc. and the vul­ner­a­bil­ity of depart­ment stores such as Macy’s Inc.

He also is avoid­ing the oil ser­vices in­dus­try and “wire­line” tech­nol­ogy com­pa­nies. Oil­field ser­vic­ing will suf­fer from a de­cline in deep-sea ex­plo­ration, he says, but he likes the bonds is­sued by some in­de­pen­dent ex­plor­ers and pro­duc­ers in the en­ergy sec­tor, par­tic­u­larly in U.S. shale.

Among the NEI fund’s top hold­ings are sev­eral is­sues of sub­or­di­nated debt in the financial ser­vices sec­tor, in­clud­ing is­sues from Ally Financial Inc., Cit­i­group Inc. and JP Mor­gan Chase & Co. Rank’s fund port­fo­lio also holds debt is­sued by Garda World Corp., a Cana­dian pri­vate se­cu­rity firm. greg ko­cik, man­ag­ing di­rec­tor with Toronto-based TD As­set Man­age­ment Inc. and lead man­ager of TD High Yield Bond Fund, says the like­li­hood of fur­ther in­ter­est rate in­creases is hang­ing over the bond mar­ket. But, he adds, credit risk is de­clin­ing as eco­nomic strength leads to higher ca­pac­ity uti­liza­tion and ris­ing em­ploy­ment.

Based on bond mar­ket av­er­ages, Ko­cik says, the spread be­tween high-yield cor­po­rate bonds and gov­ern­ment is­sues shrank to about 350 ba­sis points (bps) af­ter a high-yield rally in Jan­uary. That change rep­re­sents a tight­en­ing from about 430 bps a year ear­lier. Ko­cik doesn’t see much room left for high-yield bonds to ben­e­fit from fur­ther cap­i­tal gains and re­duc­tions in the spread, There­fore, he is fo­cus­ing on qual­ity com­pa­nies that man­age their bal­ance sheets con­ser­va­tively.

“We don’t fore­see the spread tight­en­ing sig­nif­i­cantly more, and ris­ing gov­ern­ment bond yields could be a head­wind for the en­tire bond mar­ket in 2018,” Ko­cik says. “How­ever, in an en­vi­ron­ment of grow­ing economies and im­prov­ing credit qual­ity with ris­ing cash

flows, you still want to be in cor­po­rate bonds for the con­tin­u­ing yield ad­van­tage.”

In 2017, the U.S. Fed­eral Re­serve Board raised its bench­mark lend­ing rate by 25 bps three times to a tar­geted range of 1.25%-1.5%. Three more sim­i­lar hikes may hap­pen this year.

The Fed is re­spond­ing to pos­i­tive news, as U.S. eco­nomic growth is es­ti­mated to be around 3% for 2017 and 2018, and the un­em­ploy­ment rate is ex­pected to drop be­low 4% in 2018. How­ever, both Ko­cik and Rank say the Fed will pro­ceed cau­tiously with rate hikes, as long as in­fla­tion re­mains be­nign, in order to keep the econ­omy bub­bling. In­fla­tion in the U.S. is es­ti­mated to be around 1.7%, which is lower than the Fed’s 2% goal.

Like Rank, Ko­cik chooses in­vest­ments with short terms to pro­tect against ris­ing in­ter­est rates. The av­er­age du­ra­tion of the TD fund’s port­fo­lio is less than three years.

“We’re look­ing at high-qual­ity names with shorter ma­tu­ri­ties,” Ko­cik says. “Our du­ra­tion is sig­nif­i­cantly lower than [that of] the in­dex, and that’s a ma­jor risk-mit­i­ga­tion tool for us. The yield may be lower, but the qual­ity is bet­ter. If there is a sell-off, the fund will drop less than the over­all mar­ket. De­spite our con­struc­tive view on the econ­omy, we are de­fen­sive.”

The TD fund has a 92% weight­ing in cor­po­rate bonds, about 6% of AUM in float­ing-rate notes and 2% in cash.

On a ge­o­graph­i­cal ba­sis, about 80% of the TD fund is in­vested in the U.S., 10% in Canada, 6% in Europe and 2% in emerg­ing markets.

Look­ing ahead, Ko­cik fore­sees in­ter­est­ing op­por­tu­ni­ties in high­yield bonds re­lated to the re­tail and dis­cre­tionary con­sumer spend­ing in­dus­tries in the U.S. Fears about the de­cline of tra­di­tional re­tail­ing in the face of threats from on­line re­tail­ers such as Ama­zon.com Inc., he says, “have snow­balled beyond re­al­ity.” Some re­tail­ers’ debt is­sues are trad­ing at at­trac­tive prices, al­though, he says, it’s “im­por­tant to be in the right names.” One of the TD fund’s top hold­ings is is­sued by Best Buy Co. Inc., a U.S.based elec­tron­ics re­tailer.

In the tech­nol­ogy sec­tor, the TD fund holds bonds is­sued by Sea­gate Tech­nol­ogy PLC, a Cal­i­for­nia-based sup­plier of com­puter disk drives.

Other sec­tors that have ex­pe­ri­enced sell-offs and look ripe for op­por­tu­nity in­clude U.S. health care, met­als and pa­per-re­lated names in the for­est prod­ucts in­dus­try. In health care, one of the TD fund’s top hold­ings is HCA Health­care Inc., the largest pri­vate-sec­tor hos­pi­tal op­er­a­tor in the world. He says the com­pany has strong free cash flow and its bonds are mov­ing to­ward an in­vest­ment-grade rat­ing.

In what Ko­cik calls the “unloved” for­est prod­ucts in­dus­try, the TD fund holds debt is­sued by Mon­treal-based Res­o­lute For­est Prod­ucts Co., which has suf­fered from de­clin­ing pa­per us­age by con­sumers with a pref­er­ence for dig­i­tal tech­nol­ogy, but which, Ko­cik says, is well di­ver­si­fied in other prod­ucts, such as lum­ber.

Ko­cik also is look­ing at en­ergy, a sec­tor that has been out of favour since oil prices dropped from their peaks, but is im­prov­ing af­ter sev­eral years of cost-cut­ting. He favours pro­duc­ers and “mid­stream op­er­a­tors,” such as stor­age com­pa­nies and sup­pli­ers.

He is re­duc­ing ex­po­sure to the auto in­dus­try, for which, he says, the busi­ness cy­cle has “peaked.”

Both Rank and Ko­cik are sniff­ing for value op­por­tu­ni­ties in the out-of-favour met­als in­dus­try.

“We al­ways are l ook­ing for­ward and as­sess­ing credit risk six to 12 months out,” Ko­cik says. “In­ter­nally, we cre­ate our own credit rat­ings, and a big part of our strategy is to ben­e­fit from the lag that oc­curs be­fore an im­prov­ing is­suer is up­graded by a rat­ing agency.”

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