Randy Masel, Managing Director (December 15, 2015)
The financial press was full of stories on the “rout” in high yield this past weekend, triggered in part by the liquidation of the Third Avenue Focused Credit Fund. I thought it would be useful to put the developments in high yield in perspective and what I have been doing at Granite Springs.
First off, as of the close of business on December 11, 2015, the “rout” in high yield has resulted in a year to date 4.67% total return loss as measured by the Bank of America Merrill Lynch (BAML) index. By comparison, the S&P index was down 0.25%. Ugly? Yes. Worthy of all the doomsday talk? I am not so sure. The underperformance of high yield is attributable to several factors:
- Heavier exposure to energy and mining and metals.
For example, energy bonds represent 12.1% of the high yield index but just 7.1% of the S&P 500. Moreover, almost by definition, high yield energy companies are smaller, less diverse, and more leveraged than their peers in the S&P 500. Therefore they have fared much worse in the energy sell-off than their S&P brethren.
- Lack of market makers.
A byproduct of the new banking regulatory regime has been the handcuffing of banks and broker-dealers in their ability to make markets and provide liquidity in over the counter financial products such as high yield bonds. Without these financial intermediaries to act as a shock absorber, price moves tend to be exaggerated, both on the downside and the upside.
- Fear of rising interest rates.
The Federal Reserve Bank is set to raise interest rates this week. The “party is over” talk has spooked some investors, as has the gloomy picture painted by the media in regards to high yield. This has hastened selling, which combined with less liquid markets has resulted in an unhealthy feedback loop.
The recent closing of the Third Avenue Focused Credit Fund has further fanned the fires in the media regarding high yield. I will not say that the Third Avenue fund is a complete anomaly as there are some other funds that share similar characteristics but I will say it was highly atypical of the market as a whole. 89.1% of the Third Avenue’s bonds were rated lower than B or unrated; only 12.84% of the BAML index is CCC rated. Third Avenue was full of illiquid, distressed investments with fat coupons that attracted yield hogs.
The high yield strategy at Granite Springs has been constructed in a far different manner and this construction has important implications for investors. While the strategy is not immune to what has transpired in the high yield market, I have taken several steps to help insulate it. Through the end of November, Granite Springs’ high yield strategy posted a total return of 0.29% net of fees versus a loss of 2.12% for the BAML index. December has been treacherous, however. It will be interesting to see how the year ends. I run separately managed accounts rather than a fund, so the following comments regarding the strategy as a whole are generalizations and may not be completely applicable to each account.
- Deliberate investment of cash.
I have taken my time investing the cash in the firm’s managed accounts, particularly cash that has come in over the last few months. At the same time, cash has been harvested by selling bonds whose upside became constrained by outperformance, call features, etc. As a result, several of these accounts are sitting on cash that will be opportunistically deployed.
- Bank preferred stock allocations.
The taxable portfolios at Granite Springs generally have 30% to 40% of their holdings in bank fixed-to-floating rate preferred stocks. These hybrid securities are rated high BB or low investment grade, are not held by high yield funds, and have traded in a narrow range all year.
- Limited CCC exposure.
The strategy owns one bond that is rated CCC by both agencies (3.8% of invested assets). It is a steady consumer products company and its bonds have been trading in the mid to high 90’s. There is one other bond owned that falls into the CCC bucket. Tronox (3.3% of invested assets) is rated B+/Caa1 and produces titanium dioxide and soda ash. Titanium dioxide prices have been hurt by excess Chinese production and Tronox has suffered as a result. Still, the company has good liquidity, should generate cash next year, and has no bond maturities until 2020.
- Measured energy and metals and mining exposure.
The strategy owns no mining company bonds and has one legacy position in a BB steel company that totals 0.5% of invested assets. There is one bond owned in the exploration and development space - Gulfport Energy. It represents a bit under 3% of invested assets. Gulfport has very low leverage, its credit rating was upgraded in August, and its bonds are trading in the mid to high 90s. There are also have two MLP positions totaling a bit more than 8% of invested assets. Archrock Partners leases compressors to move natural gas across energy infrastructure. The company is moderately leveraged and its business model, which is governed by short-term contracts, has been relatively stable despite the turmoil in exploration and production. Bonds trade in the mid-80s.
I recently started buying the preferred stock of Targa Resources Partners for accounts. This position has not worked out the way I thought but I also think the preferreds are misunderstood. Targa is a large midstream MLP. Its bonds are rated Ba2/BB+. While the preferreds are junior to Targa’s bonds, they are senior to all common unit distributions. In the first nine months of 2015, Targa distributed $532 million to common unit holders. Preferred dividends will only total $11 million a year. While Targa may cut is common distributions at some point, it is very hard to swallow the notion that the company can’t find room to make its preferred dividends given the cash flow it generates. I think Targa preferreds are excellent value at current prices.
Looking forward, the high yield market could be in for a further rocky ride through year-end. Media hysteria, the likely Fed hike, depressed energy prices, tax loss selling, and investors just looking to get closer to home all are creating a toxic brew. Longer term and bigger picture, things look much brighter for high yield. Companies tend to go bankrupt because they either (1) have a bad business model and lose too much money or (2) have liquidity issues and are unable to roll over their debt.
Unless there is a dramatic rebound in oil prices, there are going to be defaults in the energy sector. However, most of the damage is already priced in at this point. As for the non-natural resource sectors, the backdrop is benign. The economy remains solid with real GDP growing in the 2.5% range. Consumer spending, while perhaps not robust, is trending stronger than GDP and will benefit from lower energy costs. Banks and other financial intermediaries although inhibited by regulation, are in excellent shape and the housing sector remains firm. Moreover, outside of natural resources, most high yield companies have sufficient liquidity and have pushed out near-term maturities. So although the recent price action in high yield might indicate a surge in bankruptcies going forward, logic dictates otherwise (ex-natural resources). Rather prices indicate contagion and the lack of liquidity in the market. For patient investors who can withstand the motion sickness induced by marking to market, current high yield prices and conditions represent an opportunity. With a yield to worst of 8.75% and a spread to worst of 7.12%, high yield is pricing in too much bad news. The average spread over the last 30 years, which includes the recession at the turn of the decade and the Great Recession of 2008-2009, was just 5.75%. The last time the price of the BAML high yield index was this low was in September, 2009. At that time, the S&P 500 was trading at just 52% of its current level. Something is awry. Certainly the economy is not as precarious now as it was back then, just six months past the nadir of the Great Recession. As for the boogey man of rising interest rate hikes, even if the five-year Treasury goes 100 basis points higher in yield next year (which I think is unlikely), high yield spreads will still be 100 basis points wider than where they started 2015. One last interesting factoid worth noting – over the last 30 years the high yield market has never been down two years in a row. My guess is that streak is unlikely to end next year.
Randy Masel manages a high yield corporate bond strategy that he created and launched upon joining Granite Springs Asset Management in January 2014. He also manages Granite Springs’ Tactical Equity strategy.
Granite Springs Asset Management, LLC is a privately held SEC-registered investment advisor that specializes in fixed income portfolio management and tactical asset allocation investment strategies for private clients, family offices financial advisers, insurance companies, pension plans, and other institutional investors. The investment philosophy at Granite Springs is based on two principal beliefs; that asset allocation is the most important investment decision and; that disciplined risk management leads to superior returns over time.
Granite Springs Asset Management LLC is a Registered Investment Adviser with the U.S. Securities and Exchange Commission and qualified to do business in various state jurisdictions where required. Nothing in this article shall constitute investment advice. This article is for informational purposes only and the opinions expressed are the author’s own.
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