Host: Hello and welcome to Talking Markets: exclusive and unique insights from Franklin Templeton.
Ahead on this episode: how current market and economic conditions could benefit high yield investors, the opportunities and risks right now, and why the asset class is often overlooked or misunderstood. Bill Zox and John McClain, Portfolio Managers with Brandywine Global, join Amer Hasan for this conversation.
Amer Hasan: Bill and John, you know, with high yield spreads near historical tights, and nominal yields near historic lows, what would you say to investors who question if now is a good time to add or increase an allocation to high yield?
Bill Zox: We’ve been talking about this in much the same way for the last year, and it’s important to look at high yield, not in a vacuum, but in the context of all other asset classes. The analogy I think about is when I was in the backseat of my car and my 15-year-old daughter was learning how to drive, my wife was in the front seat. And inevitably it would end in tears with both my wife and my daughter crying. The car would be pulled over in middle of the street, and my daughter would get out of the car. My wife would take over the wheel. But in the back seat, there really wasn’t much I could do. They were not listening to me. They were not listening to each other. And that’s really how I see the high yield market right now. The high yield market is in the back seat, while the equity market is behind the wheel and the Treasury market is in the passenger seat. But one key difference is that the equity market is driving very skillfully right now. And the Treasury market is not doing too much to grab the wheel.
So, the bottom line is, on the Treasury side, we still have very significant negative real yields. That 10-Year TIP [Treasury Inflation Protected Security] is -1.2% right now. There’s still over US$13 trillion of negative-yielding debt around the world. And if you’re an investor it has the objective of a positive real return, you have to look farther out the risk spectrum to generate a positive real return. And the high yield market in the US is very compelling compared to investment grade fixed income markets around the world.
And then on the equity side, you’re still looking at near-peak multiples on near-peak profit margins, and the value of equities has exploded relative to the value of debt. So, the value of corporate debt in the US is at record lows compared to the equity market cap of US equities. So, high yield spreads are tight and yields are low, but the fundamentals are fantastic right now, in large part, because of the strength of that equity cushion, which also leads to access to capital, both equity capital, and debt capital, and on the fixed income side, the need for investors to find the US high yield market to achieve their objectives.
John McClain: I think the other piece here that we haven’t mentioned is defaults are at record lows, and they’re expected to be there for some time. So the wind is at your back. And if you look across fixed income, we still have 10+ trillion dollars of negative yielding debt, and the majority of fixed income is going to lose purchasing power over time. Inflation is going to eat into this, and US high yield is one of the few areas in fixed income where investors are generating real returns, and it’s a reasonably diverse ecosystem that has a reasonable size to it as well.
Amer Hasan: And where would you say that you’re currently finding most of the opportunities right now in high yield?
John McClain: What’s fascinating is, most of the time when we’re in this type of environment with rates at reasonably low starting yields and spreads at tight levels, we would be very defensive. However, I think that the market has changed meaningfully since the beginning of COVID. We’ve seen a number of companies come into the high yield marketplace through downgrades, those fallen angels, which has presented a number of opportunities, particularly in the reopening space. Things like travel and leisure. You can think of cruise lines as an example there. And then really, the first-time issuers. Access to capital is as good as it’s ever been. And we’re seeing very high-quality businesses coming to the high yield marketplace. So traditionally, you think of high yield as legacy industrial businesses that are slowly dying. They have hard assets and you’re really figuring out when does this thing go bust. Now we’ve got companies that are growing rapidly. You think of companies that are supported by 50+ billion-dollar market caps, and that are generating real free cash flow, and the free cash flow relative to the size of the debt is enormous. And so, we’ve seen a lot of value there. I would say also, as we continue to grow in size, we’re having the opportunity to influence deals and that’s definitely a shift over the last six to nine months where, because of our size and because of how we manage with a small mid-cap type of bias, we’re able to get a look at deals before the rest of the marketplace. And, we’re able to help set terms there, which are very beneficial for our end investors.
If you’re thinking about sector specific, one area of the market is financials. And we’ve seen a very strong housing market for the past year and a half. We don’t particularly like home builders and building products. We think they’re overlevered, and they’re not compensating investors in terms of yield, but companies like mortgage originators and servicers present very interesting opportunities. And one thing that we have seen be very topical has been supply-chain disruptions. Well, you know, where there’s no supply-chain disruptions in financials.
Another area of the market is energy. And we’ve seen a dramatic rise in oil prices and natural gas prices. And while we don’t think that we’re going to see a precipitous crash in terms of pricing, the tailwinds are there for commodities, bonds aren’t the right instrument to express a bullish opinion. And therefore, we feel like, with a commodity-specific sector, where the intrinsic value of the business is derived from the commodity, we’re not getting compensated for some unforeseen risks.
Bill Zox: Another example that came into the market as a new issuer in the financial sector, they have US$600 million first-time bond, but the business has been in the public markets for seven years and there’s a total of US$650 million of debt. And free cashflow is probably close to the net debt of this business. Leverage is 1.5x gross. Net of cash, it’s less than one times. And the price talk is in the mid 5’s, maybe it comes somewhere 5% or better for an eight-year bond. The Treasury market is at 1.3%, if you look out eight years. This is what we call a “thin file.” We love credits like this. It’s a very easy business to understand, very strong, competitive position in a growth industry. Many would not focus on it because it’s too small. A one-off US$600 million bond is not going to move the needle for a huge shop, but we love situations like this. This is falling through the cracks because investors are much more focused on the huge multi-billion dollar deals that are in the marketplace.
Amer Hasan: So on the flip side of that, what’s the risk right now that you’re seeing in high yield? Is there a certain area of the market you’re trying to avoid? How are you managing around that risk?
Bill Zox: In general, it’s valuation risk, not default risk. The equity valuation and the access to capital have brought defaults to extremely low levels, and the expectations are that they will stay extremely low for the foreseeable future. So, it’s really not default risk. It is valuation risk. So, parts of the market that you have to be especially careful about would be bonds that have a lot of duration and very little spread. So, that would be certain parts of the double-B part of the market. You’re just not getting enough credit spread to offset significant interest rate risk. And then the other extreme would be bonds that have very significant credit risk and still not enough credit spread because the triple-C part of the market is where you would find many of those bonds. And that part of the market has been, by far, the strongest this year. And there are a number of overvalued bonds in that part of the market.
Amer Hasan: John, what is your outlook right now in the economy and how does high yield fit into that picture?
John McClain: Yeah, and really this is the macro versus micro discussion. From the US economic outlook, it’s fine. Are we going to be growing at high single digits next year? Probably not. But, are we going to be plugging along? I think, yes. While we’re seeing tapering starting to occur, we are also going to see an injection of fiscal stimulus, and I feel like the asset class should do well in an economy that’s in a “Goldilocks” low- to mid-single digit type of growth environment. And our base case, right now, is that we don’t see a material drop in equities. And what I mean by that is, kind of, a 20% pullback. You could see multiples contract, you could see earnings decline, but in conjunction, that’s probably more like a 10 to 15% move lower. But if we do see a material drawdown, like we did in the fourth quarter of 2018, high yield has held in, historically, pretty well versus the equity market. That 20% drawdown during the fourth quarter of 2018 saw about a 5% drawdown in high yield. And what’s important here is, this 20% drawdown doesn’t really matter from our perspective. We’re dealing with very large equity market capitalizations. The equity market in the US has been on a tear for a number of years. And we think that, at the end of the day, the government’s going to be faced with a decision of inflation or higher interest rates. And they’re going to pick inflation between those two. That service coverage would be unpalatable for the government at higher levels, and we see inflation as a bit of a wealth tax as well. So, we believe that we’re going to see higher inflation, and inflation that’s persistent. We’re hearing that on the micro level. So, what we need to do is focus in on companies that have pricing power.
Bill Zox: And on the micro level, the number of new entrants into the high yield market in just the last couple of years, and the quality of those new entrants is really remarkable. It’s a very different high yield market than most people would envision or what we were accustomed to in prior cycles. Many of these issuers have very large public market capitalizations, multiples of the debt that they have outstanding, and they’re very high-quality businesses that do have that pricing power that John’s talking about.
Amer Hasan: So, when you’re thinking about it as an asset class, is high yield something investors should approach opportunistically when the market conditions are supportive, or do you see high yield as something that compliments equities and fixed income as part of an overall portfolio? So, is it really time to rethink the 60/40 allocation, or do you think that high yield really deserves that standalone structural opportunity in an overall portfolio allocation?
Bill Zox: Yeah, there’s no question it’s a very compelling asset class with returns over long periods of time that are competitive with equities, but much lower downside volatility. On those drawdowns, the recoveries have typically come much faster. So if you have any sort of real return objectives, it’s very difficult to start with a significant portion of your portfolio yielding well below inflation. So, 60/40 has not worked for a long time.
I think it’s interesting, in the institutional space, everybody has a strategic long-term allocation to private equity. And what is private equity? It’s an investment in the equity of highly leveraged businesses. And we are investing in the debt of businesses, some of which are highly leveraged, some of which are not. They tend to be more often publicly traded or family-owned than private equity owned. But we think the quality of the businesses and where we are in the capital structure is actually better than you would see in the private equity universe. Yet, institutional investors have a strategic allocation to the equity investment in those companies. So, I think that if investors get comfortable with that, they should absolutely be comfortable investing higher up in the capital structure in better businesses.
Amer Hasan: Great. I really appreciate your guys’ time. And I think this is an asset class that, to John’s point, is often overlooked or misunderstood. And hopefully we provided a lot of folks with some really good information they weren’t aware about before. So thank you both for your time.
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