Investing in High Yield Bonds With a Margin of Safety

Posted on October 5, 2021

DDJ President, Chief Investment Officer and Portfolio Manager David Breazzano recently conducted a video conference with Stacy Havener, Founder and CEO of Havener Capital Partners, discussing how the high yield market has evolved since the pandemic, opportunities his team is seeing and other timely topics around investing and risk.

Ms. Havener brought up the risk/reward profiles of equities versus high yield bonds, and Mr. Breazzano noted that over the past 25 years, high yield bonds have provided equity-like returns with much less volatility. Ms. Havener acknowledged the favorably-skewed risk/reward ratio but noted the aspect of credit investing which tends to spook investors is the risk of default - a risk that Mr. Breazzano explained is traditionally overblown. He responded:

“It's important for people to realize when a bond defaults, it doesn't necessarily go to zero. There is a recovery; there are still assets of the company. And to put it in perspective, a majority of the holdings in our portfolios are in private equity (PE) sponsored companies. These are companies that have been acquired by a PE firm and they've come to us and others to provide the debt portion to finance that acquisition. So, there is, in many cases, a substantial equity cushion below us. Let’s say a company were to default where we're levered at six times when a PE firm paid 10 times or 12 times for that company. The value deterioration of the enterprise has to be considerable for the bonds to take a hit. Now, they could and likely will take a hit, but they don't go to zero.

Over time the recovery rate or the loss ratio for high yield bonds is around 40 or 50 cents on a dollar - oftentimes it's higher. So, just to do simple math, if there's a 2% default rate and the average recovery is 50 cents, you lose 1%. If you have a 300 basis point yield premium and you lose 1%, you are still making two percentage points more than you would in treasuries or whatever the alternative is. Defaults are baked into long-term high yield returns.

Ultimately, yes, you have a higher probability of defaults in the high yield market, particularly in the lower tier, but you're getting paid to take that risk and the yield premium that one receives more than compensates over time for those default losses that you might incur.”

 
Interested in hearing more on topics related to DDJ’s approach to high yield investing? Check out the full video call with David Breazzano titled Under the Radar Opportunities in the Loan and Bond Markets. Click on the graphic below to get started.

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