DDJ Capital Management Blog

September 1 - September 30, 2020

Summary

• In September, leveraged loans produced a gain and outperformed high yield bonds, which experienced a loss for the first time since March.
• CCC-rated bonds and loans generated positive performance and outperformed their higher rated peers.
• We conduct a deeper dive into spread changes in the CCC-rated segment of the high yield market. 

In general, various indicators continue to show improvement in overall economic activity as the U.S. economy resumes its reopening. Unfortunately, such renewal in activity has coincided with a surge in COVID-19 cases. However, and thankfully, the most recent surge or “second wave” in the U.S., and abroad, has yet to result in an alarming increase in hospitalizations or mortality rates. That said, the recent announcement that President Trump has tested positive for COVID-19 will create further uncertainty and likely inject volatility into the markets.

When many investors hear terms like “default” or “bankruptcy”, negativity and losses probably come to mind, and for good reason. Over the past 25 years, on average, when a high yield bond has defaulted, investors lost almost 60 cents on every dollar invested.¹

“Rule 144A is therefore very valuable to issuers, as it reduced the cost of capital by improving the liquidity of the institutional secondary market for privately placed bonds.”
– Andrew Ross, CFA, Director, Portfolio Specialist

Not familiar with 144A bonds? You’re not alone. Given the growth of bonds issued via Rule 144A (“the Rule”) and their increased importance in the high yield market, we thought it would be informative to provide a brief overview of Rule 144A and the bonds issued under this rule.

Today we are very happy to announce the winners of the DDJ Capital Management White Paper Challenge. In this contest, college students were tasked with submitting a paper discussing the topic: “Does Board Diversity Impact Corporate Performance?” Of all the contestants, we have selected the following two winners.

August 1 - August 31, 2020

Summary

• In August, high yield bond and leveraged loan markets delivered gains of 0.98% and 1.50%, respectively

• The presidential election moved to the forefront, with increased volatility likely to occur in coming months

• The Fed announced a change to inflation policy expected to keep interest rates “lower for longer”

• Issuance in August was much higher than expected, driven by BB-rated issuance

Presidential politics moved to center stage in August as both political parties hosted their respective conventions, albeit somewhat unconventionally due to the ongoing pandemic. In all likelihood, the market will increasingly focus on the upcoming U.S. presidential election, with heightened volatility occurring as a result. In addition, the fragile relationship between the U.S. and China deteriorated further in August, as President Trump, citing national security concerns, issued an executive order in an effort to either try and force the sale of the popular social media app TikTok, which is owned by a Chinese company, to an American company or otherwise require it to close its U.S. operations. Furthermore, the U.S. State Department requested that U.S. colleges and universities divest Chinese holdings in their endowment portfolios. The markets will be closely monitoring for any negative developments between the two countries that could threaten the adherence to the previously agreed-upon Phase 1 trade deal.

Now that the U.S. economy is officially in a recession, what is the state of corporate credit quality? During a recent discussion with the CFA Society of New York, DDJ President, Chief Investment Officer and Portfolio Manager David Breazzano offered his opinion on the subject:

It's a very interesting question. And I'd like to answer it in a couple of different ways. One, the short answer is corporate credit quality certainly has declined as a consequence of the current recession. However, to understand this, it is necessary to look “under the hood” of the high yield market and dig into some of the statistics. If one were to look at the credit quality of a broad high yield bond index, it would show that BBs have actually increased as a percentage of the overall index since the start of the year, whereas Bs and CCCs have declined. So, at a statistical first blush, one would look at it and say, "Wow, credit quality actually has improved this year."

July 1 - July 31, 2020

Summary

• In July, while leveraged loans produced a gain, they lagged the high yield bond market, which delivered its best monthly return of 2020.
• The Bureau of Economic Analysis provided confirmation of Q2’s historic GDP decline.
• The Fed announced an extension of its monetary support measures through year-end.
• With BB-rated bonds producing positive returns year-to-date, inside we take a closer look at the spread compression of this Cohort in recent days.

At the end of July, the U.S. Bureau of Economic Analysis released its Q2 GDP estimate, which was pretty dramatic. It showed that the U.S. economy had shrunk by a record setting -32.9% annualized rate, which is more than three times the previous record of -10% set back in 1958.¹ Although a decline of this magnitude was expected, and likely already priced into the market, it provides good context for the scale of the economic disruption caused by the COVID-19 pandemic. In addition, digging into the details of the release reveals that the vast majority of the decline came from a massive reduction in personal consumption.

The market’s perception of the current state of the pandemic can change quickly and result in heightened volatility. For example, the perception that certain states may have opened too soon or that a second wave of the virus is imminent, and thus economic pullbacks are on the horizon, can increase market volatility significantly. Such changes in perception are often driven by the latest headlines, which can be misleading and therefore do not represent reality.

As prudent investors, we need to filter out the day-to-day noise and focus on the factors that will determine whether the economic reopening can continue or broad pullbacks will be needed in certain areas. In this regard, I believe that the most important factor to monitor in a specific region is hospital capacity utilization resulting from COVID-19 patients, in particular ICU bed capacity. Fatalities are of course the most important metric that we as a society must strive to minimize; however, fatalities typically rise after an increase in ICU beds and ventilator usage, and will thus lag changes in hospital capacity.

Since we launched our blog last September, we have received a lot of positive support. We sincerely appreciate you taking time out of your day to read our thoughts on the market.  

Below, we have highlighted our three most popular blog posts from 2020 to date. Two of our most read blogs this year came from our special Week in Review series during March when the market was unraveling. We’re happy to be able to provide perspective when investors need it most. See which ones made the top 3 list. 

If you have a topic you would like for us to cover, please contact us.  We appreciate your feedback.

Do you know a college student or incoming freshman whose summer plans have been impacted by recent events?

Events around the world have had a profound effect on all of us at DDJ Capital Management, as well as our clients, industry colleagues and students who are interested in pursuing opportunities in the financial markets. As stewards of our clients’ assets, we seek to prudently invest in order to generate strong risk adjusted returns, and as citizens in the financial services industry, we seek to invest in college students, who will be the future of our industry.

As we continue to hear repeated stories of students losing their internships with financial services companies globally, we at DDJ thought about what we could do to help. While we can’t replace these lost internships and the critical experiences they provide, we can try to create other opportunities and experiences. To that end, we are announcing the DDJ Capital Management White Paper Challenge.

This White Paper Challenge is a writing contest for undergraduate college students interested in financial services. Each student will submit a paper discussing the topic: “Does Board Diversity Impact Corporate Performance?” This opportunity is to encourage college-aged students to explore the issues of diversity as they relate to corporate operations and success.