DDJ Capital Management Blog

Of all the misconceptions regarding the CCC-rated segment of the high yield market, DDJ believes one of the most common is that all CCC-rated bonds have essentially the same level of risk.

One of the core tenants of DDJ’s investment philosophy is that the CCC-rated segment is one of the most inefficient of the high yield market. Why is this segment inefficient? We believe that it is due in part to the misconception listed above. As a result of the perceived riskiness of the CCC-rated segment, investment guidelines for many high yield portfolios commonly restrict or prohibit CCC-rated holdings, resulting in the CCC-rated segment of the high yield market being less researched relative to higher quality segments. In simple terms, fewer investors targeting this area of the market results in less efficient pricing and a slower incorporation of new data/events into market prices.

May 8 - May 21, 2020

Summary

• Economic data still dire, though signs of gradual improvement from March/April lows
• Leveraged credit markets generated strong returns as progress on reopening the economy overshadowed negative news regarding the current economic situation
• Oil prices rallied in face of declining supply and modest improvements in demand
• Flows and new issuance strong for high yield bonds, less encouraging for bank loans
• We briefly discuss how a surge in fallen angels can alter the composition and risks of high yield market

A clearer picture of the dire unemployment situation in the U.S. emerged on May 8^th when the Department of Labor reported that U.S. payrolls decreased by 20.5 million workers in April, causing the unemployment rate to surge to 14.7% from 4.4% as reported as of the end of March. Both the number of monthly job losses together with the unemployment rate reflected levels not seen since the Great Depression; however, both metrics came in slightly below the forecasts provided by most economists. Unsurprisingly, the Leisure and Hospitality sectors accounted for over one-third of the total number of job losses, as the COVID-19 pandemic has significantly disrupted travel on a worldwide basis. Additionally, initial unemployment claims reported on May 14^th and 21^st came in with 3 million and 2.4 million first time filers, respectively, bringing the nine-week cumulative total to almost 39 million initial filers. While initial claims remain elevated, the silver lining is that such claims have at least declined for seven straight weeks.

In a recent Q&A conducted with our Portfolio Managers, the question was posed:

“Are there any aspects of your investment team or process that you might not find at traditional high yield managers, but you believe contribute to your success?”

While there are many aspects of our investment team and process that we believe offer DDJ competitive advantages, one that we like to highlight is our in-house legal expertise.

April 24 - May 7, 2020

Summary

• The economic impact of the COVID-19 pandemic has pushed the U.S. into a recession.
• Leveraged credit markets managed to produce gains during a volatile couple of weeks.
• We briefly discuss distressed and coercive exchange proposals, as we have recently seen an uptick in this type of activity.

Confirmed cases of COVID-19 have surpassed one million in the U.S. and are approaching four million globally. However, the severity of the pandemic has varied region to region. As a result, certain governments have taken steps to loosen some of the stay-at-home orders, as well as restrictions placed on non-essential businesses, in the hopes of allowing for a modest reopening of the economy. In the U.S., states like Georgia and Florida come to mind as examples where certain businesses have been allowed to reopen albeit at a reduced capacity. Conversely, the hardest hit areas of the country, such as New York, and the Northeast in general, continue to compel citizens to stay at home and mandate that non-essential businesses remain shuttered.

DDJ Capital Management recently recorded an audio market update with Sameer Bhalla, Senior Research Analyst with 16 years of industry experience in the Energy space, to provide an update on the crash in oil prices and its implications for energy companies within the high yield universe.

One of the subjects that Mr. Bhalla and his co-host Stacy Havener, Founder & CEO from Havener Capital Partners, discussed was West Texas Intermediate (WTI) oil prices recently turning negative and the factors that led to this unprecedented development. Below is an excerpt from their conversation:

“On the supply side, the supply continues to come on. If you have oil and gas wells that are producing today, you can't immediately shut those off. Those take time to run off, and wells that were drilled a month ago will continue to come online and produce in the high level, so what you've seen is this imbalance between production that continues to increase – these volumes that continue to increase – plus the supply actions that OPEC took in March to increase their production by four to five million barrels, and then you have the demand loss. So, the numbers are staggering and basically unprecedented.

April 17 - April 23, 2020

Summary

• Discussions regarding reopening the economy increased; individual states divided on timeframe.
• Oil prices experienced historic volatility and double-digit declines given oversupply concerns.
• Economic data signals an extraordinary decline in 2Q 2020, brought on by the COVID-19 pandemic.
• Additional government stimulus approved with additional measures likely in near future.
• Volatility continued as the leveraged credit markets generated negative returns.
• YTD performance bifurcation between smaller and larger issue size in the high yield market remains significant.

Investors ended the week on Friday April 17^th on a positive note as risk markets broadly appreciated on encouraging reports regarding drug trials for Gilead Sciences’ drug Remdesivir and its potential effectiveness in treating patients with COVID-19. In addition, the previous evening, the White House Coronavirus Task Force introduced a three-phased approach as guidance for states to gradually begin reopening their economies, providing investors with optimism that that there was a “light at the end of the tunnel.” However, the diversity amongst the state governors with respect to plans to end “stay at home” orders and other virus mitigation efforts was on full display this week as some states extended the duration of such orders while others announced plans to begin rolling back restrictions and reopen their respective state economies in the coming weeks. The differences in perspective are largely driven by the degree to which a particular state has been impacted by the virus with the leaders of less affected states desiring to ease the economic hardship caused by the virus and the associated mitigation efforts sooner rather than later.

DDJ Capital Management recently recorded an audio market update with firm founder, Portfolio Manager and CIO David Breazzano to discuss the extreme volatility and liquidity challenges in the high yield market. A question was asked about where the team is currently finding strong risk-adjusted investment opportunities.

Listen to Mr. Breazzano’s response. 

DDJ Capital Management recently recorded an audio market update with firm Founder, Portfolio Manager and CIO David Breazzano to discuss the extreme volatility and liquidity challenges in the high yield market. A question was asked about the downgrading of BBB-rated bonds (aka “fallen angels”) into the non-investment grade universe and what kinds of disruptions and opportunities this activity will create.

Listen to Mr. Breazzano’s response from the call on March 27, 2020. 

There are many potential benefits of including a dedicated high yield portfolio as part of a long-term asset allocation, including improving its risk-adjusted-return profile, increasing diversification, and providing a consistent source of meaningful cash generation. In addition, as we discuss below, we believe that the high yield market (comprising both high yield bonds and bank loans) has structural inefficiencies that can be exploited through rigorous, bottom-up fundamental research and a risk management process focused on minimizing credit losses. Our view is that high yield is an asset class in which a skilled active manager can generate significant and sustainable outperformance over the long-term.

As displayed in the chart below, the high yield market, as represented by the ICE BofA U.S. High Yield Index, has generated impressive returns over the last 30-years with significantly less volatility than equities.

By David Breazzano, President, Chief Investment Officer, Portfolio Manager

In 2018, the high yield market ended the year on a low note. A negative return in December capped off one of the weakest quarters of high yield bond performance in history. Of course, this negative performance was not isolated to the high yield market. Rather, concerns surrounding trade tensions, economic growth and the trajectory of monetary policy weighed heavily on markets ranging from corporate bonds to equities. Many market observers were curious whether 2019 would bring more of the same or if markets would reverse course.

By way of background, I am by nature an optimistic person. This may seem counterintuitive given my chosen profession; after all, when it comes to investments in the high yield market, one must always be focused on what can go wrong. Having said that, I cannot help but view things through the prism of positivity. So, even in the face of dreadful performance to end 2018, I was cautiously optimistic about the prospects for the high yield market in 2019.