DDJ Capital Management Blog

This week, we continue with our third and final educational piece on high yield bonds and bank loans. In the first two parts of this blog series, we discussed where each type of debt typically sits in a company’s capital structure; the size and growth of the bank loan market; useful statistics with respect to each asset class (such as volatility measures); and why the flexibility to invest in both asset classes can enhance the long-term risk-adjusted returns of a high yield portfolio. Links to these blog posts are available at the bottom of this page.

“From the (data), one can see that the inversion period ended seven months before the 2007 recession; six months before the 1990 recession; and only two months prior to the 2001 recession.”

In May of this year, the yield spread between 3-month U.S. Treasury Bills and 10-year U.S. Treasury Notes turned negative; in other words, the yield curve inverted. The curve remained inverted until mid-October. Historically, this phenomenon has proven to be a useful leading indicator of a recession. However, while it is true that the yield curve has inverted prior to each U.S. recession dating back to the 1960’s without producing a false flag signal, there appears to be little to no information embedded in this signal that predicts the timing of the recession that follows. Admittedly this missing information is a very important piece. Be that as it may, if we assume that the indicator will once again correctly predict a coming recession, we thought that it would be worthwhile to examine how the high yield market has historically reacted to this event and whether there is a useful pattern to be uncovered as it relates to such market’s overall performance.

High yield bonds and bank loans are two asset classes that are more alike than many investors realize.  In the first part of this blog series, we discussed where each type of debt typically sits in a company’s capital structure, and why the flexibility to invest in both bonds and bank loans in a high yield portfolio can enhance the risk-adjusted returns of such a portfolio over time.

This week, we will be discussing the size and growth of the bank loan (aka leveraged loan) market, as well as other useful statistics, such as volatility measures, of loans as compared with high yield bonds.

High yield bonds and bank loans are more alike than many investors realize. Although there are meaningful differences between the two types of securities, from an investment perspective, we believe that these two asset classes should be viewed through the same lense. As we will expand on, we believe an investment manager that focuses on both segments together can create considerable value for a high yield portfolio. Furthermore, having one analyst team that focuses on both asset classes is the way to go instead of having separate specialists.

In May, the yield spread between 3-month U.S. Treasury Bills and 10-year U.S. Treasury Notes turned negative; in other words, the yield curve inverted. Historically, this phenomenon has proven to be a useful leading indicator of a recession. However, while it is true that the yield curve has inverted prior to each U.S. recession dating back to the 1960s, without producing a false signal, there appears to be little to no information embedded in this signal as to the timing of the recession that follows. Admittedly, this missing information is a very important piece.

In previous blogs (Is There a Right Time for High Yield, part 1 and part 2), we suggested that high yield appropriately deserves a place in an investor’s overall strategic asset allocation. However, a common argument that we hear against such a decision is that it bears too much of a resemblance to an investment in equity. High yield has been described as a hybrid asset class; i.e., it displays the characteristics of both equities and fixed income. In fact, high yield does display a higher correlation to equities, and those who would not otherwise recommend an allocation to high yield may say that an investor could instead obtain a similar diversification benefit with higher potential returns simply by adding to an existing equity allocation.

Many investors believe that the CCC-rated segment of the high yield market, with its relatively higher degree of volatility as compared with the BB-rated segment of the market, does not appear to be an attractive space to invest despite the higher yields and returns associated with these types of bonds.

However, for the discernable credit investor, the ability to uncover idiosyncratic opportunities provides the potential for outsized returns relative to the risk incurred. Our goal at DDJ is to identify a relatively small number of securities within the CCC-rated segment that are misrated and/or mispriced and which accordingly offer investors a compelling risk-reward profile.

This is the second blog of a series which is designed to provide some insight into to the difficulty of applying a tactical, or short-term, mindset to high yield allocations, and why, in our view, a strategic, or long-term, allocation to the asset class is optimal.

Exhibit 1 below displays returns for the high yield market over various holding periods based on different starting spread level ranges. It can be seen that, on average, extending one’s holding period has historically resulted in better outcomes, especially for starting spreads that have ranged from 300 to 700 bps, which are the levels that high yield spreads have been most-regularly observed and what we define for the purposes of this blog as “normal market conditions”.

Have you ever been tempted to take a tactical, market-timing approach to high-yield? After all, waiting for spreads to widen and the market to become “cheap” seems like a lucrative way to play the asset class. However, history has shown us that this approach comes along with a litany of challenges, and that in reality, incremental increases in spread levels do not always translate into increases in total return.

This is the first blog of a series that is designed to provide some insight into the difficulty of applying a tactical, or short-term, mindset to high yield allocations and why, in our view, a strategic, or long-term, allocation to the asset class is optimal.

Welcome to the DDJ Blog.

Since their widespread issuance in the 1980s, high yield bonds have become an important component of investors’ asset allocations and have provided the financing necessary to support a large segment of our economy. Many investors in this space prefer the debt of well-known, larger-cap issuers that are often rated just below investment grade (e.g., BB-rated), but there are a myriad of opportunities in smaller, underfollowed issuers.