DDJ Capital Management Blog

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.

June 5 - June 18, 2020

Summary

• Despite an increase in volatility driven by renewed concerns regarding a resurgence of the coronavirus, leveraged credit markets produced modest gains.
• Flows and new issuance remain strong for high yield bonds, though not as much for leveraged loans.
• We briefly analyze the industry standard calculation of the recovery rate on defaulted debt, highlighting some of the limitations of such measure.

On June 5^th, investors were greeted with a much better than anticipated May U.S. employment report, with an increase in non-farm payrolls of 2.5 million relative to consensus for a decline of 7.5 million. The report also reflected a decline in the unemployment rate  from 14.7% in April to 13.3% in May, also moving in the opposite direction as forecasts, which called for an increase in the unemployment rate to 19%. Such a rate would have represented the highest level since the 1930s. In addition, retail sales for May increased by a record 17.7% month-over-month, handily beating expectations for an increase of 8%. Such reports added to an already optimistic outlook amongst investors for a strong economic recovery beginning in the third-quarter, driven by a largely successful reopening of the U.S. economy.

In our view, the current environment is more similar to that which occurred during the Global Financial Crisis (“GFC”) of 2008-2009 or the dot-com bubble of 2002-2003 than the oil price driven sell-off during the second half of 2015. In light of this perspective, we analyzed how the quality rating segments of the high yield market performed, beginning just prior to those two historical drawdown periods and continuing as the economic recovery ensued. Using the ICE BofA US High Yield Index as a proxy, Charts 1 and 2 below display the cumulative growth of $1 invested in each quality segment of the high yield market at the beginning of the quarter in which the GFC and dot-com bubble selloff occurred, respectively. 
 

May 22 - June 4, 2020

Summary

• Leveraged credit markets produced impressive gains during the period covered and have done so for two consecutive months.
  
  
• We briefly analyze the performance of the CCC-rated bond market to better understand its relative underperformance since the recovery began.

Worldwide, confirmed cases of COVID-19 exceed 6.5 million, with cases in the United States accounting for 28% of the global total. The unprecedented steps taken in the U.S. and other countries during March and April to minimize the spread of the virus have resulted in a decline in infection rates in many areas. However, there remain several countries that continue to show a rapid growth in cases, such as Brazil and Russia. Although not unique to the U.S., the restrictive measures undertaken domestically to reduce the spread of the virus have had a major impact on economic activity. Unemployment has soared and GDP in Q2 2020, which includes the height of the lockdowns, is anticipated to show an annualized rate of decline between 30-50%. Nevertheless, with the lockdowns easing across the nation, many economists believe that the worst of the economic malaise is behind us.

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.