The Portfolio Managers of DDJ’s U.S. Opportunistic High Yield Strategy, David Breazzano, Ben Santonelli and John Sherman, recently sat down and answered a handful of questions related to investing in the high yield market and DDJ’s distinctive investment philosophy.
This week, we highlight a question involving an area of the high yield market that is often ignored by the largest high yield managers: middle-market issuers.
The Portfolio Managers of DDJ’s U.S. Opportunistic High Yield Strategy, David Breazzano, Ben Santonelli and John Sherman, recently sat down and answered a handful of questions related to investing in the high yield market and DDJ’s distinctive investment philosophy. One of these questions related to the teams of people on the other side of the investment equation.
Happy New Year!
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 2019. If you have a topic you would like for us to cover, please contact us. We appreciate your feedback.
Cheers to a new decade!
Consistent cash return that compounds over time
In a previous blog post, High Yield: Are Its Returns Too Closely Correlated to Equity for it to be Considered an Allocation to Fixed Income?, we analyzed performance data since 1998 and illustrated how on average, high-yield bonds performed in line or better than large cap equities on a rolling three- and five-year basis. Further, the volatility of high-yield bonds has been considerably lower than equities, resulting in stronger risk-adjusted performance. Observe the following long-term performance and risk statistics of high-yield bonds versus large-cap equities and small-cap equities, as shown by the S&P 500 Index and Russell 2000 Index, respectively, for the time period 4/1/1998 to 9/30/2019:
The high yield bond market1 has generated impressive returns – up 12.07% – through the first eleven months of 2019. However, examining the returns for a market in aggregate can be deceiving, as it can mask significant dispersion of returns within different segments of such market. Year-to-date performance of the high yield bond market in 2019, as well as the twelve-month period ending 9/30/19, is one of these periods. In particular, the return differential of the BB-rated segment as compared with the CCC-and-below rated segment, and the resulting relative valuation of these segments, is historically unprecedented.
In May of this year, the yield spread between 3-month U.S. Treasury Bills and 10-year U.S. Treasury Notes turned negative (i.e., yields on 3-month U.S. Treasury Bills were higher than yields on 10-year U.S. Treasury Notes). This phenomenon is known as a yield curve inversion. Since the 1960s, an inverted yield curve has preceded each recession, without producing a false signal. While the curve is no longer inverted as of the date of this post, it remained so until mid-October.
“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.
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.
Executive Summary
Imagine strolling along a little-known, wooded trail. As you pass by a brook, a shiny, sparkling object gleams at you from beneath the surface. In fact, you see many of them dotting the sandy bed of the brook. Who wouldn’t be excited by the prospect of discovering a field of gold nuggets? All of those little glittering bits must be the real thing, right?
