DDJ Capital Management Blog

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.

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.