DDJ Capital Management Blog

“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?