The extreme bifurcation between winners and losers in the post-pandemic world could set up two very different potential value opportunities in high yield.
During the financial crisis of 2008 – 09, the ICE BoA U.S. High Yield Index traded at a spread of more than 1,000 basis points for 10 months. Even in 2002 it stayed at those levels for two months. This year, it offered that kind of value for all of five days.
Over the summer, a lot of fixed income investors went from asking us about the distressed debt opportunity to asking us whether there is any value left in high yield markets at all.
Our answer is yes. We believe the impact of the coronavirus is creating perhaps the most extreme bifurcation between winning and losing businesses of any economic shock in history—and we think that is setting up two very different kinds of potential value opportunity.
The Comfort Trade
Let’s call the first opportunity the “comfort trade.”
In the early stages of the recent rally, we argued that there was no need to take excessive credit risk in search of yield or total return. We always thought that the “Killer BBBs” fear was overdone and we favored higher-rated high yield, and particularly “fallen angels.”
Those sectors have outperformed this year. In the meantime, CCCs have lagged higher-rated high yield—and, in our opinion, somewhat indiscriminately. The dispersion of trading levels among CCC issuers is close to an all-time high, in our view creating a favorable environment for credit selection.
Especially during this environment of rapid economic change, both positive and negative, we think it is critical to rely on our own credit ratings assessments as opposed to published ratings, which may be stale.
We have identified CCC issuers that our own credit ratings put at single B, or where we consider business models to be durable in the current environment, and we believe these opportunities offer an attractive yield pick-up relative to the overall market without sacrificing the default outlook of our portfolios.
The three largest overweight sectors in our CCC overweight are technology, financial services and telecoms. We think certain issuers in these industries are either benefitting from or remain unaffected by the current environment. Insurance brokers are an example whose cash flow profiles are largely unaffected but whose bonds carry above-median yields. The two largest insurance-broker positions we own grew year-over-year profits during the second quarter.
The Distressed Trade
Then there is the distressed opportunity.
At the moment, approximately 10% of the U.S. high yield market trades at distressed levels, on a par-value basis. We remain significantly underweight in this part of the market in our traditional high yield portfolios because we believe that distressed debt investing is best pursued by specialists with deep experience in bankruptcies and reorganizations.
For the dedicated team at Neuberger Berman that focuses on this part of the market, we think there will be ongoing select opportunities. Furthermore, we believe the current environment of extreme winners and losers makes it likely that the distressed proportion of the high yield market will remain elevated for some time.
We see three types of company in this universe:
First, we have stressed debt that is likely to recover its value without filing for bankruptcy. Second, there is debt that will likely reorganize, and which is trading at a price that fully compensates for the time and uncertainty of the bankruptcy process. And third, there is debt trading at levels that do not adequately reflect bankruptcy risk.
Of course, we would avoid bonds that we put in the third category. And while the number of companies with bonds trading at distressed levels is large, the number that rigorous credit and legal analysis puts in the first two categories is modest—and it is around these companies that we build our distressed debt portfolios.
But there is also a wide range of companies that are currently very difficult to analyze due to idiosyncratic, industry or macro risk. While not investable today, in our view, change in those dynamics could present opportunities in the future.
Overall, the sectors we are focused on and where we anticipate multiple bankruptcies include theaters, hotels, restaurants and aerospace suppliers.
Potential Value
So, yes, we do believe there is potential value opportunity in high yield.
We believe higher-quality, lower-yielding CCCs can be a good source of current income and potential capital appreciation—but rigorous credit analysis is absolutely essential here in order to avoid those in danger of falling into distress.
And while it is not for everyone, those who can tolerate higher risk and lock up capital may enjoy two or three years of substantial distressed and turnaround opportunities.