Mobile Strategy Brief: High Yield
PODCAST 08/27/2019 – Institutional High Yield
Lord Abbett’s Mobile Strategy Brief
VO: Welcome to Lord Abbett’s Mobile Strategy Brief
Andrew Fox: Hi, my name is Andrew Fox, an investment strategist at Lord Abbett. And I am joined today by Steven Rocco, partner and director of our taxable fixed income franchise and portfolio manager on our high-yield strategy. Welcome, Steve.
Steven Rocco: Thank you, Andy.
Fox: We talk a lot about how you would approach the high-yield market. And there's a number of ways that it can be approached. We see that from a lot of our peers. What differentiates Lord Abbett's approach in this strategy?
Rocco: Thank you, Andy. For Lord Abbett's high-yield approach, we mix the top-down with the bottom-up. We take a fundamental view around high-yield credit. And that's determined by the portfolio managers and the credit analysts who are selecting the securities. But we also blend it with a with a top-down macro approach. What we want to do is identify how we should be positioned along the rating spectrum. How we should be positioned in each sector. And how much risk should we take in the portfolio.
Fox: You and I both spend a lot of time talking to professional buyers, institutional buyers, and so forth. And there's always a part of the presentation when we're introducing the strategy where you say, "This strategy is a combination of top-down and bottom-up factors." Which is probably what they hear from every single manager that marches through the office. But we actually execute on that top- down part. Can you talk a little bit about how we do that-- and why it's so important?
Rocco: Sure. We consider the strategy to be all weather. When we're thinking about the macro, we use the resources that are at our disposal within taxable fixed income. So we're leveraging our macroeconomic resources. We're leveraging other portfolio managers, working in different asset classes across the team to come up with our overall macro view.
And then we're applying that down specifically into the high-yield market. Because what we've found post-financial crisis is that it pays to think about the top-down. If you look at the ratings dispersion between double Bs and triple Cs, and you look at the sector dispersions going back the last ten years, you would see wide dispersions amongst each ratings category and between different sectors.
You could be a credit picker in high-yield, but if you're not paying attention to those factors-- you probably are not in the top
quartile. And that's certainly a goal of ours. We've applied those macro factors. And also if you look post-financial crisis, you've seen
higher correlations across asset classes. Just being a bond picker would not have been sufficient here. You would need to understand how
the macro dynamics are playing out across markets, in particular for our strategy, within high-yield. And then you could apply that credit
selection, which has been so very strong for us over time.
In addition to that, we're able to leverage some of our work to identify attractive opportunities that are off-benchmark. So if you look at the strategy, we've invested in European high-yield credit. We've invested in emerging markets. We use convertibles and equities as well. So we're looking really across the capital structure, leveraging the investment resources that we have in place, both within taxable fixed income and in our equity department.
Fox: What is our positioning currently? How are we viewing the market?
Rocco: We came into the year low in risk versus our benchmark. We're not at our max risk position given the overall level of spreads. But we started the year at a 500 spread in high-yield and at a higher risk position than where we are now. We're able to capture some performance coming into the first quarter.
We had a big sell-off in Q4 in risk markets. We took the risk position up in Q4 and then in Q1 we were able to realize outperformance through spread tightening. So right now, high-yield spreads are sitting in the low 400s. If you go back 25 plus years, the average high- yield spread has been in the 400s, low 500s. So we're through the average. Although if you look at the high-yield composition, the credit quality of the index has improved. So you have almost half the index in double Bs. So you should probably make an adjustment there for better credit quality.
Coming into the year, we were constructive. Clearly the volatility has picked up. It picked up in May around trade headlines. It certainly picked up here in August. But we were able to kind of toggle risk up and down, as we see opportunities arise within the high- yield market. In turning specifically to overall credit positioning from a ratings standpoint-- double Bs have outperformed triple Cs, even though high-yield spreads have tightened a hundred basis points this year, it's rare to see that, where double Bs are leading.
So it's been a higher quality rally. The same has been true in the loan market. The same has been true in the equity market where higher quality equities are outperforming and large mid-cap are outperforming small-cap. So we are overall, constructive. The portfolio is long- risk. We are modestly down in credit, but our selection's been good. We are flat from a term structure perspective. And we've avoided some of the worst parts of the high-yield market this year-- which have been in the telecom area, specifically wireline telecom.
Healthcare, specifically spec pharma, and generics. And some other, more levered, idiosyncratic stories that have underperformed. So our selection has been good. That's offset being modestly down in credit--which has hurt us just a little bit.
Fox: I mean, it's been a big part of our performance on a day-to-day basis and historically as well, when we look at some of the more secularly-challenged or names that just have problems. Can you talk a little bit about looking at places where you get a tailwind rather than a headwind and how you go about making sure you keep some of those tough names, or challenged names, out of the portfolio?
Rocco: Yeah, so I tell everyone, you know, high yield is a negatively convex asset class. So it's really what you're avoiding, that's where you're making the performance, because there's only so much upside you'll get buying a credit at 102, 103, 104. So really avoiding the worst performers is how you generate performance in high-yield.
So we've done a good job over time leveraging our credit analyst and the portfolio manager on the team to identify what those securities will be. At the same time, some of the securities are large index names. So if you're a high-yield manager, just looking at high-yield, you would be, from a portfolio construction standpoint, maybe forced to own some, even if you had a little bit more negative views. You may be a half weight-- versus a 1 or 2% index name.
For us, as I mentioned earlier, we're able to look across capital structures. We're able to move off benchmark and bank loans in emerging markets. So if there are some better opportunities away from some of these more challenged businesses, we're able to construct a portfolio that way. Which has been beneficial and allowed us to take pretty negative views in some of the larger capital structures in the index that have those challenges.
It is a debt-weighted index, so you have to obviously consider that. And then the companies that are larger names in the index tend to have, obviously, more debt. And so we've been able to be a little bit more idiosyncratic both off-benchmark and within our index.
Fox: We can pick on individual credits -- which are rather large in the index -- that we've had zero exposure to over time, but
then we will move quite flexibly to establish a position if we think there's an opportunity.
Rocco: Exactly. So we don't forget about anything. Once it leaves the portfolio, we're always constantly evaluating what's in the index and coming back to it, if there's a reason to come back to it. So I tell a lot of our investors, both external and internal that, IQ is important in investing, but I think emotional intelligence is just as important, if not more important.
And being able to take a loss in something or having a negative view and then coming around to that same story again, you know, six months or a year from now when the facts have changed is a hard thing to do in investing, but I think it's something that the team has done well with over time.
Fox: Turning now to outlook. Looking at the things that were driving the market at the end of the last year. You know, concern over what the Fed was up to. Global growth. Domestic growth. You know, trade wars or threats of trade wars. We had quite a lot of that at the end of the year. All kind of went away at the beginning of the year, now some of it is coming back. So you're starting to see the headlines talking about recession and so forth. Sounds very similar to where we were-- at the late part of last year. How are we viewing the current environment?
Rocco: So we try and tune out the noise as much as we can. And clearly, there's been a market that's been dominated by Twitter. Trade headlines and the like. And obviously the market is concerned about what the Fed is going to do. Which markets are always concerned about. Obviously central banks outlooks and what they perceive the economy to be doing and not doing at any given point in time.
So we need to take a step back and look at the big picture here post-crisis. It has been a very slow and long recovery. The longest on record. We never really reached 5% growth for any extended period of time. And so you've been in this market where you've had lowish inflation and 2-3% growth with kind of brief periods of stronger growth and brief periods of weaker growth.
Which you saw and you highlighted in 2015 and obviously the 4th quarter of 2018. And so we've been able to toggle risk up and down based on the idea that you're kind of in this steady state. You're not too hot. You're not too cold. The classic Goldilocks, which is exactly what a market like high-yield wants. Because I think if you get too hot-- you'll see a central bank that responds to that more aggressively. You know, higher inflation, higher growth. And that usually is what causes an end of a cycle.
Everyone wants to remember the last one, which was the financial crisis. Obviously that is something that doesn't happen very often. And we may not see another one like that in our lifetimes. But usually what ends a cycle is a central bank that's tightened too much. Or, you know, some sort of exogenous shock. That could come from anywhere.
And certainly trade has been negative. It's not good for China. It's not good for the U.S. It's certainly not good for Europe and in fact, it's worse for, let's say, Europe and Japan than it is for us because we have a relatively closed economy.
So right now we're kind of sitting here with a central bank that has cut rates. You can argue if Q4 was a mistake or not for them to raise rates in Q4, but they cut rates and are providing support. It looks like the ECB is going to provide some support. We're growing about 2%. Inflation's ticked up a little bit, but it's still within the Fed's comfort zone, I would say. And we have these kind of negative externalities with trade and the like.
And then the Fed obviously is cutting. And I think the ECB will be even more aggressive than the Fed. But I think the Fed will provide support where needed and you're kind of looking at a market with not too much excess. A market that has central bank support. This lowish growth, low inflation world-- that's perfect for carry.
And so the challenges for our outlook would be if things get too cold. And I think that's what the market's been struggling with recently-- where you saw negative growth in Germany and the rest of Europe being particularly weak, China decelerating… because what we don't want is things to get incrementally worse from here from a growth perspective.
But if we kind of bounce back from that second quarter inventory correction and the Fed provides some support here, I think we'll have a reason for high-yield to tighten further. Despite what's come come at us this year and the headlines which suggest a really negative market backdrop, high-yield is up. So it's been good-- it's been a good year for risk.
And we expect that to continue. And so we're not being overly heroic when we talk about high-yield spreads here in the low 400s. We think they can tighten back inside of 400. We think we're in the carry from this point on and for the rest of the year and close out the year up double digits, which is something that we were calling for in the beginning of the year. So we're relatively constructive on high- yield.
Fox: When you think about typical later cycle behavior, it's often characterized by bad behavior. Right? A loss of discipline -- whether it's on behalf of issuers that are making bad acquisitions, or on behalf of folks like us, the buy side-- that are only too happy to bring it in.
How would you characterize the fundamentals and then overall market behavior? Does it it feel like late cycle? Or do you feel that the slow-down has maybe laying a little layer of discipline-- on the marketplace?
Rocco: Yeah, it's certainly not early, but I think we have got to remember that the cycle's been so different. And now you're seeing early cycle sectors like housing kind of re-accelerate again. So I think, kind of using the old cycle playbooks is probably the wrong idea here.
If you look at high-yield fundamentals, earnings have slowed but are still growing. And you've seen that play through in high-yield. High-yield obviously having more exposure to some of the more challenge sectors in the economy, which is energy and shale.
But if you aggregate it all, you would see some modesty but growth. And you would see leverage that's ticked down, although recently has ticked up just a little bit. And coverage that is close to all-time highs.
So from the standpoint of kind of high-yield fundamentals, I'd say things are okay to strong. And then obviously defaults-- and we mentioned some of the challenges that we have and the index around wireline telecom, spec pharma, energy. Areas we mostly avoided, I mean, that's where you're going to see defaults tick up. And we have seen the default rate tick up a little bit. But it's still pretty low if you look at it on a last twelve month basis and you forecast out, it's going to be hard to get it much above 3%.
And defaults usually are a lagging indicator, not a leading indicator. When you think about what gets into that default rate and how to forecast it, you want to look at high-yield. And I mentioned earlier, the composition of the index being mostly double B, you know, you have to go back to 2001-- to see the level triple C weight that we have now, which is just around 12%.
And this year if you look at the issuance activity in high-yield, which is up year over year -- you'd see most of it is all for refinancing and very, very little triple C issuance. So it's nothing like leading up to the financial crisis where you saw a lot of triple C issuance, a lot of dividend deals.
There is private equity activity, obviously that's happening. It's mostly occurring and being funded in the loan market, which has been the opposite story of high-yield where you've seen more single B and cov-lite issuance and high-yield. You see more higher-quality issuance.
So I'm just looking at the index here. It doesn't suggest to me that there's any kind of excess-- or any kind of animal spirits. And I think that's kind of the challenge that when we talk about credit markets and how this cycle ends, you'd think you'd like to see some animal spirits. You know, you'd like to see us growing quicker and people getting generally excited about things. Because right now everyone's forecasting a recession.
And I don't think you can will yourself into a recession. Something needs to cause it. Consumers have been very strong. And the consumer is a big driver of this economy. And, you see in the consumer data, the retail sales data last week. And I mentioned earlier what causes recessions-- it's usually a central bank that's tightened too much. Or continues to tighten, which we don't have now.
Oil shocks and oil prices-- if anything, are relatively contained at this point. Or some sign of excess or leverage in the system, which we don't have now. So if I think about where we're heading or where we're going, I think it's going to be more of the same, which is, in some ways, is a very frustrating market for people because they're always thinking about when the next recession's going to hit because it's late cycle.
But we get more of the same where you're kind of in this range. And high-yield tightens a little bit. And you try and as best you can navigate around that. But at the end of the year you look up and you've had a pretty good year. So that's what we're trying to do.
Fox: So we explicitly talk about our strategy as being unbiased. We want to perform well through all kinds of different markets. Are there environments that we will be somewhat out of favor? When you think about periods of time where we've had underperformance, what's usually been the driver there?
Rocco: Sure. I think for us it's two areas. One is-- when you get a real bull market in high-yield-- and you see a rally in some of these larger capital structures when the market ebbs and flows because you-- obviously, ETFs are dominant. And not so much in high- yield, but they're becoming more dominant in terms of kind of the trading flow.
You kind of, at that point-- if you're a little bit more disciplined around credit, you'll see some of these larger capital structures rally. Which we tend to avoid some of these larger capital structures in the index that are really more beta plays. So you've seen us underperform in those types of periods.
We haven't had one of those periods in quite some time, but I think that's a period where-- we potentially could underperform because it becomes less about your credit selection and more about just having a lot of beta, which has not been our style.
I would also say the portfolio is relatively idiosyncratic. At the same time, we're avoiding, you know, some of those beta plays. We are idiosyncratic off-benchmark, so if there's something that hurt us off-benchmark, that could potentially result in underperformance.
Fox: Thanks for spending some time with us today, Steve. And thank you all out there for listening and taking some time to listen to us.
VO: That’s it for this edition of Mobile Strategy Brief. If you wish to learn more about the topics covered in this broadcast, or have other questions about Lord Abbett investment strategies, please contact your Lord Abbett representative. Our audio podcasts are available on iTunes, Spotify, TuneIn, and other major streaming media services. Thanks for listening.
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