Expanding the Opportunity Set for “High Yield” Investing

[The capital structures of companies in the high-yield universe have expanded greatly from traditional high-yield bonds to an array of alternative financing solutions that include bank loans and private credit. Regardless of the growth of these various credit instruments, it remains a cyclical asset class with spreads widening/tightening based on market fundamentals and idiosyncratic issues around capital structures, providing an enhanced opportunity set for income investors.

To better understand how the growth of the alternative credit markets expands opportunities for high-yield investors, we were introduced to Donald E. Morgan, Managing Partner & Chief Investment Officer and Doug Pardon, Co-Chief Investment Officer of  Brigade Capital Management– a global alternative asset management firm, founded in 2006, that employs a multi-strategy, multi-asset class approach to investing across the broad credit universe. They have been developing best-in-breed credit expertise in fundamental corporate and alternative credits with a proven, cycle-tested active investment process to deliver risk-adjusted returns aligned to client needs.

We asked them questions to better understand their perspectives on the global credit universe, their Brigade High Income Fund (BHIIX), and their research and portfolio construction process utilizing credit rotation across the full high yield capital structure.]

Hortz: Can you give us a brief overview of the high-yield investment universe and some of the different investment areas you are working with?

Morgan: When most people think about the high-yield universe, they are thinking about corporate high-yield bonds. That asset class is a trillion-dollar-plus marketplace comprised largely of unsecured fixed-rate bonds that historically financed leveraged buyouts. That is still the core of what many fund managers focus on.

Throughout our careers, Doug, the team, and I have looked at the entire capital structure of companies which gives us a broader perspective on what we call “opportunistic” or “multi-asset credit”. It has increasingly been known as the alternative credit space where a broadly syndicated loan market has developed. These are typically first lien, but are sometimes second lien loans. These securities tend to be floating rate with five to seven years in maturity and attractive yields.

Pardon: We also have a large, structured credit team that has been actively involved in the development of the collateralized loan obligations (CLO) market over the last 15 or 20 years. These are structured vehicles that purchase broadly syndicated loans and are structured to fund those investments through the issuance of debt. There are BBB and BB portions of CLOs that would be part of our universe.

Other areas include preferred stocks, busted convertible bonds, and stressed and distressed debt. We are looking for risk-adjusted opportunities across a very broad universe of higher yielding securities that are generally sub-investment grade.

Hortz: How would you describe your fixed-income multi-strategy and multi-asset class investment style and methodology?

Morgan:  Our high-yield strategy allows us to opportunistically invest in the below-investment grade asset classes we just mentioned. Within these asset classes, we have a multi-sector approach driven by our research team. Our analysts cover different industries and sectors, searching across the full spectrum of high-yield credit for risk-adjusted opportunities that we believe offer much better relative value.

We also employ a bottom-up strategy. The research team is looking at individual companies and modeling them. Even in “bad” sectors, there can still be good ideas discovered from a bottom-up perspective. By analyzing these asset classes and industries, and then employing bottom-up research, we develop a large set of ideas and opportunities that we focus on. From there, we narrow down this universe based on the best risk/reward opportunities. The full focus is to protect principal by having a “margin of safety” for downside protection. Beyond that, we are looking to maximize the yield while also seeking total return.

Pardon: Additionally, we have a top-down macro and tactical twist to our multi-strategy approach. You will find that these asset classes are cyclical and experience opportunistic events. Something will happen in the economy – there will be a recession, credit spreads will widen and the asset class can experience high volatility in those periods, or there will be some sort of financial crisis over a shorter period of time that will cause spreads to blow out.

When credit spreads are wide, we feel like the market’s offering you a lot of “fat pitches”. We will actively move down in credit quality focusing on weaker B and CCC securities primarily within the high-yield bond universe.

Conversely, when credit spreads are tight, we will tend to lean into some of these other asset classes where we would be looking for alternative opportunities, including bank loans, and upgrade the credit quality of the portfolio by focusing on stronger B or BB securities to maximize liquidity.

Hortz: Can you further explain some of the alternative credit areas you follow and how you opportunistically manage these different sectors to add income and growth to portfolios?

Morgan: There are inefficiencies in all asset classes, including these other high-yield investment areas. What we are always looking for is when they are offering much better relative value or when, for whatever reason, we have a significant advantage over our competitors.

For instance, we have exposure to busted convertible bonds and have the flexibility to opportunistically increase that exposure when we see attractive value. If you think about a convertible bond, most are issued at par at a time when people are optimistic about the company’s stock price. Over time, if that stock has traded down for whatever reason – missed earnings, industry fundamentals – these bonds, because they are highly sensitive to the stock price, will trade down and hit what is referred to as a bond floor. They tend to have 2% – 3% coupons, which means this bond floor can be 75-80 cents on the dollar.

Now you have a security that is not very sensitive to the underlying equity. It has a low current yield because the coupon is low, but an attractive yield to worst due to the lower dollar price. If that bond trades from the eighties to par, you are going to have a high total return on that security. We will look at those credits and value them. If we feel that there is particularly good asset coverage and downside protection, we will step in.

The convertible bond market basically becomes an inefficient market in the sense that there are not a lot of people focused on this universe. The convertible arbitrage funds have gotten out of these securities. A convertible mutual fund wants more equity sensitivity. This is sort of an unloved security within a small asset class.

Pardon: On the CLO side, if you buy a broadly syndicated loan at SOFR+300 basis points (“bps”), you are usually facing a single individual issuer, and the outcome of that investment is going to be solely focused on how that issuer performs. Conversely, in the CLO market that issues BB or BBB securities, a lot of these securities are bought by hedge funds or levered vehicles, and in periods of market volatility, you will see sellers of CLO debt out of these vehicles.

When volatility forces levered players to sell, we will step in and buy a BBB CLO at a spread that is wider than the overall underlying issuers of the broadly syndicated loan market. So, you can own a BBB bond of a CLO that owns 400 different issuers, versus an individual issuer loan where you are facing that single company. And the only way to really have realized losses on that investment is if 10% of the portfolio defaults year after year, which is highly unlikely. In those types of environments, the inefficiency arises because there are more sellers and illiquidity. We can step in and, from a relative value perspective, do so at a higher spread in these securities than individual loans with much better downside protection.

We will also look at preferreds. Recently, there was a financial institution that wanted to issue preferreds to raise regulatory capital. Preferreds can pay dividends, in kind or in cash, but we structured this preferred 5% wider in yield than their underlying unsecured bonds. We also put a feature in where there would have to be a minimum level of high cash interest. I would say that our ability to do this gives us an advantage and you are just not going to find a lot of high-yield investors that are looking at the preferred part of the market.

So those are a few of the things that we look at. We also will look at stressed municipal debt, commercial real estate or other areas, but that gives a flavor of the types of differentiated areas we can opportunistically take advantage of.

Hortz: Talk to us about the capabilities of your proprietary in-house research. How was it structured differently to compete with other researchers and be effective across the full high-yield credit universe?

Morgan: One of the differentiating factors for our firm is that we have always been a partnership from day one and a lot of our research analysts are equity partners in the firm, creating one team that is growing together. I also think that the breadth of the research and the experience of our team members stack up very well against our competitors. We have 19 people on the research side with senior analysts having an average of over 20 plus years of experience, covering the same sector(s) for the majority of their careers. They have seen industry cycles and developed deep knowledge in these areas of what drives success or failure for companies within their respective industries.

The other differentiator is that the research team covers the entire capital structure of companies we are covering. Our chemical analyst is not just covering their high-yield bonds but also any syndicated loans, busted convertibles, preferreds, and fielding club deals for loans looking for extra yield and growth potential. We are all working together on the High Income Fund, so we do not have separate teams within the firm. Those are some of the differentiating factors.

Pardon: We built our firm into a diversified investment business extending our high yield expertise into some of the more interesting areas of the expanding marketplace and building the stability of a broader-based firm. The uniqueness of our overall organization has become an attractive place for specialized investment analysts to land and help us build our team. With our team, an analyst has a diversified skill set having invested for many years, not only in long-only, but also as a hedge fund investor. That adds a little bit of a unique dynamic.

Hortz: How is your Brigade High Income Fund (BHIIX) strategy positioned within your broader platform, and what makes it distinct from other high income or multi-sector credit funds?

Morgan: Within our platform, this Fund is an opportunistic high-yield credit fund that can expand into multi-sector and especially alternative credits. It is our only retail mutual fund across our investment platform, so for these investors, it is the only way to get access to our institutional high-yield investment process.

What sets this Fund apart from the broader retail high-yield mutual fund universe is the expanded high-yield universe that we are open to and actively investing in. You will see our core base of income generating high-yield bonds go up or down – depending on where we are on the credit cycle – and we can increase our weightings to alternative credit markets that can help either dampen volatility, maintain high income, generate total return, or meet other investment and risk control objectives. While there are other high-yield funds that have flexibility, having dynamic and purposeful access to alternative credits like structured credit, bank loans, as well as participating in club deals, allows us to have a more diversified and differentiated high-yield income approach.

Another nuance of this differentiation is that most of our peer group runs incredibly diversified and one-dimensional portfolios, with hundreds and hundreds of issuers at very small weightings across the portfolio. We have a more concentrated approach, and while we are benchmark-aware, we are not closet indexers by clearly being in other asset classes that are not in the broader high-yield index.

Pardon: As mentioned before, we will always have a core base of high-yield bonds generating income, but we will spend a lot of time thinking about where we are in a particular credit cycle and looking for where the best high-yield investments appear across our expanded opportunity set. Our opportunistic, or tactical, investment approach is where we are truly most differentiated.

A lot of the larger funds in this category are highly diversified, but for the most part, they may be focused on getting beta exposure to the asset class. While that is fine for some people, there is an opportunity to generate a fair bit more than that if you can have an opportunistic approach, coupled with the ability to perform deep research into alternative credits that are not as easy to find. Those two pieces are what we bring to the table.

Hortz: What type of investor or portfolio objectives is this strategy best suited for?

Morgan: We address investors who seek high income and capital preservation- such as retirees living on a fixed income. Our goal is to strive to meet those objectives through sector rotation and individual bottom-up security selection of securities that are out-yielding the market, where we see high current risk-adjusted returns and income. We place strong emphasis on capital preservation and maintaining a margin of safety in our investing approach.

This article was originally published here and is republished on Wealthtender with permission.

About the Author

Bill Hortz

Founder Institute for Innovation Development

Bill Hortz is an independent business consultant and Founder/Dean of the Institute for Innovation Development- a financial services business innovation platform and network. With over 30 years of experience in the financial services industry including expertise in sales/marketing/branding of asset management firms, as well as, creatively restructuring and developing internal/external sales and strategic account departments for 5 major financial firms, including OppenheimerFunds, Neuberger&Berman and Templeton Funds Distributors. His wide ranging experiences have led Bill to a strong belief, passion and advocation for strategic thinking, innovation creation and strategic account management as the nexus of business skills needed to address a business environment challenged by an accelerating rate of change.