Currently 23% of the domestic high yield bond market trades at a yield-to-worst under 4%.1 So on nearly a quarter of the market, investors are currently making what they might traditionally expect from investment grade debt. This is exactly why we believe active management is essential in the high yield market. We see active management as capitalizing on the structural limitations that exist within passive, index-based products and having the flexibility to deliberately and selectively allocate your investment dollars.
The high yield market has seen a big move up since the recent February 2016 lows, causing compression in spreads and yields, leading to what we see as many over-valued securities. As we sit today, the ability to “say no” and exclude certain securities is all the more essential. Over-valuation can take many forms, including those securities offering very low yields or credits where we see downside/where investor are not being compensated for the credit’s risk. We are big believers in purchasing a security at the right price and getting paid for whatever risk you are taking on. What you don’t buy is as important, if not more, than what you do buy, and we believe there is much to avoid in today’s markets.
The pillars of the Peritus investment strategy include the following:
- Security/Industry Selection: Rather than investing in hundreds of securities held by an underlying index irrespective of the credit’s value and forward expectations, Peritus focuses on the securities we believe offer the best return/risk, leading to a focused but diversified portfolio. Our portfolios aren’t weighted by the largest issuers or the largest industries in the market. Rather, we go where we see value from both an industry and security specific perspective.
- Fundamentally-Driven Analysis: We believe fundamental analysis is necessary to assess the credit’s viability and future prospects, and to position the portfolio for a given economic outlook. For our prospective core, alpha-focused credits, we do a thorough review before purchasing the security, assessing both the company’s history and future, as well as financial viability and valuation. Once an alpha-focused security is purchased, we continue to monitor the credit’s fundamentals to identify any change in the investment thesis.
- Sell Discipline: Having the ability to sell securities is necessary in high yield investing—we don’t believe just putting them in a portfolio and passively holding no matter what is the best way to participate in the high yield market. We are continually monitoring our credits to identify downside exposure and have a price threshold that triggers re-evaluation of the credit and potential sale based on our analysis. We are also continually evaluating upside movement and assessing the security price versus any event driven expectations (i.e., a call of the bonds, sale of the company, etc.) and will sell if the yield to our expectations becomes too low versus our portfolio target and/or other investment opportunities in the market (opportunity cost of holding).
- Unconstrained Investing: Flexibility is important in managing high yield debt, allowing investors to take advantage of the various opportunities the market has to offer:
- Avoiding Size Constraints and Other Arbitrary Restrictions: Certain funds have mandates to primarily only purchase securities that are of a certain minimum tranche size (for instance, some large exchange traded high yield funds have tranche size limitations of $500mm per tranche or $400mm per tranche/$1bil in total debt). However, this can eliminate a large portion of the market and it is often in these overlooked, average-sized credits that we have historically found the best investment value. We also avoid other common restrictions such as ratings and subordination. Value can often be had in “under-owned” credits, and for us this involves looking in areas other aren’t and not setting arbitrary restrictions that force us to invest in the same, often largest, issues everyone else chasing.
- Floating Rate Loans: By including floating rate loans in addition to high yield bonds, Peritus is able to expand our investment universe (as some companies only issue loans and not bonds) and invest where in the company’s capital structure we see the best risk/return prospect. Loans, via the floating coupon, can also serve to lower portfolio duration, thereby reducing interest rate risk.
- New Issue Allocation: In order to proactively work to address liquidity and dampen volatility within our investment strategy, Peritus includes a strategic allocation to new and newly issued bonds. Market data, as well as our own experience, has shown that newly issued bonds are more liquid/trade more frequently than the general secondary market in the months immediately after issuance, as the banks often support their deals and buyers (such as passive products) look to add the bonds to their portfolio. This is a more technically driven, short-holding period strategy, whereby we focus on newly issued bonds with yields over a minimum threshold and we continually sell prior new issues, often at a premium, and rotate into newer issued bonds. We believe that including this strategic allocation can help to provide investors with greater liquidity and lower price volatility, while still capitalizing on the yield this market offers.
We believe that active management, and the flexibility this affords in terms of what is purchased and what is avoided or sold, is essential in high yield investing. With our value-based, active credit approach, Peritus is able to take advantage of the variety of opportunities the market has to offer and position our portfolio for a given market environment. In today’s market, this involves bridging the gap of the very low yielding securities and some of the very high yielding securities that we believe carry aggressive risk profiles, as we work to be more disciplined and defensive while still targeting to generate what we see as attractive yield and upside potential.