Tighter spreads pose challenge for high-yield managers

Investors need to be compensated for added risk, says Manulife's John Addeo.

Michael Ryval 5 October, 2017 | 5:00PM
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The U.S. economic cycle is getting long in the tooth and the Federal Reserve is in a tightening mood, yet long-time high-yield-bond specialist John Addeo argues that the outlook for the high-yield segment remains positive. That's provided one is selective about the securities one owns.

"It's a yield-hungry world out there. We really see the demand for income from all sources, whether it's North America or globally," says Addeo, chief investment officer, U.S. fixed income and senior portfolio manager at Boston-based Manulife Asset Management (U.S.) LLC. "In a market such as high yield, where we get a so-called carry in terms of the spread over Treasuries or excess compensation for the risks we take, it continues to attract a lot of attention."

Leveraged companies that have access to capital through the high-yield market can continue to fix some of their problems by extending the maturities on the debt, for instance, or take advantage of lower interest rates, says Addeo, lead manager of the $355-million Manulife Global Tactical Credit. Yet he also acknowledges that the maturing economy is a concern and there is no escaping the business cycle. When there are downturns in economic activity, defaults increase among companies whose credit ratings are below investment grade.

Using a baseball analogy, Addeo suggests that we are in the eighth or ninth inning. "Maybe the score is tied and there is a risk we may go into extra innings, because of the competing factors out there. Economic conditions globally seem to be headed in the right direction, although not moving at a very robust pace," he says. "Demographic factors, technology and high debt levels are impediments to extraordinary growth rates that would drive inflation. So it's kind of a perfect environment for bonds, even with rates being very low."

Currently, the yield spread over U.S. Treasuries is about 380 basis points (bps), according to the benchmark Bank of America Merrill Lynch U.S. High Yield Master II Index (BOAMLHYI). That compares to 422 bps at the start of the year. "There has been some tightening year-to-date and that is the directional trend. But from a valuation perspective, it's tighter than the historic average," says Addeo. He adds that spreads within the last five years got as tight as 335 bps and as wide as 887 bps. "We are trending down to the tight end."

Since yields around the world are very low, Addeo says it's a challenge to find fixed-income opportunities that do not involve much risk. There's a "benign view" of interest-rate risk in the near term, he says, adding that credit risk is more complex to determine. Even with a fairly low default rate and the economy still chugging along, Addeo maintains "there is some extra risk that we need to be compensated for."

Based on a 2% default rate and a recovery rate of 40 cents on the dollar, Addeo suggests that the market would lose 120 bps to defaults. On top of that, he adds in about 300 bps to be compensated for other risks such as volatility. "If that was my base assumption, fair value should be about 420 bps over Treasuries. At 380 bps, and looking solely at defaults, we can conclude either we're not being fairly paid or the market has decided that the default rate going forward is less than 2%." Defaults, based on JP Morgan data, are currently about 1.5%.

Addeo is primarily a bottom-up strategic investor. "We do a lot of fundamental work and try to find durable investment opportunities, and we tend to be buy and hold," he says. "That's a long-term strategic approach to portfolio construction. But the fund is designed to go anywhere globally, hence the word 'tactical' in the title." Since Addeo has flexibility on credit quality, he can own investment-grade bonds. He can also work within the capital structure and buy, for instance, floating-rate loans.

About 80% of the fund, which has a 5-star Morningstar Rating in the High Yield Fixed Income category, is invested in a combination of high-yield bonds and floating-rate loans. The remaining 20% is in a mixture of North American investment-grade bonds and cash. As for geographic exposure, about 52% of the fund is in a mix of U.S. and Canadian bonds, 25% in Asia, and 20% split between Latin America, Europe and the Middle East.

Addeo works alongside Endre Pedersen, a Hong Kong-based manager with Manulife Asset Management (HK) Ltd., who looks after the approximately 25% of the fund in Asian securities. Highly diversified, the fund owns securities from about 270 issuers. The duration for the fund is 3.7 years, versus 4.6 years for a blend of Barclays Global High Yield Bond Index and Barclays Global Credit Index.

While Addeo is being somewhat defensive overall, he has picked up several CCC-rated bonds that offer very attractive yields. All told, about 7.5% of the fund is held in CCC-rated bonds, or half that of the BOAMLHYI benchmark.

Take, for instance, Tapstone Energy Corp., which is active in the shale sector. The company's 2022-dated bond has a 9.75% coupon and recently yielded 15%. "It's somewhat of a contrarian play, but we are generally enhancing the underlying quality of the portfolio," says Addeo, adding that Tapstone has an attractive mix of gas and oil production and is a potential takeover target. "Occasionally we will find compelling stories that will pay us reasonably well for the trouble of investing in them."

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Michael Ryval

Michael Ryval  is regular contributor to Morningstar. He is a Toronto-based freelance writer who specializes in business and investing.

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