Exploiting durable inefficiencies in high yield debt

Our approach as active managers is to try to add value in a variety of ways, from fundamental research to individual security selection to a superior asset allocation mix. One of the core tenets of our approach to active management is identifying and exploiting what we believe to be durable market inefficiencies— that is to say, market segments where the price of an asset doesn’t correctly reflect its value. In this piece, the first of a three‑part series, we examine a selection of these inefficiencies.

When we analyze high yield issues, we consider factors such as the issuer’s underlying fundamentals, credit rating, and the issue’s duration. Through our analysis, we have observed persistent mispricing in the BB credit tranche, which is priced more like lower-quality issues than lower-rated issues despite having much lower default risk than lower-rated issues and better absolute and risk-adjusted returns than higher-quality issues.

At a base level, one might assume that the distribution of default probability is spread evenly across credit ratings, with AAAs being incrementally less likely to default than AAs, and so forth. While this is accurate for investment-grade issues, it demonstrably has not been the case for high yield bonds, where the distribution of default rate is closer to exponential as we move down the credit spectrum.

When comparing the default rates of BBBs and BBs (Fig. 1), both quite low, we would expect BBs to trade at only a slight discount to BBBs. In practice, markets tend to price BBs more like Bs, which had significantly higher default rates. This raises the question: Are markets overcompensating BB bond investors for risk, and if so, why?

A bond’s credit rating directly impacts its yield. The lower the quality, the higher the rate. This is conventional wisdom that almost does not bear mentioning. However, from a fixed income investing perspective, we are focused not only on an issue’s yield but on capital return as well.

Despite having lower yields than Bs, BBs generated a higher average annual return (Fig. 2). This is due not only to their lower default risk, but also because BBs have typically been priced comparably closer to Bs in the market. As prices and yields are inversely related, these lower prices have the effect of increasing the actual return generated by BBs. Moreover, because the actual default rate for BBs has been quite low and volatility within the tranche has been more comparable to higher-quality issues, BBs also generated better risk-adjusted returns than their BBB counterparts.

In the Capital Appreciation Fund and Capital Appreciation and Income Fund,¹ investing in this segment of high yield bonds is a core tenet of our investment process and a key way in which we seek to generate alpha.² We think this inefficiency has continued to exist because of key factors that contribute to an imbalance between supply and demand, which has allowed us to consistently purchase these bonds at a discount.

We believe our focus on identifying compelling investment opportunities can enable us to capture better absolute and risk-adjusted returns without taking on excessive default or total portfolio risk. In part, this is driven by an integrated approach to diversification³ across and within asset classes, including fixed income and equities.

Within fixed income, for example, we seek to manage credit and duration through diversification that accounts for the inherent characteristics of different types of debt. While high yield bonds have credit risk and lower duration risk, leveraged loans have credit risk and very minimal duration risk, and U.S. Treasuries have very minimal credit risk but do have duration risk. By owning all of these fixed income assets, we can diversify our portfolio in an effort to deliver lower volatility.

More broadly, when investing across asset classes, our higher credit exposure is complemented by a lower volatility bias that we seek to build into the equity portion of the Capital Appreciation Fund and the Capital Appreciation and Income Fund through individual security selection. In practice, this is another way in which we try to maximize potential return relative to portfolio risk.

Our analysis (Figure 3) demonstrated that, on average, lower-risk stocks outperformed higher-risk stocks on an absolute and risk-adjusted basis. Conversely, in looking at the universe of U.S. corporate bonds, both investment grade and high yield, a comparable premium is not evident even after controlling for credit rating and duration.

Because we believe that there is a premium associated with lower-volatility equities, we think we are better rewarded over a full market cycle to take a relatively more defensive posture within the equity component of a portfolio and, conversely, to take a more risk-tolerant posture within fixed income through higher credit exposure.

As portfolio managers, we are willing to go against consensus, question commonly held assumptions, and follow through on our research and process. The high yield market offers one such opportunity to cut against the grain and pursue attractive risk-adjusted returns in an area we think the market underappreciates and misunderstands. Through fundamental research, taking a longer view, and asking the right questions, we are committed to uncovering opportunities that can add value for our shareholders.

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