The Old Mutual Dwight High Yield Fund received the 2011 Lipper Fund Award for top risk-adjusted returns in the high current yield category for the three-year period ending December 2010. The $11 million fund, managed by Ed Meigs and Sean Slein, earned more than double the average return in the high-yield category over the monitored period. To find the secret of their success, FINalternatives’ Senior Reporter Mary Campbell spoke recently to Meigs and Slein.
Your fund won the Lipper award in the high-yield category, returning roughly 16% in the three-year period ending December 2010 where the average fund in this category returned just over 7%. What do you know that other managers in your high-yield category don’t?
Ed Meigs: We think one of the key differentiators is the way we manage risk through the high-yield cycle…. We will change the risk profile of the portfolio, increasing risk and decreasing risk, [and] because of that we were very much up in quality going into 2007, 2008. And, obviously, 2008 was the key year, we, significantly outperformed in 2008. But… we then shifted the portfolio, when the market blew out to all-time wides, and increased the risk of the portfolio, so then we were able to outperform in 2009 as well.… What drove the three-year performance was really the shift in the weighting of the portfolio, although we remained up in quality… we were underweight triple-C’s throughout, but it was really just the superior selection in 2009 that drove the performance.
When was fund established?
EM: The fund in its current configuration, it was November of 2007. It was actually the combination of four funds that went back another three years to November 2004. But as far as the track record for this specific fund in this structure, it’s 2007.
How do you manage risk?
Sean SleinSean Slein: We pay very close attention to the direction and degree of monetary policy, so we tend to be in a risk-mitigation mode when the Fed is in a rate-hiking environment or a restrictive monetary environment, and to reach for more risk when the Fed is more accommodative. We also pay close attention to degree of monetary policy restrictiveness or accommodation through the yield curve.
What is the outlook for the current high-yield market and is it true you are currently wary of deal-related bonds?
EM: We’re looking at coupon-plus year for 2011, and we think that the environment is very favorable for high-yield going into 2012 as well, especially… relative to other fixed-income classes. While we expect treasury rates to back up over the course of the year, we believe the high-yield market will certainly absorb a good deal of that through spread compression and, depending on the magnitude of the backup, we may get a price decline.
We are certainly cautious about the decline in deal quality—we look very closely at the use of proceeds and obviously, we’re seeing more funding for LBOs and we’re also seeing more dividend deals…. We look at every deal very carefully, each has its own idiosyncratic risks and there are going to be leveraged buyouts where we think it’s an attractive situation but… there are certainly going to be ones that we believe are over-levered and we’ll avoid.
SS: Based upon where we believe we are in the cycle right now, we’re not surprised by the fact that deal quality is eroding. We’re not surprised that we’re seeing an uptick in dividend-type deals, and we would expect more LBO issuance as the year goes on and into 2012…. That will, for us, confirm where we’re going through the cycle and, if that were to occur, [it] would confirm to us that perhaps we should begin to become a bit more defensive over the next year, year and a half.
Right now, private equity is sitting on a massive amount of cash that they’re looking to put to work; however, given [the] equity multiples currently out there, they’re aren’t really many ready sellers…. The P/E ratio, I think, of the S&P is something like 13½ to 14 times right now, so sellers aren’t motivated and that’s frustrating private equity. Our feeling is we’re going to begin to see more strategic types of acquisitions, to begin with, and we’ve begun to see it—in the telecoms market, the chemicals space, a little bit in the energy space—where strategic buyers who really don’t want to pay a huge multiple, they’ll begin to get the ball rolling as far as buying assets, whether they’re tuck-in or bolt on. And private equity will see that and we think private equity then will begin to jump and look to pay up from a multiple perspective, which will lead to higher and higher multiples being paid and presumably more and more debt being taken on to finance some of these acquisitions. So, suffice to say, right now, private equity is a bit frustrated but we think that they’re going to get off their haunches and begin to deploy their money as the year progresses, more so in the second half.
You were in Europe recently on a marketing trip. How was the response?
EM: Very positive. Obviously, we have a pretty strong track record so it was really all about communicating the process and explaining in a way so they were comfortable that it was clearly scalable and repeatable and we got a very good reception.
The fund is at $11 million now. Is there an optimal size for your strategy?
SS: We’re scalable up to $2 billion. Beyond that, perhaps we would have to add some capacity but we’re comfortable with that amount and we feel that it’s readily doable.
Your investors are entirely institutional. Does this have an impact on your management style?
EM: Not for us, again, since we manage only institutional money, I don’t have anything to compare it to, but I don’t see any reason why there would be any difference in the way we manage.
SS: Our success really lies in the fact that our risk-adjusted returns tend to be in the top quartile, of our peer group…. We feel that the way that we manage money is sustainable and repeatable. The fact that we manage the downside risk so well I think makes us attractive to institutional investors. They understand that, through the cycle, as spreads tighten, when we’re not getting paid to take incremental risk, we’ll be defensive before most of the market and as a result, we… should likely underperform for a brief period of time before we outperform when the market falls apart. So, with that said, I think institutional investors that we talk to are perfectly fine with that as long as we continue to be consistent through the cycle as far as adding and reducing risk.
I read that you went “bargain hunting” in 2009. Can you tell me what made 2009 a good year for bargains and what kind of deals you found?
EM: Well, risk was being so mispriced going into 2009 and the assumptions were so draconian, that it just created opportunities that we certainly had never seen before. There was an assumption… about companies’ abilities to refinance or even access bank lines, and the conventional wisdom seemed to become that companies would not even be able to access committed bank lines. Now, because the Fed was being so accommodative at the time, with obviously such an extraordinarily steep yield curve, we felt pretty comfortable that banks were going to lend.
There was one situation with a cruise ship line where we started out buying the shorter 2011 paper, and we purchased that in the 70s—there was great concern about their ability to finance a ship-building program. This was early in 2009 and the high-yield market had not re-opened, so we were concerned about the outlook going forward but we felt that a company like this would continue to have access to bank facilities—and this was a double-B credit at the time. As the market sort of came on board with that, those bonds moved from the 70s to the 90s, and as we moved into March and April we became more comfortable that the market was re-opening and the company would be able to re-finance on a longer term basis. We then just moved into the 2013 paper— we felt this was still prudently taking risk, so we sold a bond in the 90s moved into another bond in the same name in the 70s, and again, as the market sort of caught up with our views on the company’s ability to refinance, those bonds moved up to the 90s as well. That demonstrates… that we sort of incrementally add risk and that’s the sort of situation where, obviously, it drove some pretty nice returns as well.