By Burton Weinstein -- Corporate bonds have posted among the best returns of any asset class in 2009. Specifically, the Credit Suisse High Yield Bond Index and the Merrill Lynch High Yield Master Index have returned 34.9% and 37.4%, respectively, through August 31. Yet despite this run up, there are reasons – both macro and micro – for continuing to invest in corporate bonds. High yield bonds, defined as bonds rated below BBB-, still offer attractive yields and total return prospects in the months ahead.
The Secular Case for High Yield
There is likely to be a consistent bid for corporate bonds in the intermediate future as a result of a shift in investor preference to earn a respectable rate of return on principal, including a return of principal, in response to the credit crisis and evisceration of equity portfolios, especially by investors who have had traditionally high equity allocations of 60-65%. Cash is no alternative, with one year CDs quoted at best at 1.25% and the 10 year treasury yield at 3.45% leaves investors more exposed to interest rate rises than if they held high yield bonds, which have a large spread to treasuries. Given the fiascos associated with auction rate securities and the lack of transparency surrounding the Jefferson County bankruptcy, investors are making a great leap of faith and sacrificing liquidity when investing in municipal securities, which also bear a large degree of duration risk, with many issues maturing 15-20 years from now. Corporations that have had difficulty in achieving returns on their pension assets will need to turn more towards the relative certainty of corporate bonds to equities. The same can be said for endowments and foundations.
According to Carmine Grigoli, Mizuho Securities’ Chief Investment Strategist, there remains $3.58 trillion invested in money-market funds earning next to nothing, representing 34% of the stock market’s capitalization. This is far larger than the $2.91 trillion level seen near the market peak in October 2007, and it is interesting to note that in 2002 before the last bull market run began, money-market funds represented only 29% of the stock market’s capitalization.
Coinciding with both the change in investor preferences and the excess capital on the sidelines that increases the demand for fixed income is the reduced supply of fixed income securities, which no longer includes billions of structured finance, mortgage and asset-backed paper. Corporate bonds, it stands to reason, will represent a greater share of the market.
A Novel Approach – T.L.C. (Transparency, Liquidity and Custodianship)
After the Lehman Brothers bankruptcy, when many hedge funds assets were trapped with inaccessible assets, there was a realization that a new model was in order, based on liquidity and transparency. Cedarview Capital embarked on the creation of the Cedarview Managed Account Platform (CMAP), a separate account structure, to address investors’ concerns. With CMAP, an investor’s assets are custodied at a brokerage firm, have no lock-up and are invested in a portfolio of fixed income securities that is constructed according to the investor’s credit and risk/return profile. We call it our TLC strategy: Transparency, Liquidity and Custodianship. Investors can see their holdings on a daily basis through access to the brokerage firm’s website. Portfolios are custom tailored to each investor’s preferences, with a focus on corporate bonds that trade liquidly, and positions are initiated with institutional trading execution, providing investors with a unique product offering that is otherwise unavailable at the retail level.
CMAP account fees are lower than a hedge fund structure at an all-in 75 bps management fee with the manager participating in 15% of the profits above a 5% hurdle rate. Fees are also less than many mutual funds, which charge 150 bps for fund expenses on top of management fees. The CMAP accounts are generally un-levered (unless an investor chooses to apply leverage) and have the flexibility to hedge through ETFs or the short sale of bonds. As part of the CMAP platform, for accounts over $5 million, Cedarview also offers separately managed accounts to invest in leveraged loans for investors seeking exposure to a floating rate asset class with superior downside protection. From a standing start at the beginning of the year, Cedarview has raised $35 million for CMAP and, as a firm, now manages more than $100 million of investor capital.
While we are hesitant to say that the economy will exhibit a V-shaped recovery, there are many signs that lead us to believe that the worst is behind us and that a long-tailed recovery has begun. Specifically, we are encouraged by the following key signs of an economic recovery:
- The Conference Board consumer confidence index rose to 54.1 in August from 47.4 in July, with a 10-point increase in the expectations component driving most of the move, and the University of Michigan Confidence index rose to 65.7 from 63.2.
- New single-family home sales jumped 9.6% month-over-month in July to an annualized pace of 433,000, and there was a net upward revision of 34,000 to prior months. New home sales are now up 32% from their January trough, but they are still only at their highest level since last September and one of their lowest levels in the last half century. With sales so low, there is considerable room for a rise in coming quarters even if one does not expect home sales to get anywhere near their level at the peak of the housing boom (over 1.3 million).
- The July durable goods report, which was quite strong, joined other data in showing that manufacturing is on track to grow again in the third quarter after a number of quarters of weakness.
- Initial jobless claims fell to 570,000 in the week ending August 22 from 580,000 in the week ending August 15 (revised from 576,000). Jobless claims are still high, but it appears that they are trending down. This is clearly positive for the labor market.
The economic backdrop was described by Peter Acciavatti, the head of Global High Yield Strategy at JP Morgan, in a report published at the end of August. He wrote that “the positive rate of change still being exhibited by many economic indicators, coupled with the likelihood that economic conditions will continue heading in the right direction over the next month, leaves it increasingly unlikely that a meaningful correction in risky asset prices is imminent. Instead, it is more likely that double-digit yields (11.1%) and spreads still more than 300bp above their long-term median (876bp versus a 517bp 20-year median) will continue to attract interest from investors over the coming months and support the current spread environment.”
The Current Opportunity Set
A cornerstone in any economic recovery is the opening of capital markets for IPOs and lending for new M&A. We just witnessed the first such fully committed leveraged loan deal announced last week as Warner Chilcott received a fully financed commitment letter to buy Proctor and Gamble’s pharmacy unit. In the chemical sector, Huntsman is buying Tronox out of bankruptcy, and in the oil and gas industry, Baker Hughes is buying BJ Services for cash and stock. In the media sector, Disney is buying Marvel Entertainment There have been several recent IPOs of Sponsor owned high yield companies, including Avago and Emdeon, and several more have been announced, including InfrastruX and Dollar General Corp. Many IPOs are used for de-leveraging, thereby benefiting the bonds in the companies’ capital structures. M&A transactions also serve to establish multiples and valuation benchmarks that will embolden private equity investors to bid for companies. This will benefit the bonds of small to medium capitalization companies as bonds of smaller companies tend to trade at higher yields than those of larger companies. The following companies (which Cedarview owns in its portfolios) have similar characteristics – they are businesses exhibiting strong and steady free cash flow, with debt maturities in the next 3-5 years, where there is a significant amount of equity cushion below the debt based on comparable industry valuation multiples.
|United Components 9.375% Senior Sub Notes due 6/15/13
||Manufacturer of automotive aftermarket replacement parts
|SGS International 12% Senior Sub Notes due12/15/13
||Graphics designer for consumer products packaging
|Reddy Ice Holdings 10.5% Senior Notes due 11/1/12
||Manufacturer of ice for consumer use
|Travelport 9.875% Senior Notes due 9/1/14
||Provider of content from travel industry suppliers to travel agencies
* Debt through the tranche of the bonds
** Market value of debt through the tranche of
the bonds relative to YE2009 expected EBITDA.
The bonds listed above are representative of many high yield securities that are trading with attractive yields, partly as a function of issue sizes, but more so because of the dislocation that has occurred on Wall Street in the last year. Specifically, many traders who made markets in these bonds at their former firms may not be assigned to trade them at their new locations. With the increasing demand for corporate bonds, boutique trading firms are picking up the slack by making active markets, even without committing capital to the trades. Additionally, Private Equity firms are forming Annex funds, raising cash to be able to take advantage of discounted bonds of companies in which they own that are in older funds that are unable to invest new cash. This will provide additional bid support to the high yield market.
We are therefore excited by the historic investment opportunity that remains in the high yield market place and clients that wish to take advantage of this opportunity will be well served by our T.L.C. approach in our managed accounts platform.
Burton Weinstein is the Managing Partner of Cedarview Capital Management, a New York based Registered Investment Advisor. Prior to establishing Cedarview, Weinstein served as a portfolio manager for four years managing a $120 million hedge fund, Aviary Capital, dedicated to bank loans, high-yield bonds and distressed debt investments. Before that, he worked at Gabriel Capital, a $1 billion New York-based hedge fund where he concentrated on distressed investing and risk arbitrage.