John Sheehan on the Schwab Network: Why “Junk Bonds” is a Misnomer

Sam Vadas: It's time to spotlight the fixed income market. Joining us now is John Sheehan, who's the Portfolio Manager at Osterweis Strategic Income Team. Okay. I suppose we can't talk about the bond market and what we've seen certainly in some of the investor reaction to the news headlines is obviously the pressure on Powell and what that did as far as offering us a bit of a glimpse into what the market might feel as far as whether he was shown the door, particularly when you look at a steepening yield curve. I just want to sort of get your 30,000 feet view on how you're looking at the bond market right now.

John Sheehan: Sure. Yeah. So obviously a lot of attention around Jerome Powell. We think that if you take a look back, the yield curve has been flat for quite some time now. It's really back to the regime when we had much higher inflation. We've made a lot of progress on inflation, but not all the way down to the Fed's 2% target. So I think Powell has stated numerous times that he's going to be patient, his decision's going to be data-based. But he's even alluded to the fact that he's probably holding off even longer because of the threat of tariffs.

He doesn't know how that's going to impact inflation, and if those higher prices from tariffs are going to filter through to the consumer. At the end, we think a lot of this is just headlines and not really having that great of an impact on what we do and how we look at the world. So I think it's going to blow over like a lot of the big headlines that we talk about in the world these days, and that we do expect that we'll probably have one or two rate cuts by the end of the year, and it's not going to be very heavily influenced by the politics.

Sam Vadas: Okay. Good to know. I mean, once we've got that headline out of the way, we can unpack some of your thoughts about how you do see the world, and one of those is that you think that investors should rethink junk bonds.

John Sheehan: Yes.

Sam Vadas: Talk to us through that thesis.

John Sheehan: Sure, absolutely. So when the junk bond market really came to its birth, that title, "Junk bond" is a little bit of a derogatory negative connotation.

Sam Vadas: Right.

John Sheehan: So that stuck with it really for the next 30, 40 years. And we think that the market has evolved quite significantly, in particular that the credit quality has improved. Even if you look at the rating agencies, they place 20 different categories of ratings whether a company is going to pay you back or not. They drew a line between triple B and double B, between investment grade and non-investment grade.

We think that in many ways is oversimplification. There's some very good qualities that they give below investment grade ratings to, some pretty heavily levered companies that may not be able to meet their debts in the investment grade world. So we think that that junk bond terminology is not necessarily accurate of the credit quality in the market.

Sam Vadas: Interesting.

John Sheehan: If you look now, over 50% of the bonds in the high yield universe are rated double B, which is the highest rating in the non-investment grade world. Over 50% of the investment grade bonds have now rated triple B. So you've seen this very heavy concentration around that line created by the rating agencies.

So the companies that we look at tend to be smaller, which is why they're non-investment grade. We don't think that that necessarily makes them a greater credit risk. It's just one of the criteria that the rating agency use is the size of the company. So we're able to find very good companies, smaller companies, that we feel very good about their credit profiles.

Sam Vadas: What do they say, one man's trash is another man's treasure, or something like that? I mean, that's also, I suppose, a derogatory term in this context, particularly because you are talking about, you have to sort of shift your perception as to how these credit ratings are actually scored.

John Sheehan: For sure.

Sam Vadas: To your point. You mentioned some of the companies, I mean, where are you seeing a good return on some of that higher yield? What sectors? What companies are you looking at?

John Sheehan: Yeah. So I'd say first and foremost, we look at eliminating the biggest risks in the marketplace. We manage our fund towards protecting the downside for our investors. So we avoid sectors that we think have the greatest risk. So energy and production is one, and the oil universe. One of the metrics that we think about is if this company were to go away tomorrow, would anyone notice? If an energy and production company went away, there'd be someone there punching a hole in the ground tomorrow to take their place.

So this leads us to companies that are crucial to the economy, crucial to their customers. So we own a good number of food distributors. They distribute groceries to supermarkets. We have a good investment within the airline space, both in terms of carriers and the lessors. It takes a tremendous amount of time and energy to produce an airplane in this day and age. The people that have that equipment and are able to lease it out to their end customers, the airlines, are in a very good place right now. They're starting out as high yield companies, but it's important for them to get to investment grade. So they do what it takes to improve their credit, which benefits the bondholders.

Oftentimes, they'll get too successful and move beyond our yield targets. And then we have other kind of smaller companies. We own a company that produces the credit cards. They don't issue credit cards. They produce the physical credit card. They have a very substantial percentage of the marketplace. So you lose your credit card, someone hacks your credit card, you call up your bank. They're the ones who put it in the mail and send it to you. But it's a very technical process, making sure that it's secure and there are billions of cards outstanding and they have a big place in the marketplace.

Sam Vadas: I don't know if this is related, but I've just got my bank actually calling me on my phone, but I won't answer that phone call. But I would like to pick your brains on private credit and certainly as far as the regulatory environment is concerned for banks, how that's impacted the broader market there as well.

John Sheehan: That's another piece of our calculus as to why we think high yield represents value here. So when the high yield market began, it was a two-tier market. There was investment grade and non-investment grade. Over the last 30 or so years, we've seen the evolution of the broadly syndicated loan market, leveraged loans, and then private credit. So now if you're an issuer, you have four different tiers of the marketplace. Highest quality go to investment grade, then high yield.

So private credit and leveraged loans tend to be the lower quality issuers within the credit market. To your point, a lot of that came to be because of the regulatory changes after the financial crisis. The big regulators did not want systematically important banks lending to lower quality borrowers, both individuals and corporations. So pushed out a lot of that lending activity away from the bank market into non-regulated entities like the private credit providers.

Sam Vadas: Okay. Which is why you obviously see some of the opportunity there with the rapid growth we've seen there. It's been a really fascinating chat. Thank you so much. We have to wrap it up there. We've run out of time. But thank you for joining me on the desk today.

John Sheehan: Thank you for your time. I appreciate it.

Sam Vadas: Awesome. That is John Sheehan, the Portfolio Manager of Osterweis Strategic Income Team joining us here.