Published on July 9, 2024

If you were unable to join the Not All High Yield is Junk webinar, watch the replay to learn why ratings alone are insufficient to define such a diverse and dynamic market and how investors can utilize market inefficiencies to construct high yield portfolios with risk profiles similar to investment grade portfolios.


Shawn Eubanks: Good morning, everyone. My name is Shawn Eubanks and I'm the Director of Business Development at Osterweis Capital Management. I'd like to welcome you all to our educational webinar titled, "Not All High Yield is Junk: It's a Market of Bonds, Not a Bond Market."

Today's session will feature our strategic income team, including Carl Kaufman, Craig Manchuck, Brad Kane, and John Sheehan. Thank you all for attending today.

Carl Kaufman: Thank you Shawn, and thank you for attending as well.

Today we hope to give you a better understanding of the high yield market, hopefully dispelling some of the myths surrounding it. As we like to say, "it's a market of bonds, not a bond market."

We'll start with how the rating agencies look at the market. We'll follow with an overview of the market, and we'll finish with some of the risks to avoid and opportunities in high yield.

But first I'd just like to give you a little history of the high yield market for those of you who weren't around when the railroads were being built in the 19th century, like I was. That was really the beginning of non-investment grade bonds. But the modern high yield market really began around 1980 with a seminal paper that was written by a gentleman named Michael Milken, who many of you may know of, who posited that the excess yield found in the high yield market non-investment grade bonds more than compensated for the risk of higher defaults.

Clearly, at the time he wrote it, we had very high interest rates and banks were collecting a lot of deposits. Insurance companies actually started using high yield as a way to compete with banks in their insurance annuity products, especially guaranteed investment products, where they guaranteed a rate higher than the banks in their annuities and kept the excess for themselves. It was very profitable.

When you look at that beginning, clearly you needed paper to be created for them to buy, and as with anything, cycles go too far. We had our first default cycle at the end of the 1980s, and after that, high yield got a bad name. That's with the S&L crisis I'm sure you're all aware of. But since then, the market has matured. It's gotten much bigger. It's become a regular source of capital for companies raising money that are not investment grade. We'll hope to get into that a little bit later and show you why it's a great asset class.

And with that, I'll turn things back to Shawn for our first polling question.

Shawn Eubanks: Thanks, Carl. This is our first polling question of three, for the day. The polls are designed to give you an opportunity to share your perspective on investing in the high yield market. They'll also provide us with a little more insight into how you're thinking about the topics that we're discussing today, so we can make sure that the presentation addresses what's top of mind for you. Also, the polls serve as informal section breaks. Each time we have a polling question, we'll be pivoting to a slightly different topic.

The first question on your screen is fairly straightforward. We're curious to see how you allocate to high yield in your portfolios. This will not only let you see what your peers are doing, especially if you're financial advisors, but your answers will help us understand the types of investors in the audience today. We're anticipating a decent split between people who use high yield and those who do not, but it will be helpful to see what the actual numbers look like.

Okay, so the polling is up. It looks like the vast majority, about 62% of the audience, uses between 0% and 15% allocation to high yield in their client portfolios, with the next largest section being 16% to 30%.

I'll now turn it over to John Sheehan to present the next few slides.

John Sheehan: Thank you, Shawn. The construct around investment grade and non-investment grade, (or high yield or even junk bonds), is created by the rating agencies. The two primary rating agencies are Moody's and S&P. As Carl mentioned, they came to being in the mid-1800s around an increase in issuance of bonds to fund the railroads.

But we wanted to peel things back a little bit and give an explanation as to what the rating agencies are trying to convey with their system. And really, what they are looking to do is put a system around a particular company or a particular bond and its likelihood of paying you back in full and on a timely basis. We've took here two mission statements, both for Moody's and S&P. We compared them side by side. I'd say that we were struck by some of the similarities between the two statements.

First and foremost, they both use forward-looking opinions. This makes sense, given the fact that bonds have principal and coupons that pay in the future. So it really needs to be an estimate or a prediction of the likelihood of those payments coming through in the future. And then they also look at the credit risk within. They do have slightly different takes on how they define that credit risk, but I think you'll see there's some similarities between the two. But these two statements are really the framework for the entire division between investment grade and non-investment grade.

The first rubric here is from Standard & Poor's. They use what we would describe as a building block methodology. The first starting point that they use is the country risk. If you think about a corporation that's located in the United States with its laws and regulatory environment relative to an emerging market company, you can see that the country risk is a logical first place to start.

Next is industry risk. There are certain industries that are inherently riskier. If you were to think about a biotech company, something that's a very digital outcome on the future of the company, versus something a lot more stable like a utility or other companies with regular cash flows. They use that to define the business risk. Then on top of that, they look at the individual company's financial risk. This is getting at the cash flow and the leverage that the company has able to pay back their debt.

This is what they use to form their core company risk. Then they layer on top of that different modifiers. You can look here on the screen, but capital structure, financial policy, liquidity, are some of the more important ones that will lead them to come with their standalone credit profile.

And then lastly, they put an overlay of group or government influence. I think this is most relevant for regulated industries. If you think about a bank or an insurance company, the government has a very, very strong influence on the company's likelihood of paying their bondholders back. And they take that to come with the final issuer credit rating.

Moody's uses some of the same input. I think their rubric is a little more descriptive in terms of the weightings that they place on each of the different inputs. The first is the scale of the company. This is something that we'll talk about a little further in detail, but this is a big driver of when companies are rated investment grade versus non-investment grade.

Moody's places a big 20% weight on the scale of the company. You'll see a lot of the companies in the investment grade universe are just bigger companies with larger footprints. Not necessarily better credits, but because of that 20% input, they tend to be more rated investment grade than non-investment grade.

Business profile, this is something that we do spend a good amount of time on. I'd say this is probably the most overlap between looking at a company for its equity research versus credit. This is something that we here at Osterweis use when we're doing a bottom-up analysis of a company.

Profitability and efficiency. I think it's a little funny that they only place a 5% weighting on that. I think something like the profitability of a company should be given a greater weighting.

Then the largest weighting that they have is what the market analysts and market participants probably focus the most on. So it's interesting that it's only 35%, when it's probably the vast majority of the discussion in the marketplace. But these are leverage and coverage ratios. This is just identifying how much of a company's cash flow and how much of their organic business is available to pay debt service. This is something that we focus on, but I think you'll see later in the presentation again that there's a pretty heavy crossover between the leverage and coverage ratio of investment grade companies and non-investment grade companies.

And then lastly, 15% is allocated toward financial policy. This is something that we feel is underlooked in the marketplace. This is really how the C-suite of a company manages their business with respect to the equity holder and the shareholder. This will come down to policies regarding their dividend, share buybacks, M&A, et cetera. We do focus quite significantly on that last pillar.

This is a slide that I'm sure we're all well aware of, but what we're trying to show here is the line that is drawn between investment grade and non-investment grade. We've included Fitch here along with Moody's and S&P. But really, they're taking a tremendous amount of granularity, when you look across at all the different ratings buckets, for what is really a binary outcome.

A company either pays you in full and on time or they don't. And you'll see that some of this is, in our minds, a little bit of false precision where some of the non-investment grade companies have better credit metrics and ultimately have a better probability of paying you back than some of the lower investment grade. We'll also see later on in the presentation that there's a heavy concentration of bonds outstanding in the lowest rungs of investment grade and the highest rungs of non-investment grade.

Now I'll turn it over to Brad for a discussion on default rates and how the rating agencies look at that across the spectrum.

Brad Kane: Yeah, thanks John.

Here's annualized default rates by rating category at time of default through 2023. And as one expects, the lower rated categories have higher default rates. It's worth noting though, that as company fundamentals deteriorate over time, rating agencies are downgrading debt securities. Corporate issues are most often then rated CCC+ or lower, immediately prior to default. And only about 5% of initial ratings are in the CCC category. So the lion's share defaults were more highly rated at some point in their life cycle.

If you go to the next slide...

As a bondholder, you either get paid as expected, whether it's at maturity or you get called or tendered, or the company defaults. And when defaults come, they can come from non-payment of interest to principal, violating an indenture. Or when a company tries a liability management exercise, often referred to as a distressed exchange. Distressed exchanges are typically highly coercive and they push bondholders to take a haircut on their existing position in exchange for a higher coupon and future maturity. All this really does usually is kick the can down the road...may not help your overall recovery at the end of the day.

It's important though to note that when bonds default, they don't default from par. Like the ratings categories declining over time as fundamentals deteriorate, so do bond prices. And so by the time companies default, typically the bond price is reflective of the estimate of what the recovery value would be. If you sold it after a default, that would be your recovery value. Or if you held it through a default, through a bankruptcy, that's most likely what the market thinks your recovery value is.

For example, if a bond defaults and the recovery is 45%, your default loss would really be 55%. It's not 100% default. So the thing to always think about is where is the bond trading when it defaults and what you paid for it, versus looking at the general market and saying, "Oh, well, let me just say everything's going to go down 55%." It doesn't exactly work that way.

And the other thing to note, distressed exchanges have been the majority of the recent wave of defaults. In fact, in 2024, 81% of all defaults were distressed exchanges. This has skewed default rates a lot higher than you would typically see if it was just based on non-payment or violations of covenants. It's a trend we're looking at and waiting to see as those waves of distressed exchanges kick the can down the road, and whether you see higher default rates down the road from the non-payment.

And now I'm going to pass it over to Shawn for another poll.

Shawn Eubanks: Thanks, Brad. As you can see, we've posted our second polling question which asks for the breakdown of how much of your fixed income allocation is passive.

As I mentioned earlier, the polling questions are also informal section breaks in the presentation. The next few slides, we'll take a closer look at how fixed income indexes are constructed and some of what you hear may surprise you. We'll also take a look at the structure of the investment grade and high yield markets, including how they differ, and more importantly, how they align.

Okay, we can see the results of the poll. Looks like about 66% of respondents said that 20% of their fixed income allocation is passive, while 13% responded either 21% to 40%, or 41% to 60%.

I'll now turn it over to Craig to present the next few slides.

Craig Manchuck: Thank you, Shawn.

The high yield market at a glance: it's a $1.4 trillion market. That has grown substantially over its time in the last 40 years. There have been times when it's probably been as big as 1.8 trillion and through debt repayment and other refinancing options, it's now down to about 1.4 trillion.

Should be said that both the leveraged loan market, which tends to fund the CLO issuance and private credit, are two other alternatives that exist out there in the below investment grade universe. They're not captured as part of this high yield index. This index only represents fixed-rate coupon bonds with at least one year until maturity that are issued in a size of at least $250 million issue size.

It's comprised only of corporate debt and most of the companies are small- to mid-sized companies. You won't find the Googles and Apples of the world in the high yield market, although there are a few who are fallen angels, who at one point were investment grade, but through difficult times, poor operations, lower profitability, some bad corporate event, have fallen out of investment grade and become non-investment grade. Those are then added to the high yield index.

A lot of the companies are newer and they tend to have shorter operating histories, or they are the result of bankruptcy exits. Another large cohort comes from leveraged buyouts, which are backed by private equity sponsors who use the high yield market as one of the vehicles with which they're able to lever up their equity investments for the benefit of their limited partners.

Next slide please.

This is just a quick rundown of the composition. Most importantly and most tellingly here, we look at the ratings by weight and you can see that 48% of the market is BB. That has increased and improved significantly again over the last 30 or 40 years. Previously, I would say it was a much lower quality index overall. And much smaller companies, or much more highly levered companies with weaker operations, were financing in the market.

But today, as John alluded to earlier, the difference between a BB and a BBB can sometimes be very, very slim. And it's essentially somewhat of an arbitrary line that the rating agency's drawn between the two. So with almost half of the index now being comprised of BB credits, the broader market is really quite a healthy market, made up of pretty good companies that are generating consistent free cash flow and with a very high probability of paying us back.

Just go back for a second.

The single B is at 39%. So with CCCs at only 13%, the market is in pretty good shape credit wise. And just quickly, the sectors by weight, energy tends to be a very large sector and issuance because you have a lot of E&P companies and energy service companies that are in the development stage, drilling for oil. As they start out in the early stages of their history, they're generally spending money and not generating cash while they're drilling wells and things. Eventually if they do well and they're successful, they'll grow themselves up and out of this and into the investment grade market.

Next slide.

These are the top 10 issuers in the market here. As you can see, Charter Communications, it's a pretty large company, but they also are extremely indebted. What you tend to see is that the largest issuers tend to be fairly highly levered. Charter cable company, four and a half times leverage. But Altice, which is a private cable company at over seven times. TransDigm at over six times. Bausch Health and Community Health at over seven times.

The index, as you look at it, is a really strange animal. John will probably talk about this a little later, but the way the market sets up is unlike the equity indices where they have a market cap waiting. The high yield indices are skewed by the companies that actually borrow the most, not necessarily because of the size of their market cap.

So, it can create an odd distortion as to what you actually would like to buy as an investor if you're buying the index rather than investing in somebody who is security selecting out and eliminating from their investment pool, some of these names that are the most highly levered, but just happen to represent a large component of the index.

John Sheehan: Just following on from Craig, a little background on the investment grade market. The index that we look at, and I'd say is the market standard, is the Bloomberg US Aggregate. First off, the investment grade market is substantially larger than the high yield market. The index represents about 27 trillion, which is about 20 times the size of the high yield market.

When you drill down into the components, you can see a lot of the reason why the size is so much greater. 42% of the index is U.S. Treasuries. That number has been growing and will continue to grow. We all know about the growth of the deficit at the U.S. federal government. The index reflects that, and we'll likely see that 42% weight and continue to increase.

The next largest component of the investment grade index are securitized bonds at 28%. The bulk of this are mortgage-backed securities; Fannie, Freddie, Ginnie Mae securities. Commercial mortgage backs come next, and then a small piece in aspect securities. Corporations are 25%. And then 5% in other government issuers.

If you look at some of the security types, there is a lot of overlap in terms of the type of bonds. They're fixed rate, they have at least one year to maturity, senior, and subordinated. This does not include contingent capital securities. Really, I think they look and say anything that can be converted into equities is not included in the investment grade bond market.

Similarly, when we look at the ratings breakdown within investment grade corporates... This is just focusing on the 25% of the index that is issued from corporations, close to 50% are rated BBB. A very similar percentage that is rated BB in the high yield index. You can see that heavy concentration around that dividing line that the rating agencies have created.

Within sectors, the banking sector is the largest sector by weighting. If you are a large G-SIB bank, the regulators pretty much dictate that you have to be investment grade, otherwise they'll restrict your balance sheet growth, et cetera. But outside of the banking sector, it's a very good snapshot of the economy in general. When we go into the top 10 issuers, you'll see where some of the heavy concentrations lie.

As I said, this is the top 10 issuers within the index. It's notable that 70% of the top 10 are BBB. If you contrast that to the index as a whole, it's 48. It's, again, heavily favoring the largest issuers. There's one exception in here, Apple. They are AA+, they're AAA by the other rating agency. They do have a significant amount of debt outstanding, they're below one times levered. And this is really just a tax play. They sell products overseas, they don't want to pay taxes on bringing that proceeds back home. So they keep the cash overseas and they issue debt here to access the cash.

But with the exception of Apple, if you were to look at the other nine of the ten largest investment grade issuers, I'd say 20 years ago, this probably would've been a blue-chip equity portfolio, all big household names. But they are also very, very heavily indebted. Several of them have over a hundred billion of debt outstanding. And again, when you look at the leverage ratios, many of them are three or four times levered. Craig highlighted some of the high yield issuers that have similar leverage. And then something like a Duke or even an Amgen at five or six times levered, that's really getting into high yield levels of leverage.

And I think the rating agencies, back to the rubric, they do give these companies a good benefit of doubt given their scale. They feel that they have lots of levers that they can pull when they need to. Some of where they are, in terms of their leverage and the amount of debt outstanding, is collective. A lot of these companies gorged themselves on issuing debt when interest rates were incredibly low. They used that to fund M&A, they used it to fund share buybacks, dividends, et cetera.

But I think when you look at the balance sheet of some of these companies, especially some of the ones at the top, like a Verizon and AT&T who are in slowing businesses and businesses that are facing secular changes within the products that they offer, they have very, very little margin of error. So, pretty much every dollar of free cash flow at an issuer like Verizon or AT&T is already spoken for between dividend share buybacks and debt repayment. If there was a significant change to their business, you could see some pressure on their ratings.

Taking it back to the high yield market. The ratings are static, so they do change over time, but they are slow to change. I think the rating agencies will look quarter to quarter or even over longer time periods. But what we look at is how the bonds are trading on a daily basis, even minute-by-minute basis.

What we've done here is we've taken the trading range. The left axis is the OAS or the spread to Treasuries of bonds by ratings bucket. And I think what you can notice here is there's a very wide dispersion of where a bond could trade within a given ratings bucket. We highlighted a band across of spreads between 200 and 500, and with the exception of the bottom rung, in the lowest rung of CCCs, there are bonds that trade between 200 and 500 in pretty every ratings category in the marketplace.

This tells us that the market has very different views on the credit risk of the bonds than the rating agencies would imply, and it also tells us that there are great opportunities through doing credit work when you can find good risk-adjusted returns and not relying solely on the rating agencies.

We've identified one research firm. This is a system that Bank America has developed called Credit Stress Indicators. But instead of looking at the rating agency rubric, they've created their own rubric. They have three inputs into their system.

The first is market access. Most of the bonds in both investment grade and high yield do not get paid off with cash. They get paid off by issuing another bond. Having that ability to refinance is crucially important. They look at the volatility in both the credit and equity of a given company. And they look at how frequently the bonds trade in the marketplace.

They then take them and they break it into 10 deciles. The lowest decile, the tenth decile, is where we see 95% of the default in the marketplace. A further 4% of default come from the ninth decile. If you look at this, it is just proof that you can identify where the most likely defaults are going to come from, and it doesn't always correlate with the market. There are CCCs all the way up into the seventh decile. There are BBs all the way down into the seventh decile as well. So there's a tremendous amount of overlap.

And this is just a graphic proof of how credit work can help you identify where the defaults are most likely to come from. And on the positive side, where potential upgrades into investment grade are likely to come from.

Craig Manchuck: Okay, thanks John. One of the things that we feel is a key to being successful as an investor in this space is to make sure that our incentives as bondholders or lenders are aligned with those of the company. What I mean by that is, we want to make sure that the company wants to invest the capital that we're going to give them in productive uses, rather than using them to try to pump up their stock or leverage the business up for share buybacks, or to pay dividends out to equity holders who are lower down in the capital structure.

We often probe and poke at our companies to make sure that they aren't doing something stupid with capital. Many years ago, Peter Lynch wrote a book called One Up on Wall Street and he said, "Invest in companies that an idiot can run because someday an idiot will be running them." And we need to make sure that our management teams are not being stupid with the capital. So aligned incentives are really key here for us.

Next slide here.

We always have to stay on guard and we're looking at two different elements here. One, large benchmark issues which are bought by all the passive investors and by the benchmark hugging strategies, they tend to attract the largest amount of demand. They tend to price the tightest. Oftentimes they are bigger companies, so people feel like there's more safety, but they feel like there's safety in numbers of investors.

What tends to happen there is the yields tend to be lower and they tend to get whipped around in a much more volatile fashion with market moves. We can buy them opportunistically and we like having them out there in the market so that we can put money to work during opportunities that are created during selloffs. But for the most part, you're just buying the index in doing that.

The important thing that we have to be careful about is investing in sponsor-backed leveraged buyouts. This is one of the areas that is fraught with the most risk. When you read about it in the media, it's talking about the junk market, and this is what they are really alluding to. It's primarily because the sponsors are using leverage to lever the companies up as much as possible to supercharge the returns on their equity for their LPs.

It's not necessarily an aligned interest with ours as bondholders, and it's not really in the company's best interest. This is just what they're willing to do because they tend to play with the house's money. They also tend to tilt the tables very far in their favor in terms of covenants and protections. It allows them the flexibility to do a lot of things that can be very damaging to bondholders. That's something that we always tend to shy away from.

Shawn Eubanks: Thank you, Craig.

We'd like to share our third and final polling question now. This one's designed to give you a chance to express your biggest reservation about investing in high yield bonds. We've had a lot of conversations on this topic with investors over the years, and this includes three of the most common concerns that we hear about. During the next section, we'll do our best to address some of these concerns that you may have about the asset class in general, which of course we think is a good fit for many portfolios.

Okay. This is more widely spread here. I would say that obviously the top response is that high yield bonds are too correlated to equities.

John, if I could ask you to cover the next few slides please?

John Sheehan: Sure, absolutely.

Here we want to just do a little retrospective on how high yield has performed. Here we're focusing on the returns versus investment grade, but also versus equities. Again, we want to reiterate that both the investment grade index and the high yield index is weighted by the amount of debt outstanding. It really favors indebtedness and rewards indebtedness, whereas the equity index, the S&P 500 is a market cap-weighted index, so it really favors and rewards success.

But all that said, you can see here how high yield has performed versus both equities and investment grade. We started this back in the beginning of 2001. It's notable that high yield had outperformed equities up until about the end of 2020, also with substantially lower volatility. And really, high yield has outperformed investment grade at every step. You did have a slight dip in 2008 around the financial crisis, but what we'll show in the next slide is that high yield recovers very well in those downdrafts.

Here, it is breaking out high yield versus the three components of the investment grade index. I think it's important to note here just the duration of the different products. U.S. mortgage backs, Treasuries, investment grade corporates, all have substantially more duration risk than high yield corporates do.

They also have substantially less yield, so it really puts the focus on credit selection. Even at the index level, you're able to more than compensate for the credit risk through the incremental yield, and also because of the shorter duration, you are able to have your initial principal returned to you, and reinvest so that high yield corporates do better in a rising interest rate environment than the longer duration investment grade products would.

This gets to, I think, the correlation versus equities. Many advisors like to have a fixed income product that is an offset or a counterbalance to their equity portfolio. I think that that is a perception in the marketplace that is a little bit overvalued, in our opinion. In the handful of times where high yield does have a down year, it snaps back very nicely. Here we show how it performs in the next year, but there's many studies that have shown that high yield significantly outperforms for the next two, if not three years, after a downdraft.

And then lastly, when comparing the investment grade corporate market versus the high yield market, we wanted to show the percentage of the yield of investment grade corporates that is attributed to its spread. If you take the yield of a corporate less the yield of the underlying Treasury, we are pretty much at all time lows right now. Right now you're getting less than 20% of the total yield from credit spreads.

So really, what this is meant to convey is that investment grade, even at the corporate level is really just a bet on duration. If you get duration right here, you're going to do okay, but you're not going to be compensated with enough spread. In the investment grade corporate index 50% BBBs, you're taking a lot of BBB risk for very little compensation.

Compare that to an extreme time like the Covid lockdown, the yield of investment grade corporates was almost 80% attributed to spread. So there, you didn't need to get a duration right. And that's pretty much exactly what happened, is that the tightening of spreads from that point has more than offset the increase in yield due to duration.

Here we'll turn the last two slides of comparison over to Carl. I think this is just a good snapshot of the duration which I alluded to, but also the risk and the return of the various asset classes.

Carl Kaufman: Thank you, John.

In sum, I think you can fairly say that the original premise of high yield in Mike Milken's paper still holds and has been proven out. High yield returns as you can see here, including delinquencies, still well above investment grade while delivering higher current income, sharpe ratios, and a lower sensitivity to interest rates.

If you decrease risk by actively avoiding the riskiest sectors of the market, as Craig mentioned, the LBO-sponsored as one example, being proactive with your maturity profile and being selective of the type of risks you buy, then I think you can even increase this outperformance even more.

Next slide please.

In summary, ratings are a guide, they're not absolute measure of credit risk. They should be taken as such. Indexes are dominated by the biggest borrowers who are not always the best credits.

High yield is misunderstood. I think inefficiencies in the marketplace and in the ratings agencies give us opportunities to deliver higher risk-adjusted returns than investment grade, which is typically the largest allocation to fixed income by investors. And while it is non-correlated, so is my desk, but it doesn't make it a good investment over time. So we feel it's an excellent complement to traditional core investment grade.

And with that, I'll turn it back to Shawn.

Shawn Eubanks: Thanks, Carl.

We'll now begin our Q&A. As noted on the slide, please ask a question through the Q&A window or raise your hand to ask a question over your computer audio or by phone.

Have a question here for the team. Do you think there's still alpha capture in fallen angels?

Carl Kaufman: Okay, I'll take that one.

Yes. Fallen angels come in different flavors. Typically, what it is, it's a company that has been deteriorating either through industry conditions or company-specific actions. It can happen slowly, it can happen quickly. They generally do not trade at investment grade yields the day before they get downgraded to high yield, so they're already there. But for the quality of the company, if the yield is the same as high yield and there's a chance that they fix their problems and get upgraded, there is upside there.

I don't know if my fellow panelists have any additional comments.

John Sheehan: I would just add that oftentimes there's a technical element where when those bonds are migrating from the investment grade index to the high yield index, oftentimes they can overshoot on evaluation because you have a flood of forced sellers and you've got to find people to absorb those bonds.

And in particular, the shorter duration bonds tend to get cheaper the most, just because those are the bonds that people don't mind selling and are willing to take a little bit of a haircut on. That technical factor can drive valuation as well.

Shawn Eubanks: Can you define distressed exchanges?

Craig Manchuck: Yeah. I got that one, Shawn.

A distressed exchange is where a company is heading towards bankruptcy or some other type of restructuring, and rather than go through a formal legal court ordered bankruptcy process, they'll reach out either through an advisor and/or a lawyer to their bondholders or other debt holders, and speak to them about a way to maybe renegotiate their debt obligations.

As a result, what they often do, the bonds tend to have been trading down at a discount. And they will come back and the companies will say, "Well, you take these billion dollars' worth of bonds that we owe you and we'll exchange it for $650 million with a higher coupon and maybe some higher seniority."


Brad Kane: I would add one thing to that, which is that per J.P. Morgan, 39% of distressed exchanges ultimately go into another default down the road. So all you really do, as I said before, you're kicking the can. Yes, you might get some coupons in the short term, but you're not really changing the outcome for your ultimate investment.

Shawn Eubanks: Thank you. I have a question. Can you compare and contrast the high yield market with the CLO market please?

Carl Kaufman: Bradley take that one.

Brad Kane: Yeah. The high yield market, obviously, market of bonds as we're talking about. CLO market, structured products, investing in leveraged loans. What we've seen over quite a few years now, the majority of the leveraged loans are being used to finance large, highly leveraged private equity-funded leveraged buyouts.

And so you're taking on both floating rate and the levered, essentially high yield exposure within the loan market. Not directly with corporate counterparties that we would like to see being good stewards of capital, but ones that are trying to find ways to take capital out to fund the dividends and the sponsor returns.

Carl Kaufman: I would also add that CLOs are basically passive investments. Once they've structured it, that's it. And they are tranche, so you can buy different tranches of it. Each will have a different yield structure, but they are a little bit opaque. I'll leave it at that.

John Sheehan: Yeah, there's a big ratings arbitrage where the structure is geared towards people who are constrained by ratings and are not necessarily capable of doing their own credit work.

Shawn Eubanks: Thank you. Can you elaborate on why you say it's a market of bonds and not a bond market?

Craig Manchuck: Yeah, I'll take that one, Shawn.

Carl Kaufman: John'll take it.

Craig Manchuck: In our world, every single security is structured differently in the high yield universe. That's very different than what you see in the investment grade universe. In the investment grade, corporate bonds are all typically issued with the same covenants. That's essentially zero.

In our high yield world, every single deal is hand-carved and structured to make sure that the protections, and the limits on leverage and limits on moving capital around, are allowing the company enough flexibility to operate their business and do what they need to do to run the business, but not giving them too much room to suck too much money out of the company.

Each investment that we make, coupons are different, maturities are different, business risk is different, but structures also tend to be very different. And so when we can go out into the market and invest, we don't want to just say, "Oh, the market yields this" or "CCCs yield this."

John had a slide earlier where he showed the dispersion of spread and yields that exist within different ratings buckets. We can find a CCC that has a reasonable amount of leverage, or maybe it's a smaller company, but we think has a higher probability of paying us back than sometimes a B or B+ rated credit that we think is a far riskier endeavor. We might be willing to accept a slightly lower yield for a certain CCC than we would for another type of single-B. And so, you can't just buy the market broadly. You have to actually look granularly at each individual issue.

Carl Kaufman: If we had shown a similar slide for investment grade, which we probably should have done, you would've seen much narrower bands and they would have been rising with the declination of quality. You'll not see a BBB trading at AA spreads, typically.

John Sheehan: I think another way of thinking about that is, if you were to look at the high yield index right now, it's yielding seven and three quarters. In the new issue market, there are very few bonds that price at seven and three quarters, there are lots of bonds that price in the high sixes, low seven. Lots of bonds that price in 9%, 10%. So, there are very few average bonds in the market.

Shawn Eubanks: Thank you. I have a question here. If we do experience a recession in the next 12 months, where would you see spreads widening out to?

Carl Kaufman: It depends on, one, how much the fed cuts. Because that's one way that spreads widen, high yield can stay stationary. If their cutting rates and yields are going down in investment grade, the spread will widen. Or if it turns out there's an exogenous event and it's going to be a very deep recession, then you'll also get the risk premium on the high yield market will rise, as well as the yield on Treasuries coming down. And that's where you typically get wider spreads.

Each cycle is different. In 2008, we had almost 2,000 basis point spreads. We didn't know we were going to have a banking system. In 2020, we got to 1,000 over. So as a broad brush, that's probably the two worst outcomes. 1,000 to 2,000.

I doubt we get 2,000 again, it's just too easy to buy the good companies when markets are at that spread. Probably not going to be that easy on us this time.

Shawn Eubanks: Okay. I have an interesting question here. You showed the AGG index as 42% Treasuries. How's that changed over time and what would you say it was, say, 10 years ago?

Carl Kaufman: John?

John Sheehan: Yeah, that number has been increasing pretty much in straight line. In my past life, we used to talk about how would the spread markets work if there was no Treasury issuance. I think the last time the government had a surplus was in the nineties. I don't know exactly how low the waiting got within the AGG, but I'd say easily 10% or 15% lower than where we are now.

I anticipate that that will continue to grow. The deficits seem to be one of the only thing that the two parties agree upon. So we're likely to have heavy Treasury issuance for the foreseeable future, and that will be reflected in the weighting in the AGG.

Carl Kaufman: And they don't agree in a good way.

John Sheehan: Yeah.

Shawn Eubanks: Okay. You detailed the current tightness of IG spreads, but can you discuss high yield spreads versus historical averages?

Carl Kaufman: Sure. High yield spreads are tight versus near term, but not at record tights. Investment grade, I believe, got to record tights recently. All time.

I think the record tight was in July of '07 at 250 over. Rates were about where they were here. And spreads right now are in the low 300s so we're getting there, but we're not there yet.

Craig Manchuck: Yeah. The other thing to consider is that, again, these are index and market spreads, and as we said, because it's a market of bonds and not a bond market, we have to look at the opportunities of each individual security. So, just coming up with an average doesn't really give us a fair representation of how we see the opportunity set out there.

There are definitely still opportunities to invest at attractive yields and spreads. And then there are other companies where the spreads are just far too tight to make sense for the risks that you're taking.

Shawn Eubanks: Thank you. I have another question here about whether there's a time to consider floating rate loans, and when would that be?

Carl Kaufman: That is easy. That is when rates are really low and going higher. We buy floating rate bonds when that happens, and that's the time to look at those as well. But when rates are high and going lower, that is not the time to be in floating rate bonds. That is the time to be in fixed coupon bonds.

Shawn Eubanks: Okay. Do you have any thoughts on the so-called crowding out effect of ballooning global debt on credit spreads? How developed are the high yield markets globally?

Carl Kaufman: A good question.

I've been hearing about crowding out for about 40 years now. It hasn't happened yet. If it does, it's at the margin. There always seems to be demand for good corporate paper. It may happen in emerging markets where the country is going bankrupt and no one wants to touch that country, so you do get crowding out, but that's across the board.

In the U.S., I just don't see it happening. And in fact, we have seen it before and we're starting to see it now. There are a few of the very high quality issuers whose shorter-term notes trade through Treasuries.

People are putting a higher probability of getting paid back in something like an Apple, which is as big as many economies, than they are in the Treasury. Certainly if we're getting crowded out, you would not see that in the marketplace.

Shawn Eubanks: Another question. I've heard murmurs of systemic risks coming from insurers, reinsurers, via over-allocating to private credit. Do you guys think there is a viable systemic risk out there?

Carl Kaufman: I don't think it's systemic, because the market is not big enough yet. It's about the same size as the high yield market, about 1.34 trillion. When you look at the size of the debt market as a whole, it's many multiples of that.

I think there is risk in those markets because there is too much money chasing too few good deals. And a lot of the newer players who have raised a lot of money, it's the shiny new toy right now because rates are high and the returns are high and they tend to be opaque, there are long lockups. They do not mark to market.

People are getting accustomed to getting those big coupons. If and when rates come down and we get a recession and we start getting credit events in private credit, there's going to have to be marks taken. And we'll see how that turns out. I think there's risk, but I don't think it's systemic.

Craig Manchuck: Also, what I would say is, the advent of the private credit market started with insurance companies and they're in many ways the best natural buyer of that risk. It's because a lot of times they have very long-tail liabilities that they have to invest against, so they don't have capital coming in and out like a mutual fund does, and therefore there isn't a mismatch between the asset and the liability there.

But they, historically, were buying privates-all different types of private debt-for years. And what's happened is, the sourcing of that has now been moved out from being an in-house function to others that are doing it themselves directly and sourcing. So the insurance companies now are investors or LPs in those funds, instead of necessarily doing it themselves.

I do think it's a little bit of a natural extension as that competition has come in and it's crowded them out of being able to do it directly.

Shawn Eubanks: Okay. I have one last question, gentlemen. Good high yield IG comparison, but why would I pick high yield bonds over floating rate loans where there's potentially more yield in the current environment, lower duration, and historically lower discount margin versus volatility?

Carl Kaufman: Craig, go ahead.

John Sheehan: You want Craig? Okay.

Craig Manchuck: Again, just like we have this market of bonds in high yield, loans are similar. It's a market of loans and it's not just a loan market overall.

What you also have in the loan market is, is a bit of adverse selection because there are a number of companies that went to the loan market simply because they could get deals done that they could not get done in the high yield bond market. And that's because they are much less creditworthy. Weaker credits, but they're able to get those done within the CLO constructs because so many of the CLO managers are scrambling for paper to fill up their buckets.

And as Carl said, once you construct your CLO bucket, it's passive. They become active in the way they manage it if ratings are moving around. But otherwise, they like to just keep things as static as possible and use those cash flows to offset their liabilities.

The loan market at times may show higher yields, but the credit quality can often be very, very dubious. And many of those companies just could not actually get deals done within the high yield bond market. There's a lot more risk there that you're not considering if you're thinking you're just buying the senior part of the cap structure. That may be a senior part of a much, much weaker cap stack.

Brad Kane: And the other thing I would quickly add is twofold. One is that, because of the buyer base and the amount of money that's been put into the loan market, you're not seeing covenants and the protections that you can get or used to get on bank loans, and you still get in bonds.

And two, you have no call protection. So if you actually have a loan that is improving in quality and the company's doing well, what they'll do is reprice. They'll come to market and they'll pay off the loan with a new loan at a much lower coupon.

And so what you're doing is you're capping your upside, unlike in bonds where you have call protection and you have premiums if they want to take you out early. So there are a lot of inherent positives that you don't just see when you look at just spread or just the yield on one of these.

John Sheehan: Right. They're low duration, but they're also negatively convexed. You have all the downside of a bond, but you don't have the upside of a bond. We have bonds that trade up 5, 10, 15 points. That will never happen in a loan.

Shawn Eubanks: Great. Thank you very much. And thanks for your time and your insights today. Carl, Craig, Brad, John, any final comments?

Carl Kaufman: I think we've covered it all, but if you have any questions, you know where to reach us.

Shawn Eubanks: Thank you.

Carl Kaufman: Thank you for joining us.


Carl Kaufman

Co-President, Co-Chief Executive Officer, Chief Investment Officer – Strategic Income & Managing Director – Fixed Income

Carl Kaufman

Carl Kaufman

Co-President, Co-Chief Executive Officer, Chief Investment Officer – Strategic Income & Managing Director – Fixed Income

Carl Kaufman joined Osterweis Capital Management in 2002 after almost 24 years in various positions at Robertson Stephens and Merrill Lynch. He has managed the Osterweis Strategic Income Fund since its inception in 2002. In addition, he is the Managing Director of Fixed Income and a lead Portfolio Manager for the Osterweis Growth & Income Fund.

In his management role at the firm, he is responsible primarily for investment matters and is a member of the firm’s Management Committee. Mr. Kaufman is a principal of the firm. Additionally, he is a member of the Board of Trustees for the San Francisco Conservatory of Music.

Mr. Kaufman graduated from Harvard University and attended New York University Graduate School of Business Administration.

Craig Manchuck

Vice President & Portfolio Manager – Strategic Income

Craig Manchuck

Vice President & Portfolio Manager – Strategic Income

Prior to joining Osterweis Capital Management in 2017, Craig Manchuck was a Managing Director of Fixed Income Sales at Stifel Nicolaus, where he was responsible for sales and origination of high yield bonds, leveraged loans, and post reorg equities. Before Stifel, he held a similar role at Knight Capital. Prior to that, Mr. Manchuck was the Executive Director for Convertible Securities and then High Yield/Distressed Securities at UBS. He has previous experience in Convertible Securities Sales at Donaldson, Lufkin & Jenrette, SBC Warburg, and Merrill Lynch.

He is a principal of the firm and a Portfolio Manager for the strategic income strategy.

Mr. Manchuck graduated from Lehigh University (B.S. in Finance) and NYU Stern School of Business (M.B.A.).

Bradley Kane

Vice President & Portfolio Manager – Strategic Income

Bradley Kane

Vice President & Portfolio Manager – Strategic Income

Prior to joining Osterweis Capital Management in 2013, Bradley Kane was a Portfolio Manager and Analyst at Newfleet Asset Management, where he managed both high yield and leveraged loan portfolios. Before that, he was a Vice President at GSC Partners, focusing on management of high yield and collateralized debt obligations. Earlier in his career, he managed high yield assets as a Vice President at Mitchell Hutchins Asset Management.

He is a principal of the firm and a Portfolio Manager for the strategic income strategy.

Mr. Kane graduated from Lehigh University (B.S. in Business & Economics).

John Sheehan, CFA

Vice President & Portfolio Manager – Strategic Income

John Sheehan, CFA

Vice President & Portfolio Manager – Strategic Income

Prior to joining the Strategic Income team at the end of 2023, John Sheehan spent five years as a portfolio manager for the total return strategy. Before that, he spent more than 20 years working at Citigroup, first as Managing Director responsible for Investment Grade Syndicate in New York City, where he advised issuers on accessing funding in the corporate bond market. Later at Citigroup, he was Managing Director in charge of West Coast Investment Grade Sales in San Francisco, where he covered several of the largest U.S. investment grade credit investors.

He is a principal of the firm and a Portfolio Manager for the strategic income strategy.

Mr. Sheehan graduated from Georgetown University (B.A. in Economics). Mr. Sheehan holds the CFA designation and is a member of the CFA Society of San Francisco.

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