Market Cycle Contrarian in High Yield
Neuberger Berman High Income Bond Fund
Author: Ticker Magazine
Last Update: Jan 24, 11:56 AM ET
|The high yield market has evenly expanded from mid-sized and smaller companies to large issuers as bonds have gained more favor in recent years. However, investors remain aware of the potential downsides of high yield bonds, such as equity-like volatility, lack of liquidity, and significant credit risks. Portfolio manager Patrick Flynn explains how the Neuberger Berman High Income Bond Fund benefits from a large research team in search of investment opportunities among larger companies with significant cash flows and long-term track records.
“What is consistent is our focus on credits we believe are capable of surviving entire cycles—companies, often larger issuers, featuring consistent cash flows, flexible cost structures, and liquidity options.”
Q: What is the history and mission of the fund?
The Neuberger Berman High Yield group was founded in 1997 and consistently maintains its original investment philosophy, to outperform the benchmark over market cycles marked by periods of high defaults and recovery.
We seek to add value beyond our benchmark, the Bank of America-Merrill Lynch U.S. High Yield Master II Constrained Index, by avoiding credit deterioration and engaging in top-down rotations in credit quality and industries.
To accomplish this, we maintain a large research staff to proactively seek to avoid defaults. During periods where we don’t like the market’s risk/reward, we become more defensive, whereas when we think the economy and high-yield market are headed for expansion, we add risk. So, while we historically tend to add the most value versus the benchmark in times of credit volatility because we avoid deterioration, we have historically kept up with and often exceeded the market during times of expansion.
Q: Did the 2008/2009 credit crisis alter the fund’s investment philosophy in any way?
Despite some tactical shifts in the issuers and industries we own, our core philosophy remains the same. Anticipating certain of the problems of 2008/2009, we defensively positioned the portfolio to seek to avoid the ensuing defaults. Subsequently, we anticipated a better market for high yield, and expected defaults rates to decrease, and bought more CCCs in more cyclical industries.
Arguably, the biggest challenge since the crisis was the sharp decline in commodity prices the past two years, e.g., oil, metals, coal, and natural gas, followed by the inevitable increase in defaults.
To avoid defaults, we reduced our weighting in oil and gas producers, and as the oil market began to recover, we added some oil and gas, metals, and mining names, mostly by purchasing “fallen angels,” as names downgraded from investment grade to high yield often had better credit profiles than typical high-yield issuers.
Q: What guides your investment approach and philosophy?
Our clients want to invest in high yield. We seek to provide them downside mitigation with upside participation.
The type of credit we buy changes, depending on where we are in a cycle. Between 2006 and 2007, we grew concerned with leverage build-ups. Huge debt expansion arose across every asset class, debt service and coverage ratio were declining, and proceeds usage, vis-à-vis leveraged buyouts versus refinancing, was at an all-time high.
CCC-rated bonds, as a percentage of new issue, were also at high levels, so we reduced our holdings, increased our BB and BBB holdings, and reduced cyclical industry exposure.
In contrast, 2008 and 2009 saw us significantly reduce BB and BBB holdings in favor of CCCs, and rotate into more cyclical industries.
What is consistent is our focus on credits capable of surviving entire cycles—companies, often larger issuers, featuring consistent cash flows, flexible cost structures, and liquidity options. We don’t invest in smaller companies, or those with high fixed costs or unhedged currency exposure, and avoid companies with high tail risk where we believe sudden moves in a commodity or currency, for example, makes the credit untenable.
Q: What drives your investment process?
We have a credit best practices checklist, built and developed over decades of investing. Each analyst uses it in their due diligence to thoroughly explore the investment thesis for each portfolio credit and any underlying assumptions.
We start with a top-down analysis of the economy and where we are in the credit cycle, followed by an analysis of each company’s industry and where we are in that industry’s lifecycle. We look at the competitive landscape, the regulatory environment, analyze competitors, and, for each individual issuer, we focus on business fundamentals.
For example, we only invest in companies with long-term track records that have weathered a downturn and have the ability to de-lever their balance sheet, typically through free cash flow generation. We typically avoid companies whose operations expanded via roll-ups or acquisitions, as they often have integration and accounting issues. We seek organic growth.
As a high-yield bond manager, it is imperative to verify companies have sufficient cash to service their debt load. There can be no material discrepancies between income and cash flow statements. We do scenario analysis—financial projections and a base case, downside case and upside case—to make sure that even in a downside scenario the company can cover its debt.
We thoroughly analyze a company’s capital structure to establish how much secured and junior debt it has, what are the rights of that secured debt versus junior debt, whether it can strip assets from the company, and how permissive covenants are.
Companies often brag about having considerable liquidity in terms of cash and bank lines, yet, historically, where there have been problems with credits, it turns out that cash was dedicated to other uses. Perhaps it was restricted, or trapped in overseas subsidiaries, or is needed to run the day-to-day business. And they can’t tap bank lines if they don’t comply with covenants or lack sufficient collateral. We want to see sufficient liquidity available to pay us.
Lastly, we look at management systematically. We have identified eight variables, such as a management team’s ability to manage a leveraged company, what incentives management teams have, or the strength of corporate governance practices. We grade them, A to F, and only invest in those who score an A or B.
Q: How would you describe your research process?
We have a large research team that pays close attention to the actions of rating agencies, as that impacts how bonds perform. For example, when a bond is downgraded or upgraded, it affects the trading dynamics, resulting in possible capital gain opportunities, and may prompt us to exit or avoid a name. We also generate our own internal credit rating, which often significantly varies from that of the rating agencies, forming the basis of our relative-value decision.
Our research staff talks to management teams, and meets with them, which enables us to buy ahead of good developments or sell when problems arise.
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