Getting Through the Matrix: Staying Disciplined in an Evolving High Yield Bond Market

High yield bonds have recovered in value alongside the broader market after a steep fall in March. Meanwhile, credit fundamentals have largely deteriorated, and potential sources of market volatility remain squarely in view. What do Oaktree’s high yield bond investment teams think about the recovery thus far, and how are they positioning their portfolios for the near term? What are their thoughts on fallen angels and potential defaults?

High yield portfolio managers Madelaine Jones and David Rosenberg, along with senior trader Justin Quaglia, join Oaktree marketing executive Richard Young to address these questions and more.

Richard Young: In times of extreme market stress like we experienced in March, how do you maintain rational decision making?

David Rosenberg: The strength of our investing approach is simple: we strive to stay out of trouble. When markets fall, instead of panicking and scrambling to sell, we’re often able to go on offense and start bargain-hunting.

The key to this strategy is strict adherence to our Credit Scoring Matrix, a rigorous set of guidelines that ensures every purchase and sale we make undergoes consistent and thorough analysis. Howard Marks, our co-chairman, and Sheldon Stone, a pioneer of high yield bond investing, developed this tool more than 30 years ago. It forces us to concentrate on credit quality, not price. If a name doesn’t pass the matrix, we’ll skip it regardless of the yield it “promises” to provide.

It has also enabled us to be more opportunistic. Having confidence that our current investments meet the matrix’s demanding criteria means we don’t have to play defense when markets become volatile. Instead, we can be more aggressive and pivot as necessary.

For example, in March we initially became liquidity providers to funds that needed cash to cover hedging losses or redemptions. We put together a list of solid businesses less vulnerable to the impact of Covid-19 and pushed these desperate sellers to reduce their prices — by as much as ten points in one day.

But then the U.S. Federal Reserve stepped in. When Chair Jay Powell announced in late March and early April that the central bank would buy investment grade corporate bonds, fallen angels and even high yield bond ETFs, the market dynamic shifted dramatically. Credit spreads that had widened significantly during the crisis suddenly began to narrow.

So we pivoted. We began zeroing in on companies that were right in the crosshairs of the pandemic: lodging, leisure, gaming and anything travel related. We were picky and structured deals that worked for us, offering liquidity in return for attractive yields and security.

Today, markets have rallied significantly, with yield spreads on U.S. high yield bonds contracting by more than 50% from their March highs. Because of the flexibility we applied in the teeth of this crisis, we now have the luxury to become more defensive and consider taking profits in anticipation of future volatility. Ultimately, all of these moves were made possible by our primary focus: getting individual credits right.

Richard Young: During such a violent market selloff, how does the trading desk ensure access to liquidity?

Justin Quaglia: During periods of volatility we emphasize collaboration, communication and discipline.

As headlines start to cross the tape and prices begin to move, it is imperative that we collaborate as an organization to share knowledge, experience and potential investments. The goal is to generate a list of names that are of interest and levels where the pricing begins to get attractive.

Once we establish areas of focus for the different strategies, it’s time to survey the universe, gather intel, filter information, and share our objectives with the broker community. This process allows us to build strong partnerships with our counterparties as they field waves of incoming inquiry, and it inserts Oaktree as the first call on investment opportunities. Tight communication and quick feedback become paramount throughout the process, giving us the opportunity to act quickly. This communication and information-gathering process also allows us to understand the other side of the trade and who the sellers are, because severe periods of volatility often bring out forced sellers who may be facing margin calls or redemptions. They have immediate cash needs and are often price takers, which will give us the opportunity to buy securities at deep discounts from current market prices.

Lastly, and perhaps most importantly, we ensure access to liquidity by following the disciplined trading approach that has long set Oaktree apart. When we sense fear in the market, we take toehold positions and wait for the market to come to us instead of aggressively seeking offerings. By making small purchases over time, we set ourselves up for the first call from the brokers, keep our average cost low, and allow the market price to fall to a level where we can clean up all the supply at deep discounts.

Richard Young: One major topic during this crisis has been fallen angels — or previously investment-grade bonds that have been downgraded to high yield. What has been their impact on the high yield universe?

David Rosenberg: During the early days of this year’s sell-off, some investors and analysts were concerned that fallen angels would overwhelm the U.S. high yield market, weighing on prices. But even though plenty of these downgrades have occurred since March, investors have eagerly scooped up these bonds — likely attracted by the higher relative value compared to many other asset categories and encouraged by the Fed’s support of these issuers.

Our approach has been to first classify fallen angels into two broad types. There are downgraded companies that have the ability to become investment grade again because of their sound business models. And then there are firms whose credit ratings are likely to plummet straight to the lowest ratings — CCC and below. Investors can waste time and money if they fail to distinguish between these two categories.

Richard Young: Since this market downturn began, many industry pundits have been trying to predict the shape of the eventual recovery — with some arguing it might be v-shaped, suggesting rapid improvement. While this hasn’t yet materialized in the real economy, we have seen a v-shaped move in the prices of risk assets. What’s your view on the causes and implications of this?

Madelaine Jones: The unprecedented actions of central banks, most notably the Fed, likely played a major role in the swift recovery of many risk assets. Policymakers seem to have taken cues from Mario Draghi, the former European Central Bank president, who said in 2012, during the height of the eurozone crisis, that the institution would do “whatever it takes” to support the eurozone. This may have taught central bankers that it takes dramatic action to stabilize the credit markets — including massively increasing balance sheets and even buying corporate debt. These moves have certainly had the desired effect, as bond prices have risen sharply since March and the credit markets have continued to function.

But fundamentals tell us we’re not out of the woods yet. The eurozone continues to grapple with an economic recession. GDP rebounded in the third quarter, but output remains well below pre-pandemic levels, and the resurgence of the virus and related restrictions are likely to undermine the recovery going forward. Meanwhile, the U.S. is still seeing historically high unemployment levels.

So now is a time to be cautious. There are limits to what central banks can do to prop up markets if underlying economic conditions don’t heal. So given the speed of this broad market rally, we have no interest in going out too far on the risk curve in the search for that last bit of yield.

Richard Young: That raises the question of default rates. They’ve recently been picking up in the U.S. Where do you think they’re headed?

David Rosenberg: In March, when the market was at its bottom, many strategists said U.S. defaults would probably be between 10% and 12% this year. We believed roughly half of these defaults would occur in the energy sector, while the other half would be in the industries hardest hit by Covid-19 — especially retail and travel and leisure. But because of the central bank actions we’ve already discussed, companies that might otherwise have defaulted have been able to raise the liquidity they needed, pushing off their cash crunch for, most likely, another year.

So we’re now looking at a default rate of probably 6% or 7%. To put that into perspective, the U.S. 30-year average default rate in high yield bonds is 4%. In the past few years, the average has been more like 2%. So the projections for this year still represent a significant increase — just not as dramatic as we originally feared.

Richard Young: As we head into the end of the year, do you expect to see volatility pick up?

Madelaine Jones: While I expect markets may be volatile in the coming months, the broader trend over the long term points toward economic recovery and largely depends on when we resolve this pandemic. Much of the improvement in markets since the spring has been based on the belief that coronavirus cases will decline and economies in the U.S. and Europe will recover. So until fundamentals really do improve, conflicting economic data and political shocks could spark more market ructions. In advance of this, we are positioning our portfolios so that we can seize the opportunities this unpredictable environment may bring.

David Rosenberg: Another important point to consider is that much of the discussion about stressed credits today centers on liquidity — having enough of it to remain afloat through this year or, as many companies now say, this “period of lost revenue” caused by Covid-19 lockdowns. What people don’t talk about enough is that companies accessing liquidity aren’t getting grants; they’re getting loans that will have to be repaid. So companies that have been struggling are now going to be even more leveraged exiting the crisis than they were coming in.

Richard Young: Moving on to opportunities, how would you compare the attractiveness of U.S. and European high yield bonds on a relative basis?

David Rosenberg: The value is fairly even right now, as their comparable spreads indicate. Both have unique advantages and disadvantages. The U.S. has more energy exposure than Europe, but some European countries have suffered more severe Covid-19 flare-ups, based on per capita deaths and infections. So when you balance it all out, there’s no obvious reason to favor one market over the other.

Madelaine Jones: I agree with that. We spend a lot of time analyzing data about each region, looking at relative value, and deliberating over positioning. But, ultimately, there are very few moments when only one market is hugely dislocated — and this isn’t one of them.

Again, our approach really boils down to fundamentals. We find idiosyncratic opportunities based on our views of individual credits’ relative risk at a granular level.

Richard Young: Finally, in a rapidly shifting market — influenced by everything from a once-in-a-century pandemic to unprecedented government stimulus — what are the potential landmines, and how can they be avoided?

Justin Quaglia: To understand the unique risks and opportunities in today’s market, it’s useful to look at issuance figures first. U.S. high yield bond issuance has been shattering monthly records this year. Through the first week of October, the 2020 total stood at $345.6 billion, breaking what had been the longstanding record of $344.8 billion in 2012. This trend shows little sign of abating, so, moving forward, we’re likely to see even riskier offers coming to market.

Oaktree should stand out in this type of environment. We’re not going to buy just any instrument with a decent yield simply to put money to work. We’re going to underwrite the right credits at prices that adequately compensate us for the risk. It’s the type of discipline that is forged through decades of experience investing in dislocated markets.

Madelaine Jones: This takes us back to the Credit Scoring Matrix that David discussed earlier. At times like today, there may be hundreds of credits we could be comfortable owning, but the Matrix helps us concentrate on the relative value of only the best.

Starting with a pool of quality names that have been rigorously tested gives us the confidence to act — even when markets are falling. It also means we aren’t likely to find ourselves in a cash crunch during a downturn; instead we can be selective about what we buy or sell. It’s not easy to invest with such conviction during a crisis. But that’s why it’s so important to have an investment philosophy that prioritizes downside protection — and a team disciplined enough to stick with it.

EndNotes

¹S&P Global Market Intelligence LCD.

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