Fixed Income Boutique
Growing up in China, my musician father was overly optimistic about my musical talent and enrolled me in classical piano lessons. To his dismay, my musical ability comes from my tone-deaf mother’s side of the family. I recall spending countless hours in front of the piano under the strict supervision of my father. This felt like an eternity and secretly I wished I could be outside running wild, training to become the next karate kid.
Years later, I didn´t quite become the concert pianist my father had hoped. Instead of spending hours honing my craft at the piano to prepare for the next virtuoso performance, I chose to spend my time at a Bloomberg terminal hunting for the next opportunity in the global high-yield bond market, sharpening my skills as a virtuoso portfolio manager.
With hindsight, I am grateful for the piano training I received as a youth. It not only enabled me to cultivate some much-needed artistic acumen, but also taught me the value of timing and tempo, which is priceless in the world of high-yield bond investing.
There are two types of opportunities we explore repeatedly when it comes to high-yield bonds:
Just like musicians who develop precision timing and awareness within music, those same skills are crucial for high-yield portfolio managers in maximizing opportunities.
For example, we started the year with an overweight positioning in the CCC and single B segments of the market vs an underweight in BB. The prevailing reflation narrative early in the year, coupled with more attractive valuations in the lower quality part of the market, drove a strong outperformance in CCCs and single Bs vs BB rated high-yield bonds for the first six months of the year. The call to be long the lower quality part of the market became the consensus with a strong underweight positioning in BB rated bonds among high-yield portfolio managers.
We took the view that the BB underperformance had gone too far and did not reflect the stable fundamentals in that segment of the market. This, coupled with the large underweight positioning in BB credits, could provide the ingredients for a strong rally. As a result, in June and early July we increased allocation to the BB segment of the market with a particular focus on oversold credits without fundamental deterioration. The BB segment staged a strong outperformance vs the lower quality part of the high-yield market during July and August.
For these types of trades to work well, one needs to act ahead of the curve and start scaling into positions before sell-side strategists advocate the trade. Once such trades become the “consensus”, the entry levels become much less compelling. Hence, timing and tempo is key, much like this piano piece from Mozart , which ought to be played in an “Allegro” tempo. Rotation trades in high-yield bonds need to be fast and vivacious to ensure good entry levels.
The forward-looking trajectory for a high-yield issuer is not always clear. In selecting investments for the portfolio, we not only focus on picking the right issuers but also the right bonds on the right part of the curve in order to increase the chance of being right and reduce the downside if we are wrong. This is especially pertinent for credit situations where the outcome can be uncertain. In this type of a situation, completely avoiding the issuer is not always the best option as the negative outcome is often partially priced in and the potential upside on the bond from a positive event may outweigh the downside on the bond from a negative event.
One example is Carnival Cruise Line (CCL) in 2020. Following the breakout of the pandemic in March, the entire CCL capital structure collapsed. The EUR senior unsecured 2022 bonds dropped 35% to a cash price of 67 and a yield of 20% as the market priced in a meaningful probability of debt restructuring in two years. The panic was understandable given CCL´s operations came to a complete halt with no visibility of a re-start. And in the meantime, CCL consumed hundreds of millions of cash every month just to maintain idle ships. In the following months, in order to boost its liquidity and “sail through the storm”, CCL issued secured bonds in the 3-to-7-year parts of the curve. The secured bond issuance gave us a good opportunity to buy unsecured bonds maturing before the new secured bonds because the more debt the company issued after the 2022 maturity, the higher the probability the company would be able to pay back the short-dated bonds because it had bought itself more time to wait out the storm. These secured bond issuances can, however, have negative implications for the longer dated CCL unsecured bonds as it depresses potential bond recovery in the event of a debt restructuring down the line if the operation does not recover.
For this type of situation, the decision is not only whether one should get involved in the CCL bonds, but also which points of the credit curve (front, intermediate, or back end) and which part of the capital structure one should get involved in (1st lien secured, 2nd lien secured or unsecured bonds). To make the right decision, one needs to follow the situation closely, reassess based on new information that comes to the fore and could be supportive or opposing to the investment thesis and be ready to add or reduce the risk based on the new information. There is a lot of deliberation and the musical part of me feels like it is a dance along the CCL bond curve and credit story, a bit like Chopin’s Waltz in C-Sharp Minor .
High-yield bond managers are a lucky bunch, a good day in the office can feel like a front row seat at a symphony orchestra concert. Some days it is a rondo from Mozart; others a waltz from Chopin. On the other hand, there are some days when we are forced to throw the classical playbooks out of the window, dive into the mosh pit of a rock concert and jam with whatever the markets are throwing at us. One thing is certain: there is never a dull moment in high-yield bond investing; every day, in equal measure, we learn from our wrong notes and our finest performances.