During the first two months of 2022, prices of high yield bonds dropped in response to heightened inflation, a rise in U.S. Treasury yields, an anticipated change in Fed policy, and a sharp increase in geopolitical risks associated with the upheaval resulting from Russia’s destructive invasion of Ukraine. While it is impossible to forecast when this current widening trend will reverse, in our view, the move thus far this year has created an attractive entry point to invest in the high yield bond market.
We observe that the current sell-off is being driven by exogenous factors described above rather than a change in underlying business fundamentals, which remain healthy and, in aggregate, stand at pre-COVID levels. Further, indicators of credit stress remain stable as the current default rate remains historically low, as do indicators of future defaults such as the distressed ratio.1
Nevertheless, selling pressure has increased and nearly $19 billion has flowed out of high yield bond mutual funds thus far in 2022. Conversely, leveraged loans, although susceptible to the same potential negative global economic ramifications of a prolonged conflict in Ukraine, benefit from rising yields and a Fed pivot. With that in mind, we are not surprised that leveraged loan funds have received net inflows of $15 billion to date in 2022. These inflows, coupled with continued collateralized loan obligation (CLO) creation, have resulted in a steady bid for loans relative to their fixed rate peers (Chart 1).2
Chart 1: High Yield Bond and Leveraged Loan Prices through February 28, 2022
Source: ICE and Credit Suisse; HYBI and CSLL represent the ICE BofA U.S. High Yield Index and the Credit Suisse Leveraged Loan Index, respectively.
Of course, at Polen Capital, we are not looking for relative value between the two asset classes at the broader market level. Instead, we seek to take advantage of the flexible mandate enjoyed by most of our fixed income investment strategies, which enables us to target the opportunities with the most attractive risk-reward profile across the high yield bond and leveraged loan market. Broadly speaking, for long-term investors, we see the current sell-off in the high yield market as an opportunity to add to, or enter, the asset class. With that noted, within the current portfolios, we are making changes at the margin to take advantage of the recent dislocation.
A recent example of a relative value swap that we implemented in certain portfolios was exiting a position in the Asurion L+3.25% First Lien Term Loan due July 2027 in favor of adding the Viasat 6.5% Senior Notes due July 2028. In executing this transaction, we added incremental yield to the portfolios while concluding, as result of our bottom-up, fundamental analysis, that the swap did not otherwise expose the portfolios to excess credit risk relative to the broader market (Table 1).
Table 1: Relative Value Swap – Adding Yield While Controlling Risk
|Asurion L+3.25% First Lien Term Loan due July 2027||99.30||98.38||4.77%||5.09%|
|Viasat 6.5% Senior Notes due July 2028||100.25||92.25||6.41%||8.07%|
|Asurion L+3.25% First Lien Term Loan due July 2027||3.33||30%||Ba3/B+|
|Viasat 6.5% Senior Notes due July 2028||3.25||33%||Caa1/B|
Source: Polen Capital. Yield represents Yield to 3-year Take-out for the Asurion First Lien Term Loan, which is a customary yield measurement for loans, and Yield-to-Worst for the Viasat Senior Notes. At the time of the transaction, the Asurion First Lien Term Loan was yielding approximately what was recorded on 2/28/2022.
Leverage represents leverage incurred through the particular debt instrument, and LTV represents the Loan-to-Value (“LTV”) of the total debt through each debt instrument relative to the total enterprise value of the business.
From the table above, at year end, Viasat’s Senior Notes were already providing incremental yield relative to Asurion’s First Lien Term Loan. There were several factors influencing this yield advantage, such as the difference in ratings, relative size, and position in the capital structure, to name a few. However, from our perspective, the relative risk of an investment in these Senior Notes as compared to the Asurion First Lien Term Loan (and specifically the downside exposure from a credit loss perspective) is similar as indicated by their respective Loan-to-Value (“LTV”), which are more or less equal to one another. However, as a result of the technical pressure and exogenous risks being exerted on the high yield bond market broadly, and Viasat’s Senior Notes in this example, as of February 28, 2022, the Senior Notes offered approximately 300 basis points of incremental yield, considerably greater than the incremental yield offered at year-end, for what our due diligence shows is approximately the same level of risk relative to that of the Asurion First Lien Term Loan. While the foregoing is just a singular example of a relative value swap that we executed on behalf of our client portfolios, we nonetheless believe that it is representative of the opportunities that we are observing in the high yield market at this time.
While we at Polen Capital do not make macro calls and do not claim special expertise in predicting the outcome of escalating geopolitical tensions, we nonetheless have confidence in the applicability of our investment process and philosophy in the current environment. In our view, the increased volatility has created not only a more attractive entry point into the high yield bond market, but also exposed buying opportunities across leveraged credit. Given the fundamental health of the issuers across the high yield bond and leveraged loan markets, we do not believe that the current market environment is indicative of the beginning of a rapid acceleration of defaults. Rather, we believe that the uncertainty of today’s environment presents discerning investors with with an opportunity to capture attractive risk-adjusted returns over the long term.
1The distressed ratio measures the percentage of the ICE BofA US High Yield Index with an option adjusted spread greater than or equal to 1,000 basis points.
2Source: JP Morgan.
The information in this document is provided for informational purposes only. Opinions and views expressed constitute the judgment of Polen Capital as of March 4, 2022, may involve a number of assumptions and estimates which are not guaranteed, and are subject to change without notice. Although the information and any opinions or views given have been obtained from or based on sources believed to be reliable, no warranty or representation is made as to their correctness, completeness or accuracy. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice, including any forward-looking estimates or statements which are based on certain expectations and assumptions. The views and strategies described may not be suitable for all clients. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. This document does not identify all the risks (direct or indirect) or other considerations which might be material to you when entering any financial transaction.
The information provided in this document should not be construed as a recommendation to purchase, hold or sell any particular security. There is no assurance that any securities discussed herein will remain in the portfolio at the time you receive this document or that the securities sold have not been repurchased. The securities discussed do not represent the entire portfolio of Polen Capital. It should not be assumed that any of the securities, transactions or holdings described were or will prove to be profitable. A complete list of our past specific recommendations for the last year is available upon request. The ICE BofA U.S. High Yield Index is a broad, unmanaged high yield index. The Credit Suisse Leveraged Loan Index is constructed to reflect the investible universe of U.S.-dollar denominated leveraged loans.
“Loan-to-Value” (LTV) is defined as the market value of the reference class of debt in which a portfolio has invested, divided by the total enterprise value of the issuer as of such date (as determined by Polen Capital in its reasonable discretion).
“Yield to Worst” is a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting.
“Yield to Three Year Takeout” is the yield associated with a bank loan assuming that the loan will be retired in three years.