Concrete Concepts for High Yield Research: Part 1 – The Fixed Income Perspective
Investors looking for yield face a challenge in the current market environment. With many of the world’s major central banks engaging in quantitative easing, sovereign debt yields are at or near historic lows. That drives fixed income investors to look at bonds with lower credit ratings, specifically non-investment grade bonds, or more appropriately, high yield. That demand is being met by new supply. In fact, March saw U.S. high yield volume reach US$34.9 billion. That’s the highest monthly output since October of last year. However, high yield isn’t an asset class where an investor should just wade in and buy up whatever supply hits the street. Investing in high yield requires rigorous research, and as the head of Principal Global Fixed Income’s high yield research, I’ve found that it’s useful to keep in mind ten concepts that help summarize the many factors and variables that interact to make high yield unique and challenging. Here are the first five:
- Cash Flow – Cash flow is important to everyone, but it’s critical in high yield investing. We look at cash flow as the life blood of a company. It is what is left after a company sells its products and pays the costs to produce and sell those goods. Cash flow is a crucial predictor of which companies will flourish and which will fail. As we research issuers, we want to know that companies are generating cash from their business activities and not from financial engineering.
- Capital – Companies don’t just pop into existence; they’re formed using cash and assets from investors. The way these investors organize themselves is called the “capital structure.” Sometimes, the capital structure is ordered in ways where some investors have higher claims on the business than others. It’s important in high yield investment analysis to understand who has a higher claim (typically, bank loans are senior to traditional high yield bonds) and who has a junior claim (e.g., common stockholders, preferred stock, convertible debt). Some companies’ capital structures are “simple,” in that each class is clearly junior to the ones above it. However, there exist numerous companies with “complex” capital structures, where assets are divided among many subsidiaries and lenders have differing claims on those subsidiaries.
- Cushion – Everyone wants to buy something for less than it’s worth. Similarly, when lending money to companies (which is essentially what bond investors are doing), we want the value of the assets supporting our investment to be worth more than what we have lent. That helps give confidence that we’ll get our money back. This amount of excess value is called the “cushion.” For publicly traded companies, much of the cushion can be observed through the value of the company’s stock (we call this the “equity cushion”). For every investment we make, we determine if the underlying value of the business and its assets are worth more than what it’s borrowing.
- Cyclicality – The economic cycle causes demand for various goods and services to expand and contract. However, some businesses grow faster in good times, but also contract faster in the recessionary periods. We call these businesses “cyclical.” For high yield bond issuers, the combination of high leverage and high cyclicality can lead to very bad outcomes. Therefore, we must understand where the economy is in the cycle and how each of our companies is expected to perform in that cycle.
- Competition – When everyone needs a widget, it’s obvious that you’d want to be the only widget maker. With no competition, you’d control the market. In most cases, though, every company and sector has competitors and potential substitute products. Understanding the complexities of industry and company dynamics is critical to our investment decisions. Lending to companies with solid strategies in well positioned industries is a cornerstone of our research process.
Those are the first five “concrete concepts for high yield research.” Check back next week for the next five!