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| Michael Collins |
Collins is a portfolio manager and strategist on the high-yield team at Prudential Fixed Income, which manages $12 billion in high yield from Newark, N.J. The fixed income group runs a total of $146 billion. Are double-B credits the sweet spot of the market?
That is my long-term view. But in the near term the view still holds because of the yield compression we've seen across the credit quality spectrum, which has been very dramatic. You don't get paid a lot more for moving down the credit ladder--the yield pick-up is pretty flat right now. A lot of investors sacrifice credit quality for extra yield, but there isn't enough of a pick-up to compensate for the additional credit risk. A lot of high-yield portfolio managers and high-yield mutual fund managers aren't happy with the absolute level of yield and feel compelled to increase risk or yield by going down in credit quality, which can work for short periods of time.
Why do you believe now is the right time to invest in higher-quality credits?
A caveat to that is right now we're still in a very good, strong part of the credit cycle. The default rate is around 1% and the upgrade/downgrade ratio is 3:2. And if you look at corporate earnings, all of these factors support taking credit risk right now. For the very near term, you can pick up risk and it will work out.
But degradation in credit quality will cause damage to your portfolio and it's almost impossible to upgrade your portfolio when that happens. So you should start to do upgrade trades when you get the chance. You'll forgo extra yield in the short term, but you'll make it up in spades in the long-term.
When do you think the credit cycle will turn around?
The cycle is still a couple of years away from turning around. Since October of 2002 the sector has been exceptional: we've generated close to 40% total return over the two-year period. We've seen very strong performance and a lot of the lower-quality stuff has been responsible for that. Valuations have gone from being very cheap to being slightly cheap or fair-valued today. As valuations get to the point where they become expensive, companies will start focusing on their equity returns. It's inevitable that, over the next couple of years, we'll see leverage on balance sheets pick up.
At the moment, companies are still cutting capital expenditures and being disciplined about capital spending. There remains an excess capacity overhang from the '90s and companies are reticent to add to utilization. We're at very low levels of productive capacity, around 76% up from a low of 72 or 73%. As productivity increases, companies will feel like spending more and will start using free cash flow to buy back shares for acquisitions and to boost their equity, which will be a warning sign the cycle is turning around.
Are you concerned by an increase in shareholder-friendly behavior?
We've seen some isolated anecdotal evidence recently with companies paying dividends to shareholders. They're not just using capital but are also issuing more debt, which is even worse for bondholders. But these companies and their equity sponsors will get penalized the next time they try to do something similar. The threat is investment bankers need to make money and they are pursuing ways for companies to raise capital. Companies are generating free capital, liquidity profiles have improved and they don't have incentives to tap the capital markets. So between bankers' and shareholders' needs, and bondholders' demand for credit risk and new bonds, the market will continue to fill that need with things like dividend deals.
What is your outlook on high-yield supply?
Last year, 75% of issuance was used to refinance bonds or bank debt. This year, about 66% of issuance was refinancings. Those kinds of numbers will probably continue but as we mature in this cycle, we will see more companies funding for capital expenditures. I expect to see that ratio come down, but don't anticipate a significant increase in issuance. In terms of total issuance, we're nearing record levels of issuance this year but I expect to see that fall off. If the economy is still doing well a year from now, we may see some cap ex increases, merger and acquisition activity and another wave of refinancings as '07, '08 and '09 coupons expire.
Where do you find value in the market right now?
We're executing a strategy that emphasizes credit research. We have six portfolio managers and 10 research analysts focused on the high-yield market. There are still pockets of value in the market right now. Rating agencies are behind the eight ball in terms of upgrading, so we look to pick up improving credits.
We also are looking to add value in the market by understanding where each company falls in terms of the production and pricing-power chain. Companies early on in the production chain in the commodities sector have been attractive. For example, companies providing equipment to mining companies have had a lot of pricing-power. We've seen tremendous price increases and tremendous earnings. But as you move down the production chain, companies have been getting squeezed. The auto suppliers have had to accept steel at very expensive prices but have very little leverage negotiating prices with the clients they sell to. Also, in the packaging sector companies have been buying resin from chemical companies at expensive prices and have had little leverage with their big clients such as Frito-Lay and PepsiCo.
At this point, it's a matter of getting back to the basics and identifying companies that have pricing power. We expect to see that migrate to the intermediate part of the chain. Our job is to look for the next trend and to identify companies in the middle of the food chain which may experience more pricing power. It's an art to picking the inflection point and we're trying to figure out when commodities producers are fully priced in. This is a shift that we expect to see, so we will reduce our exposure to companies at the front-end of the food chain. We've already taken some profits in the steel and forest products sectors.
What sectors are most attractive?
One of our biggest overweights is in the lodging sector, which has been benefiting from business spending on travel. We're not seeing companies using cash to add capacity; we're not seeing a lot of building of high-end hotels. So there's not a lot of new supply, but businesses are willing to spend money on travel right now. Occupancy rates are at or above pre-Sept. 11 levels. We've liked high-profile credits such as Starwood [Hotels and Resorts Worldwide], who owns Sheraton, Host Marriott and Hilton [Hotels].
Hilton, which is now investment grade, is actually a great example of a crossover opportunity. As a company gets closer to investment grade, its spreads are around 160 basis points over Treasuries and it will tighten 30-40bps on becoming investment grade, regardless of the industry, because it looks cheap to high-grade buyers. A lot of high-yield investors give up early; we're more willing to hold on to get that final upgrade because you get a tremendous pop. We sell the credits once they've become investment-grade.
What has been your strategy with regards to interest rates?
We are sensitive to the idea that interest rates are more likely to rise than to fall. If rates back up, it's important to be defensive. We're underweight our index, the Lehman Brothers High-Yield Index, in terms of higher-quality stuff. Our overall double-B exposure is to be defensively positioned, but we're overweight relative to most other managers. The index is heavy high-quality because of fallen angels. Secondly, we've also moved in on the yield curve. A lot of companies have many bonds outstanding and many issuers, especially fallen angels, have 30-year bonds so the index has more long bonds than it used to. You can play the yield-curve more now than ever and we've taken a lower duration exposure. We're a little bit short the index, but a little bit long to most of our competitors.
We plan on increasing our allocation to the higher-quality part of the market over the next year or two years. You have to gradually increase that part of the portfolio and start now. We've been caught a little bit by the fact that rates are so low. If rates hit 5% we'll start to do some more upgrades, but even with the recent back up, we've added longer maturity and higher-quality paper because of the fall in prices through names such as Georgia-Pacific.