Mike Della Vedova, T. Rowe Price portfolio manager of the T. Rowe Price Global High Income Fund was in Australia recently and Elizabeth Moran sat down with him to learn more about the high yield market and his fund.
EM – Thanks Mike for making the time to speak to us. The proposed hybrid changes are fairly well flagged, and we have a large retail investor base wanting yield. Do you have some suggestions where they can get that sort of yield?
MDV – I think when you look at alternatives, one that has been used for decades for retail investors is high yield. It is now referred to as high yield as opposed to junk, but I don’t mind what people call it. It’s sub-investment grade and that’s key. And I think that’s something that retail investors here need to appreciate up front. People should be aware of the risks because there is no free lunch.
You can get very good returns, but it comes with risks. To my mind it’s about how you identify and manage risks. I think people would be shocked at companies that are in the high yield world, recognisable household names. Netflix was for many years and now it is a rising star. A lot of the big chains, KFC for example, had bonds that are rated high yield. James Hardie, is another example which had sub investment grade, high yield bonds.
There’s Australian companies, global companies, locally focused companies around the world and it’s just the nature of where they are in their own development and cycle, it usually means they have more debt versus their earnings and cash flows than is healthy over a long period. But you can find a lot of companies that over the long period are going to improve. They’re going to be the winners. If investors are used to investing in equities, they’re used to giving companies time, which is similar to high yield investing.
Whether the company is going to develop a product or expand or turn itself around. They’re all the same things we look for in sub investment grade corporates, but we get paid to do that. We get paid a coupon and that’s sort of the real magic in fixed income. We are looking at a market where standard bonds are under five years to maturity. Where your duration is, depending on what market you look at, often sub three years. And right now, you’re picking up well over seven and a half percent yield when you look at the market.
So, you’re able to be compensated for the same ideas that people are very comfortable investing in equities. There’s over a 60% correlation between US high yield and the S&P500.
High yield investors are not waiting on dividends that aren’t legally mandated. They get paid. What you have to focus on is avoiding defaults and loses.
EM – Absolutely. Can you talk a little bit about the composition of the high yield market?
MDV – Sure. I think it would surprise people, but the size of the market is almost US$2.5 trillion. It’s a large market. It’s mainly USD issuance, which is about 55% of the market. The next biggest area would be Europe, which makes up close to a quarter of the market and then followed by emerging markets (EM), which makes up almost 20% of the market. Now, the real reason we’ve seen the growth up to almost US$2.5 trillion is Europe and the emerging world.
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Post GFC, local banks couldn’t lend at discounted rates versus their funding costs to corporates. New rules came in and capital requirements are exponential versus the rating. So it’s multiples you would have to offset to lend to a single-B company then say a triple-B company. Once you get deeper into sub investment grade and the corporates, just because the regulations change, it doesn’t mean corporates don’t need more capital, but it really meant they sought it from the public market.
Back in 2000s, people thought, the market would change but then we had the banking crisis and this is now a permanent source of capital for European corporates. It is similar in the emerging world. There we’ve seen a burgeoning middle class often pretty industrialized countries, with very large populations.
That middle class demand capital. Emerging market companies operate locally, but source capital globally.
EM – Mike, just delving down a bit, what sectors do you prefer at the moment and what sectors are you avoiding?
MDV – One of the biggest sectors is US energy. That’s due to the US becoming far more than self-sufficient, the ability to export natural gas and that sector’s growth. The US market is dominated by commodities. The biggest industry for example in the emerging world is also energy, largely through Latin and South America. But the second biggest industry in the breakdown for high yield on EM is banking. And that’s the biggest sector in Europe.
The second biggest sector in Europe is telecommunications. Now, banking and telecommunications are highly regulated at the local level than a pan-regional level. And so, that means the investor knows the playing field, which is a good place to invest.
Right now, we do like telecommunications. Not just all telecommunications, but look at mobile.
Mobile telecommunications really are the backbone of data transfer in the digital age. They’re not phones as we know. It’s really mass data that has been moved around. Post dot.com bubble, people realise it wasn’t just a dream but the funding and the timing was out. Tied in with that, the cable sector, with the fibre industry, which is not so much cable TV, but the backholing of information as well.
EM – But they also need lots of capital, don’t they? If they’re developing-
MDV – Exactly. Cable is good, it costs us a lot and it’s evolving. So we’ve gone from twist head copper to coax, to fibre and the capacities are up. The pipes still exist but the updated cables still cost. This sector isn’t going away. It’s paramount to all our current and future digital needs. That’s the type of area we like. We also like the services sector. There’s a lot of different companies, a lot of different areas.
Most services are business that someone has outsourced. Now as soon as you outsource, then you change the dynamics, the cost base of the customer, they’ve outsourced that. It will become prohibitively expensive to bring it back in and it will change their own cost dynamics and margins. Often that service is absolutely necessary, but you can price it in a way that it doesn’t disrupt the customer. It’s that small piece you need, but it doesn’t change the dial that much on your profitability if you’ve got to pay it.
So, if you can do it efficiently as the servicing company, it doesn’t matter that if it’s HR, if it’s finding people work or supplying temporary storage, temporary power generation, backup supply, businesses that service heating HVAC type of systems, software type companies, in the greater scheme, they’re a small cost but without them, the corporation stops. They’re good business. They’re not all good, but that’s a very good hunting ground for opportunity and so, we generally like that sector.
EM – Excellent. What about some to avoid?
MDV – Autos probably right now, I’m not going to say any sector we completely avoid, but you’ve got to be more cautious than switched on. What we’re hearing and what we see in the market, what we hear from corporates or the car companies, it’s tough out there. When you look in Europe, when you look at the US, there is significant targets on EVs. They have to produce them but the demand actually isn’t always there.
That’s an expensive option because a lot of the car is the same but not all of the car is the carry. Manufacturers have to buy that technology or develop it from scratch. It’s expensive. And the other issue is with some demand waning in China, the absolute demand for the total car park is lower than it was, years pre-lockdown. It just hasn’t come back. The number of automobiles out there, broadly will undershoot some analyst’s expectations. And so, that’s an area, I’m not going to say you avoid, but you have to be very cautious.
There are good areas for example, every company, every car needs seats. It doesn’t matter if it’s electric. It doesn’t matter if it’s an internal combustion engine, it needs seats. It needs interiors. There are areas you can look where there’s still opportunity in a sector that overall were a bit more sanguine, a bit more negative on, for example, but that’s one area.
EM – I absolutely agree with you. Can we talk about spread compression, and what you’ve seen there and how you are combating that? I assume your fund is active, Mike, but are you in a more holding frame of mind right now, because you’ve bought securities and you’re watching, you’re getting the flow of that price appreciation and compression. Is that fair to say?
MDV – It is fair to say. When investors start to look at fixed income, especially corporate fixed income, one of the aspects they don’t appreciate, is that big corporates have multiple bond issuance. And so, you’re able to consider, do I want shorter exposure? Do I want to take a lower spread, maybe a lower yield because of the curve, but I’m closer to being refinanced. So, in some cases, we’ll look at that and in other cases we go, “We really like this credit.” We see it as a general winner, it’s going to improve its ratings.
So, we would prefer to take longer exposure to it, and we’ll go further out. So, it’s not all holding and taking that carry. In some cases, we’ll look to take that gain, we are making that capital appreciation. The bonds might be in the $90s and we go, “You know what, they’re going to refi them early. They’re looking at their call structure. They can take these bonds out of par and they will refi it to secure the liquidity needs for another five years.” That’s a good bond to buy because we’ll pick up the carry and the capital appreciation. The other aspect is, there’s a lot of companies currently refinancing for that reason.
People will say, why don’t they just wait for the ECB and the Fed to cut rates and they can do it more cheaply? The answer is a lot of companies need to refinance now and a lot of corporates if they can refinance at a reasonable rate take that option as it secures its financial future. It’s a premium they’re willing to pay.
MDV – Two thirds of the high yield market right now is rated in the BB range. It’s the highest sub investment grade rating. Leverage is under control and lower than it has been for long time. Interest coverage is high. The fundamentals are good, and while default rates went up a little, they’re peaking in the three percent, everyone expects them to go to 10 percent. That’s not what we believe will happen. And so there’s no major triggers for pan market volatility. In terms of potential risks, you have to look outside the market.
EM – Mike, can we talk a little bit about your global high-yield income fund? Can you talk me through just the numbers, number of holdings, the value of the top 10 securities, the average credit rating, what your top three holdings are?
MDV – The average number of holdings is around 200, out of potentially 3,500 issues. We’re very selective. That’s key. And the reason we’re selective is because your biggest disruptor in fixed income is not getting your money back. Not being paid your coupon; it’s the default.
We say no a lot more than yes, the avoidance far outweighs the concentration on the other side, but we still have a very diversified portfolio. Now, our average rating is around the B+, slightly below the market average. And it’s simply because we do this on a bottom-up basis. We see greater opportunity in single Bs simply because of the price discovery and the opportunity is greater there.
As I said, we like some of the cable operators. We like entertainment and leisure. We like the service area. Entertainment and leisure is interesting. For example, cruise lines have come back, post-COVID far more strongly than a lot of people expected.
EM – Spread compression has been significant, are you still getting value in the sector?
MDV – We believe we’re getting compensated right now on the credit side because credit quality is far superior than what it’s been.
The spread, at the most basic sense, it’s a reflection of your credit risk. High yield credit quality is far better than it has been historically because debt and default rates are under control. And that’s because a lot of the dead wood has been cut out. Post COVID, high yield US default rates were over 6%.
Companies were struggling to adapt to a digital world and as they couldn’t adapt, they defaulted. Spreads have tightened but they’re still well above all time lows and they’re stable.
The other thing to bear in mind right now because of where rates are yield curves are stable. Rates haven’t come down yet. The asset class is still priced on average below par, which means you are going to get as well as an average coupon, which at the moment is well over 6%, you’re going to get around 5% that capital appreciation as that matures to par.
And the key is as always, the more losers and defaults you avoid, the more you keep in your pocket.
EM – I think that just about sums up the whole interview and the asset class, right? Avoid the losers, and you’re going to get the yield and it’s going to be rewarding.
MDV – The average US and Europe default history, since 2015, is around 3%. So, 300 basis points roughly. Our history, at the same time is 17 basis points. Now, I would love it to be zero, but we try hard, but we can’t avoid them all. But 17 basis points versus 300, that’s a huge saving for our investors.
Passive investors will own those 3% defaults. We don’t, and by picking and choosing, we get to avoid the losers a lot more.
