30 June 2016
Anthony Smouha suggests thinking about a company’s equity as a good place to start when appraising its bond offering. This might strike you as odd, but the seasoned credit specialist’s methods are proven to unearth attractive income sources.
Before Smouha even looks at the debt offering of a company, he surveys the name holistically. “Investment-grade corporates very rarely default”, he explains. “So by first considering if a company is able to issue an attractive equity offering (at any price) provides helpful guidance on how interesting their debt offering might be.” To find attractive levels of income in today’s increasingly challenging environment, Smouha identifies very high-quality, well-run companies then invests at the more junior end of their debt structure. This allows him to capture higher yields, as junior debt holders are more richly rewarded compared to senior debt, without unduly compromising on the credit quality of his portfolio. He likens his approach to collecting rent: “the paper we hold provides a consistent income. We don’t suffer from bouts of feast and famine – we regularly clip coupons so our yield is realistic and reliable".
Consistency is something that has proved more challenging for income hunters in recent years. Elevated volatility levels and uncharacteristic trading patterns have eradicated many of the traditional correlations and cycles. “We avoid exposure to binary risk at all costs – this is essential for steady income generation”, states Smouha. “The debt of corporates, and particularly financials, in economies like Greece and Portugal is a complete no-go for us – however attractive the underlying businesses. It poses too many systemic risks.”
Big shifts in regulation and governance across the financial sector have also helped credit approaches become a more attractive income source. “The new rules make the system safer for everyone”, comments Smouha. With tax-payer bailouts no longer an option, financials have to hold solid capital buffers. “Some banks are already back to paying dividends in line with pre-crisis levels. Therefore we can safely move down their capital structures to book the more attractive yields on the subordinate paper. Names such as Lloyds Bank are stable with very well-funded balance sheets, making its junior debt one of our most attractive and high conviction holdings.”
Regulatory changes have also done much for the mortgage-backed security (MBS) sector, particularly the residential market (RMBS), which remains somewhat shadowed by the 2007 sub-prime crisis. Gary Singleterry, a market veteran who has ridden its evolution for over 30 years, says the sector is looking very healthy. “Homeownership rates have settled with prices coming back to their long-term trend and proving fairly affordable based on the long-term average, which makes for fewer defaults and better credit quality – and more reliable income payments.”
He highlights that media coverage on the sector can often lead investors astray, as it tends to focus on extreme examples and overlook the fundamentals. “Remember the coverage on how Ben Bernanke couldn’t get a mortgage? As a man who earns USD 250,000 for a speech, it’s safe to say he would be a reliable borrower, but strict regulations and a recent job change meant his application was initially turned down. This got completely blown out of proportion by the media, but was actually encouraging for RMBS investors, as it highlighted the stringent standards the industry operates to – currently 60–70% of applications qualify for loans.”
At around USD 7 trillion, the US RMBS market offers plenty of scope for scrupulous investing. “We scour the entire market for debt that offers high yield returns without the leverage”, states Gary. “We buy complex agency trust structures as well as non-agency bonds, as the yields on simple agency debt, which is government backed, are minimal. By not being limited to one sector of the RMBS market – which is the second-largest fixed income sub-sector in the US – means we can switch out of the different risk types if one becomes expensive for a period, such as shifting from credit risk into pre-payment, for example.”
“RMBS is an interesting income option as it is largely uncorrelated to corporate debt”, notes Singleterry. It’s a consumer market, reliant on homeowners’ ability to repay their mortgages. “We also try and take interest rate risk out of the equation” he notes. Returns are typically a little less than in the high yield market, but the volatility is substantially lower. On the topic of interest rates, he advises that a drastic adjustment would probably cause some temporary drawdowns, but modest adjustments are not a concern. For Smouha, rising rates indicate strong economic conditions, which are good for spreads and therefore his approach.
Bringing an equity mind set to bond markets adds a fresh dimension to the yield hunt. Considering more niche opportunities in sectors that have evolved considerably over the past few years is a smart option. Non-traditional debt securities can provide attractive levels of income while increasing diversity, unrestricted by interest rate direction.
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