June 2009
Paul Grillo, CFA
Kevin Loome
Paul Grillo, co-chief investment officer – total return fixed income strategy, and Kevin Loome, senior portfolio manager and head of high yield investments, recently discussed their views on the state of the fixed income markets, conditions in the high yield market, their investment process, and what concerns they have regarding today's economic environment.
Q: How would you assess the plethora of government action to attempt to heal the credit markets thus far? Do you share the market’s recent optimism?
Paul Grillo: You can’t deny the fact that the federal government has addressed the liquidity crisis, as well as the broader economic crisis, in a very significant way. It has come out with unprecedented programs to address liquidity, some of which recently have had significant effects on yield premiums and lowered borrowing costs, both of which, we believe, are part of a longer-term cure for what has ailed the credit markets.
Federal programs have enabled the introduction of new issues in many parts of the market, which again helps to get credit flowing.
Today, it looks like the "patient" that was dying has stabilized and is starting to attempt to heal.
That said, the bond market remains incredibly "medicated" in that improvements thus far have largely been a result of government action, and we believe it needs to stay so, as the economic environment continues to be challenging. We expect defaults in many areas to ramp up this year and even into 2010. Given this environment, the medication needs to continue to be applied broadly.
This outlook reflects our opinion that the current economic downturn is more than just a normal cyclical inventory correction. More likely, we are facing an extended period of deleveraging. The reduction of debt and the gradual rebuilding of balance sheets by both consumers and the financial sector should take many years to accomplish and may weigh on economic growth. Finally, the Federal Reserve is likely to create its own set of aftershocks as it tries to manage the reversal of its recent, massive injection of liquidity into our financial system. While long-term, consistent economic weakness is unlikely, we believe a prolonged period of frequent turns between growth and weakness seems possible.
Q: Much has been made this year of what have been called historic opportunities in the credit markets. What’s your view of the corporate credit market today?
PG: If you look at yield premiums, it’s hard to pass up some of the opportunities that are available in the credit markets today. And in our opinion, the investment grade market still offers incredible relative value compared to where it has been historically. Across our portfolios, we are maintaining an already healthy exposure to investment grade corporate bonds, but are in the process of transitioning the makeup of our exposure.
Specifically, we are seeking to replace some investment grade securities whose yields have declined during the significant rally of the past eight weeks with higher yielding opportunities that our analysts deem worthy. Ultimately, we may even sell some of the newer positions if their yields decline as well.
On an industry level, spreads on investment grade industrial credits are still beyond their widest levels of 2002, the credit markets’ last period of severe stress. Within the financial sector, spreads remain way beyond anything we’ve ever seen and, for that reason, we believe certain credits offer attractive opportunities, particularly those in the parts of the capital structure with which we’re comfortable. Spreads refer to a bond’s yield above risk-free Treasurys; spreads are often used to measure a bond’s perceived level of risk.
Within our diversified funds, we are overweight financials but remain highly selective in our individual credit selection decisions. For example, we look for companies with adequate capital levels, run by quality management teams. Additionally, it can be very beneficial for finance firms to be deemed systematically important by our government or regulators in the current environment. These firms could receive additional assistance, which should benefit the senior levels of debt. For companies that have the ability to earn their way around the current economic weakness, both senior and subordinated levels of debt can be attractive investments.
And within our diversified funds, we are ratcheting up our exposure to the high yield sector.
Q: Can you elaborate on what makes the high yield sector attractive to you at the moment?
Kevin Loome: Year to date, the Merrill Lynch U.S. High Yield Master II Constrained Index is more than 20% through May. Importantly, though, we think the asset class still has some room for growth. Credit spreads on high yield bonds have rallied from 2000 basis points over Treasurys to approximately 1000 basis points over Treasurys at the end of May, but they are still wider than they were during their past two peaks in December 1990 and September 2002. (Source: J.P. Morgan.)
Additionally, we believe that the high yield sector is currently attractive compared to other fixed income sectors. We view the high yield market today as exhibiting at least some of the same qualities one might typically look for in dividend-paying equities. That is, we believe the high yield allocations within our mutual funds currently offer growth potential, with a degree of interest rate sensitivity that’s at the moment more limited than usual from this type of asset.
In our view, much of the rally within the high yield market in 2009 thus far has been due to technical factors, such as growing interest from both retail investors as well as large institutions.
The fundamentals for many companies appear to be range-bound at the moment; yet, an important difference from even a few months ago is that high yield companies once again have access to capital.
In fact, net inflows to the high yield market have been of a historic nature so far this year, and new issuance in 2009 is already above that of all last year. (source: J.P. Morgan.) Many companies are bringing new issues to market in order to relieve internal balance-sheet pressures, pay back loans, or repay previous bond issues.
The proceeds from these bond issues don’t appear to be going toward potentially inefficient uses of capital, like mergers or acquisitions, as they had in previous years.
So far, the ability to access the credit markets has been open only to companies in the higher-quality end of the high yield market, but we believe that it could become available to lower quality companies again in the coming months.
Q: Does the rush of inflows to the high yield market present any dangers for you? Has a “herd mentality” — one in which investors pour money into high yield bonds without considering the risks — taken over in any way?
KL: In a word, yes. While we are generally optimistic that the high yield market, and particularly the higher-quality part of the market, is well positioned relative to other fixed income sectors, rushing into high yield bonds could present some issues to investors. In our view, for example, some investors are beginning to overpay for investments in larger, higher-quality companies. In addition, there have been a number of “reverse inquiry” deals that have taken place in the past several months. (A reverse inquiry deal is one in which an asset management firm approaches an investment bank with the request that the bank bring a new deal to market.) This sort of money tends to pose grave problems for investors who reach for yield at the expense of solid, fundamental credit research.
In past cycles, high demand was soaked up by exposure to credit default swaps or other derivatives. Derivatives, such as forwards, futures, options, and swaps, are financial contracts, or financial instruments, whose values are derived from the value of something else (such as the market value of a currency or a commodity, such as oil). Many people seem reticent to go down that road again, which we believe helps to explain the current demand for cash bonds these days.
The “warning bell” indicating to us that the high yield market may be overheating would be when yields on the higher-quality parts of the high yield market, such as BB-rated bonds, start to compress to a point where they encroach upon yields that can be attained in the investment grade bond market.
Defaults are another ever-present danger in the high yield market, but particularly so in today’s environment. J.P. Morgan estimated the default rate as of April 2009 to be in the 7% to 8% range whether viewed on a par value basis or by issuer. It estimates the annualized default rate in 2009 could soar as high as 15%.
Q: With the default rate exhibiting the potential to double by year end, how do you analyze default risk and attempt to avoid defaults within the funds?
KL: We believe it comes down to picking the right credits, and we attempt to do so entirely through our dedication to fundamental research. Our analysts are charged with providing a comprehensive understanding of a particular security so that we are comfortable with the underlying company’s prospects before even considering investing in a bond. Throughout the credit crisis, we also have placed a particular emphasis on ensuring that we are in the right part of the capital structure in all the bonds we hold.
In any discussion of defaults, it’s also important to recognize that the markets are forward-looking that is, they tend to rise or decline before economic conditions noticeably change for better or worse. At this point, I’d say that for about 90% of the companies that are going to default, it’s apparent to us currently that those companies are in serious trouble simply by looking at the price action of their bonds. It shouldn’t surprise investors, for example, when a bond trading below 50 cents on the dollar defaults. And we believe that a good portion of the price erosion that brought some bonds to trade below 50 cents on the dollar already took place in 2008.
Another consideration is that some companies may manage to avoid default altogether simply because they have access to capital once again. We also believe that, as balance sheets gradually improve, certain high yield companies may be acquired by investment grade companies that could be in a position to make an acquisition.
Q: The Delaware Investments Fixed Income team has long touted the features of its organizational structure. How does the structure help you do your job?
PG: Simply put, our structure promotes the introduction of ideas and opportunities because everybody — traders, analysts, and portfolio managers — feels that they are an equal partner in the process.
KL: From my standpoint, the regular “back and forth” I have with analysts and traders is unique, and helps me better manage high yield assets. For example, analysts and traders who cover investment grade credit regularly provide me with insight into companies that have been downgraded into the high yield space; in some cases, they may have been covering these companies for years. We use this type of research to gauge our performance against suitable benchmarks and do relative value work, which has been particularly important during the past year.
Here’s an example, the number of financial companies in the high yield sector has more than tripled in the past year. Yet, given the way that our team is structured, I am fully prepared to evaluate and selectively invest in what we believe are the most suitable new entrants because Craig Dembek, our analyst who covers the financial sector, spent 2008 (and the years before that) covering many of these same financial credits. From my perspective, some fixed income managers appear to be piling into every financial name just to keep up with the Merrill Lynch U.S. High Yield Master II Constrained Index.
In addition, our exprience has shown us that many high yield companies are very dependant on the asset-backed securities (ABS) market. Having access to resources like Stephen Juszczyszyn, who is an analyst and trader covering this sector, provides me with an additional point of view on many companies that are either in our funds or that we have considered adding to our funds — a point of view that I may not have gained were it not for our team’s structure.
Q: Given the aforementioned environment, how has the team positioned high yield assets within the mutual funds?
KL: Broadly, we’re attempting to maintain our portfolios’ risk tolerance in the middle of the road. We entered 2009 underweight BB-rated bonds (by approximately 10 percentage points) versus the Merrill Lynch U.S. High Yield Master II Constrained Index; today, we’re trying to increase that underweight as much as we can, mostly in favor of B-rated bonds, not necessarily more speculative CCC-rated bonds.*
We continue to view B-rated bonds as an attractive area of the high yield market. CCC-rated bonds have risen more than 20% in 2009 (source: J.P. Morgan, as of May 2009), but we believe they may have overshot their fair value at this point, especially given that there is not much liquidity in this part of the market and there has been no significant new issuance. If there were a real fundamental recovery, you’d see new issues coming to market. It’s also important to note that we very much favor bonds over bank loans due to our belief in bonds’ higher relative value currently.
Since the beginning of 2008, the high yield sector has undergone a major change in that the composition of financials has markedly increased — financials have risen from about 3 percentage points to about 10 percentage points of the Merrill Lynch U.S. High Yield Master II Constrained Index due to the number of “fallen angels” — those credits that have been downgraded from investment grade into the high yield space (source: Merrill Lynch). Within our high yield portfolios, though, we are underweight the financial sector by 3 to 4 percentage points.
Q: Broadly speaking, what general lessons do you believe fixed income investors have learned since the beginning of the credit crisis?
KL: Across the investment landscape, I do think the credit crisis has made investors more respectful of risk and of credit research, which plays to our strengths. Many investment managers tout the benefits of credit research, but in our view, not all of them mean it.
I think the past 18 months — with some bonds trading at 30 cents on the dollar — has made investors realize that risk management and credit research should matter. It’s not always the guy taking the most risk who wins the game.
It’s important to note that our investment processes haven’t changed. Across the Delaware Investments fixed income team, we have always heavily relied on fundamental research in building each of our portfolios, and we believe that ours is a sound portfolio management strategy during periods of particular stress such as the past 18 months or so, or during more stable markets with steep yield curves.
Q: Finally, given your view that the credit markets have “stabilized and [are] starting to heal,” what concerns you most today? What events could induce the market to revert to crisis mode?
PG: My main concerns lie in the tightrope walk that the federal government must perform to attempt to keep the economy on track.
On the one hand, we are concerned that the federal government may, as the economy improves, misinterpret future economic growth as being natural, and not a result of the significant “medication,” or government assistance, the markets are under currently. This concerns us because, under such a scenario, the government might prematurely pull back any further planned economic stimuli, potentially creating an additional round of stress on the U.S. economy and credit markets.
On the other hand, given that the federal government is already highly involved in nursing the economy back to health, we are concerned that the government may overstep, attempting to shape politically acceptable outcomes for certain companies in which it has significant stakes.
Such an action could significantly undermine any level of confidence that investors have because it may involve stripping one of secured lending’s most prominent features — that is, being attached to property, plant, and equipment. Meddling with that specific area of contract law, or of capital structure in any way, could likely be unnerving for investors.
All data within this commentary were provided by Bloomberg unless otherwise noted.
Important Information
*Ratings determined by Standard & Poor's. B and BB-rated bonds are considered to be noninvestment grade speculative. CCC-rated bonds are considered to be extremely speculative, as they are close to default.
Investing involves risk, including the possible loss of principal.
Carefully consider a Fund’s investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Fund’s prospectus, which may be obtained by clicking here or calling 800 523-1918. Investors should read the prospectus carefully before investing.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.
The Fund may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Fund may be prepaid prior to maturity, potentially forcing the Fund to reinvest that money at a lower interest rate.
High yielding, noninvestment grade bonds (junk bonds) involve higher risk than investment grade bonds. The high yield secondary market is particularly susceptible to liquidity problems when institutional investors, such as mutual funds and certain other financial institutions, temporarily stop buying bonds for regulatory, financial, or other reasons. In addition, a less liquid secondary market makes it more difficult for the Fund to obtain precise valuations of the high yield securities in its portfolio.
The Fund may invest in derivatives, which may involve additional expenses and are subject to risk, including the risk that a security or securities index to which the derivative is associated moves in the opposite direction from what the portfolio manager anticipated. Another risk of derivative transactions is the creditworthiness of the counterparty because the transactions rely upon the counterparties’ ability to fulfill their contractual obligations.
Diversification may not protect against market risk.
The Merrill Lynch U.S. High Yield Master II Constrained Index is a market value-weighted index that tracks the public high yield debt market. Index performance returns do not reflect any management fees, transaction costs or expenses. An index is unmanaged. You cannot invest directly in an index.
* Not FDIC Insured * No Bank Guarantee * May Lose Value
Delaware Investments is the marketing name for Delaware Management Holdings, Inc. (DMHI) and its subsidiaries. DMHI is a Lincoln Financial Group® company. Lincoln Financial Group is the marketing name for Lincoln National Corporation and its affiliates.
Delaware Investments® funds are distributed by Delaware Distributors, L.P., an affiliate of Delaware Management Business Trust (DMBT), DMHI, and Lincoln National Corporation.
The views expressed represent the Manager's assessment of the Fund and market environment as of June 2009, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice.
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