High Yield with a Margin of Safety

MainStay High Yield Corporate Bond Fund

US > Non-Investment Grade >

Apr 27, 2015
  • 52 Week HL
    57.6 - $23.6
  • Net Assets
    $974.3 M
  • Expense Ratio
  • Inception Date
    Jan 27, 2017

Q: What is the history of the company and how are you organized?

MacKay Shields, the fixed income investing firm, was founded in the 1930s and is an indirect, wholly-owned subsidiary of New York Life Insurance Company. The firm is made up of four separate investment groups that share a common compliance and support infrastructure. In addition to our high yield group, the other three groups at the firm focus on global fixed-income, municipal bonds, and convertible bonds. 

Our group focuses on high yield debt. Today we manage approximately $21 billion of high yield assets for clients through our mutual funds and institutional separate accounts. The Mainstay High Yield Corporate Bond Fund has been around since 1991 and currently has about $8 billion of assets under management. We also manage the Mainstay Short Duration High Yield Bond Fund, which we introduced in 2012. Our institutional clients are a pretty diverse group of domestic and foreign investors.

We have a team of very experienced sector portfolio managers. They have an average of 24 years investment experience; each of them has gone through different cycles and understands the nuances of restructurings and covenants. Most importantly, we have a deep knowledge of the value and risks of the companies in which we invest. In short, we are a flat, decentralized team of seasoned high-yield experts.

Q: How do you define your investment philosophy?

For starters, we are bottom-up investors with a value orientation and long term outlook. 

We have a simple and straightforward investment philosophy that has remained consistent through our group’s history. Because of the asymmetric reward and risk profiles, investing in high yield bonds requires special attention to downside protection. 

We look for that additional cushion, or “margin-of-safety” through asset coverage. We define asset coverage as the value of a company compared to the amount of debt it has. It’s a similar concept as loan-to-value.

For example, if we think a company is worth $4 billion and its debt is $2 billion, the asset coverage is two times. For us to consider investing in a high yield security, we require the asset coverage to be at least one-and-a-half times.

This investment process imposes a discipline that keeps us focused on credits with significant downside cushion, so that an unforeseen development doesn’t immediately put a recovery value at risk.

Finally, it is important to mention that we are not indexers, although we are aware of the index. Rather, we are credit pickers that spend a lot of time getting to know the companies we invest in, and we view ourselves as lenders to the companies we invest in. 

Q: What is the size and nature of the high-yield market?

The U.S. high yield market has experienced strong growth in recent years—it is about $1.6 trillion today, compared to about $950 billion at the end of 2008, according to JP Morgan. It has also matured, and today’s high yield market is very different than the one from less than a decade ago.

First, the overall quality of high yield bond has significantly improved. Larger companies with stronger credit profiles have become the most active issuers of high yield bonds. Leveraged buyout, or LBO firms, used to be much bigger players in the high yield market. According to Credit Suisse, during the credit bubble era, approximately one quarter of all new issuance was associated with LBOs. Those deals now account for only 5% of all new issuance. 

The highly leveraged, often opaque, LBOs have been displaced by higher quality issuers, many of which are publicly traded companies. This trend has accelerated in recent years. Over half of the new issuance in the last two years has been rated BB or higher by the independent credit agencies, compared to a long-term average of about 40%, according to JP Morgan.

High yield capital structures are also often simpler today. Back then, many capital structures had both a secured term loan and a high-yield bond. Today, companies tend to either borrow in the bank loan market or the high-yield bond market; only about a quarter of new issues in high yield bonds also have a term loan.

Finally, high yield has transitioned to a more stable, unleveraged investor base with a longer-term view. During the financial crisis, high yield spreads widened as dramatically as they did because of the significant leverage in the system, the huge amount of hung LBO bridge loans, and the prominence of hedge funds. That dynamic is completely different today. 

According to JP Morgan, pension funds, investment grade funds, insurance companies, and foreign investors make up between 65% and 75% of the high yield market, mutual funds and Exchange Traded Funds are about 25%.

We believe the high yield market today is attractive because of the world we live in, in which global economic uncertainty coupled with extremely low interest rates has made relatively stable, unleveraged income difficult to obtain. High yield bond market is primarily exposed to the U.S. economy, which seems to be on better footing than other regions. In addition, its relatively high spreads make high yield less sensitive to interest rates than most other fixed income asset classes.

Q: What is your investment process?

We start out with a few thousand issuers in the high yield space before narrowing the list down to a group of companies that meet our size and quality criteria. In general, we have a preference for larger companies. Then, we look for bonds that are offering at least 200 basis points spread over U.S. Treasuries. We may look for higher minimum spread depending on market conditions. 

The next step is the margin-of-safety analysis I talked about before—making sure we have at least one-and-a-half time asset coverage for each security under review. We approach asset value in as many ways as we can, to make sure credits meet our asset coverage minimum through as many ways as possible. This is the point where the rigorous credit analysis really happens. A lot of time is spent on due diligence, understanding companies and judging the nature of their assets and how strategic they are. We speak to management teams and assess their views on their capital structure.

Capital structure and covenants are very important to us. Right now, over a quarter of the bonds in the portfolio are secured and we prefer low levels of bank debt. We generally have fewer bond offerings from LBOs than the index because they generally have weaker covenants and our views on what the capital structure should look like often conflicts with those of the private equity shareholders.

Finally, we look for a catalyst. For example, we may think that a company may be acquired by an investment grade company, or that a bond has a restrictive covenant that would compel a company to redeem it early. However, the most important catalyst for bonds is improving credit profiles.

Q: How important is the price you pay for bonds you like?

Before we buy a bond, we always ask ourselves if we are prepared to buy more if the price were to go down significantly. It is a good way of gauging the long-term value of the company in the face of a temporary setback or if the market doesn’t agree. It’s also a good way for us to measure our own conviction level.

When many high yield managers own a bond that goes down, they tend to sell, but we do not automatically do that. Instead, we look at that bond to figure out if it still has a margin-of-safety and if we are getting paid appropriately for the risk. If we are, then we may buy more. We try to avoid defaults, but we are not afraid of them either.

Within the portfolio, we assess relative value through our system of risk groups. Every bond in our portfolio is grouped into different risk buckets, each of which has an assumed long-term default rate. 

Group one credits are our highest quality bonds which are least likely to default. We think of group two credits as our typical high-yield bond. Group three high yield bonds are higher on the risk scale and they are the most research intensive bonds, often trading at a discount to par. They still have one-and-a-half time asset coverage, of course. Last, we have a group four for special situations, which are typically a small part of the portfolio.

We compare the spreads of credits both within an individual risk bucket and also between risk buckets to determine whether or not we are getting paid appropriately for the risk. For example, the spread of a group two bond would have to be sufficiently wider than a group one bond to represent the better relative value to us, in order to compensate for the higher long-term default rate.

For the past several years, we have been defensively positioned and our portfolios have had far less CCC-rated bonds than the broad high yield market. This is because we viewed the default adjusted spreads of group three credits as being too tight compared to group one and group two credits. In addition, many CCC-rated bonds failed to meet our minimum asset coverage metric. We have also had shorter duration than the market because we have been able to find many higher quality companies that offer reasonable returns, without having to accept extremely narrow spreads and long maturities.

Q: Could you illustrate your research process with some examples?

One of our largest positions currently is in bonds of T-Mobile, the nation’s fourth largest wireless carrier. T-Mobile, majority owned by Germany-based Deutsche Telekom, is traded on the stock exchange with the ticker (TMUS: chart). We believe that T-Mobile is a low-risk bond, as it benefits from substantial asset coverage derived from its spectrum positioning, and growing network of customers. Several larger companies have attempted to buy T-Mobile at prices far in excess of the debt level. 

The capital structure—which is all unsecured bonds—is simple, with no priority debt. In addition, management has been conservative with regards to the company’s capital structure, and the company recently issued equity to maintain balance. T-Mobile’s recent bond issues had coupons of 6% and 6.375%, and currently trade with yields in the mid-5% range, which we consider attractive for how strong we believe the credit is.

Q: Would you quote another example?

For several years, we had a large position in the bonds of Texas Industries (TXI: chart). The company, which was publicly traded, was the largest independent cement company in the U.S. with plants in Texas and California, as well as aggregates and concrete operations in Texas. We were attracted to the strategic nature of the assets. The company had modern, long-lived assets in desirable locations in Texas, which is important because there are limits on how far you can move cement. 

The barriers to entry are also significant due to the high upfront capital costs and the difficulty in obtaining environmental permits. Even using conservative assumptions, we believed that asset coverage was over two times. The capital structure was simple—the 9.25% senior notes represented all of the company’s debt. 

TXI’s profitability declined sharply beginning in 2009 due to the recession, and the price of the bonds declined as the company’s credit metrics weakened and liquidity became challenged. However, the market underappreciated the significant asset value of the company. Over 80% of the U.S. cement industry is owned by international cement companies; almost all of them had strategic interest in TXI. In 2014, the company was acquired by Martin Marietta, a publicly traded competitor, and the 9.25% senior notes bonds were tendered for at a premium.

Q: Do you rely on ratings of bonds from independent agencies?

The risk groups I described earlier serve as our rating system. Once we have determined the investment merit of a bond, we place the bond in one of the risk buckets. From that internal group analysis of risk we determine a default adjusted spread, which enables us to figure out what we should pay for different bonds in the market. Therefore, credit ratings from the independent agencies do not play roles in our investment process and analysis. 

However, we recognize that credit ratings affect the market’s perception of a bond. For example, if we view two credits as similar but one gets upgraded to investment grade, its spread is likely to tighten meaningfully in comparison. Conversely, if we view two credits as similar and one gets downgraded to CCC, it will likely come under selling pressure. When we are looking at a potential investment, we prefer a bond which we believe is stronger than its credit rating suggests, because it may have some long-term upside. 

Q: What is your portfolio construction process?

Once we have identified the securities that fit our investment process and the risk group that each falls into, we look for relative value. As a group, we discuss where securities in the different risk groups should be trading. This process helps us in determining where the best relative value and risk/reward is.

The next step is ensuring that our portfolios are properly diversified. This is where the benchmark indices come into play. We use the Credit Suisse High Yield as the benchmark for the MainStay High Yield Corporate Bond Fund and many of institutional clients. 

Our other clients use broad indices from Bank of America Merrill Lynch and Barclays Capital. In addition, we manage several portfolios benchmarked to the Merrill Lynch BB-B Non-Financial Index for clients with more conservative guidelines. 

To ensure that the portfolio is diversified across sectors, we generally limit any single industry’s representation to 15% of the portfolio or two times the weighting in the index. An individual issuer’s positions’ size is determined primarily by our conviction level but also other factors including issue size and trading liquidity. We impose a limit on any single issuer to a maximum of 4% of the portfolio.

We shift our positioning depending on our assessment of relative value. As I mentioned earlier, for the past several years, we have been—and continue to be—defensively positioned. We believe our portfolios have better credits and less volatile bonds than the broad high yield market. What happened in the energy sector in 2014 is a good example. Earlier last year, a lot of different bonds coming to the market were dependent on oil prices at $100 for the capital structure to work properly. The energy sector ballooned to be a large part of the high yield market—over 16%.

However, a lot of those bonds did not fit our investment process. We spent a lot of time studying what the decline curve for energy companies was and how much it cost those businesses to extract the oil and gas in the ground. We took a net present value of the audited amount of energy to get a firm value and compared it to the amount of debt using $65 per barrel of oil, which is what we consider to be the marginal cost of oil over a longer period of time.

As a result, we are underweighted in energy sector. Since then, a large number of energy bonds have sold off, and we have selectively added to our exposure to the energy sector because now a lot of these bonds look cheap compared to other sectors.

Q: How do you define and manage risk?

We often tell our clients that the two principal risks to the high yield market are credit risk and interest rates, in that order. As I mentioned near the beginning of the interview, investing in high yield bond requires special attention to downside protection. 

Interest rates are difficult to assess, and high yield would not be immune to a sudden spike in rates. However, it is important to remember that high yield is shorter duration relative to other fixed income asset classes. In addition, U.S. interest rates are not excessively low in today’s unusual global context. Still, our portfolio contains fewer long maturity bonds than the overall market because a maturity date is often a bondholder’s best protection against changing events.

The best way to manage credit risk is through a thorough understanding of the individual credit investments and maintaining discipline to our investment process. Because we are always looking for that additional cushion, or “margin-of-safety,” we believe an unforeseen negative event should not change the fact that we will be repaid.

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The history of the fund actually starts before it was established. The team came together at the end of 2003. Using the same strategy we employ today, we primarily managed institutional international and global equity portfolios.

The history of the fund actually starts before it was established. The team came together at the end of 2003. Using the same strategy we employ today, we primarily managed institutional international and global equity portfolios.