We asked portfolio manager Gene Neavin for his take on how rising rates and equity-market headwinds are affecting high-yield bonds and their equity counterparts, leveraged company stocks.
Q: How big a concern are rising rates? High-yield bonds historically have done well in rising-rate periods. In fact, in each of the 10 periods of rising rates over the past 25 years (defined as the 10-year Treasury increasing by about 100 basis points over the course of a year), high-yield bonds generated positive absolute returns and significantly outperformed high-quality bonds.
That may seem counterintuitive because you might expect companies with the most debt to underperform when rates go up. But rates typically rise when the economy is strong and corporate profits are growing, as is the case today. In these environments, you get equity multiple expansion (rising P/Es) and spread tightening (a narrowing gap between high yield and comparable-maturity Treasury yields). This is ideal for risk assets such as equities and high-yield bonds.
It helps, of course, that the four key factors we use to evaluate the high-yield market—the economy, credit quality, supply & demand technicals and valuations—all remain supportive.
Q: A lesser-known aspect of the high-yield market are the stocks of leveraged companies. Can you explain? Leveraged company stocks are the publicly traded stocks of high-yield companies—the same companies you’d find in a high-yield bond portfolio. There are some 600 high-yield issuers that have publicly traded stocks with a combined market cap of more than $3 trillion. Most fall in the small- and mid-cap ranges.
Just as high-yield bonds are expected to outperform investment-grade bonds—and historically have—the same is true of leveraged company stocks compared to the broad equity market. They have a long history of outperformance versus the broad equity market as well as alpha-generating and diversification potential. So an investment in a portfolio of these stocks has the potential to benefit many existing equity allocations.
Q: What about the higher debt of these companies? Any finance textbook will tell you that debt, when used responsibly, can increase shareholder value. It creates tax shields that allow shareholders to retain more earnings, forces corporate management to more efficiently utilize their free cash flow and can increase return on equity. So for many of these companies, debt is an intentional choice. Also, a company can borrow large amounts of capital at reasonable rates only if its creditors determine that the business is strong and stable, with tangible assets, predictable cash flows and a defensible market position. So these are good businesses that have leveraged balance sheets.
Of course it’s critical to differentiate between balance sheets of strong-performing companies and those that are over-leveraged due to deteriorating business conditions. High-yield bond analysts assess complex balance sheets on a daily basis and are ideal candidates when it comes to evaluating these companies from an equity perspective.
Q: Does your outlook for high-yield bonds apply to that of leveraged company stocks? Yes, there is a strong correlation between the performance of a high-yield company’s bonds and its equity. Both pieces of the capital structure would benefit from an expanding economy, strong cash flows, tightening spreads and favorable technicals. And because the equity is the highest risk/reward tranche of the capital structure, we would expect it to meaningfully outperform the bonds. Conversely, if our outlook is wrong, the equity would underperform.