Finding Opportunity in High-Yield Bonds - Return To Top - Reprints

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Sep 4, 2017 - By Leslie P. Norton. The Mainstay High Yield Corporate .... backup to 3% by the 10-year Treasury? Not very
% THE DOW JONES BUSINESS AND FINANCIAL WEEKLY

www.barrons.com

SEPTEMBER 4, 2017

An Interview With Andrew Susser Head of High-Yield, MacKay Shields

Finding Opportunity in High-Yield Bonds The following has been excerpted By Leslie P. Norton The Mainstay High Yield Corporate Bond Fund has beaten its peers since Andrew Susser assumed leadership of the $10 billion fund three years ago. Susser and his 10-member team ply their trade at MacKay Shields, a unit of New York Life, combing through more than 1,000 issuers and looking for companies where assets—what a buyer would pay to own the company—are at least 1.5 times debt, that are generating free cash flow, and where credit is improving. The team includes four well-regarded former sell-side analysts, and everyone “loves learning about companies,” he says. Susser, 52, grew up near New York City and was a corporate lawyer and a casino analyst before he became an investor. Like the stock market, the high-yield bond market today looks stretched. Susser doesn’t see another crash in the offing, but thinks investors should play defense for now. To learn why, keep reading. Barron’s: How has the high-yield market changed? Susser: Quality has improved over the past five years. About 55% of new issuance is rated BB, compared with a long-term average of 43%. Coupons have come down, so there is more interest-rate sensitivity in the market. During the credit-bubble era, before it burst, a quarter of the new issuance was for leveraged buyouts, typically funded with a secured term loan and junior-priority high-yield bonds. Now, LBO financings are just 5% of high-yield issuance. And over 60% of the top 100 highyield issuers are in the Russell 1000 list of

largest stocks; historically, the high-yield market was more the smaller private companies. Issuance of PIK [pay in kind] toggle bonds, which allow the company to pay interest in more notes instead of cash, are now exceedingly rare. What’s your outlook for high-yield, where valuations are stretched? It’s flashing caution. Spreads are about 400 basis points [four percentage points] over Treasuries, rich by historical standards. The 20-year median is a spread of about 525 [basis points]. We aren’t at extreme levels like in the first half of 2007, when spreads were below 300 [basis points]. You would expect right now, though, that credit spreads would be relatively tight—stocks hit several new highs this year, interest rates are low around the world, and volatility is low. High-yield has moved with all of the other asset classes. Jeff Gundlach and others have sounded alarms for high-yield. Firms are shifting allocations from high-yield to high-grade bonds. That’s logical. Managers should be playing more defense than offense, clip their coupons. We are increasingly looking for bonds that are very unlikely to go down under any scenario. We aren’t at the stage yet where high-yield is a keg of dynamite, because the quality is good and coupons are still relatively big. You don’t have the kind of exuberance you’d normally see when the market is about to go through a real downturn. What would give you pause? If pundits were more positive instead of

negative. If you saw more leveraged products coming into high-yield, or retail flows coming into high-yield exchange-traded funds and mutual funds. But flows have been pretty choppy. The investor base is almost all unleveraged long-term investors. Pensions and insurance companies are half the market. There’s nothing that would lead anyone to believe there will be a real downturn. You’re still getting a reasonable spread and a big coupon, and it is a low-duration asset class. Still, the coupon is about what your grandma got in her passbook savings account. My grandma used to travel around to different banks to try to get the best rate. The average high-yield coupon is 6% and change. Everyone is looking for good stable income. It’s very difficult to invest in high-yield and end up losing money, because the coupons catch up and pay you back. Also, your choices right now are not great. You can buy stocks. You can buy investment-grade bonds, which are very tight and very, very interest-sensitive. Even if high-yield bonds are trading rich, you will clip your coupon and get a reasonably low volatility return. How vulnerable is high-yield to a backup to 3% by the 10-year Treasury? Not very. It is vulnerable if interest rates went back to the levels we saw historically. Today’s abnormally low interest rates are very strange. You have to question how sustainable they are. If rates rose pretty rapidly you’d see outflows from all credit classes, and high-yield would be hit. If it happened over time, because the average (over p lease)

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duration of a high-yield bond is less than four years, people would recycle money at higher rates and they would be protected. How have ETFs changed this market? ETFs are only about 3% of the high-yield bond market, and their performance has been pretty dismal. They are the marginal buyer and seller. On risk-off days, people sell, the ETF goes to a discount, and suddenly the high-yield market is hit with selling pressure. It can create a negative loop. Alternatively, when everyone looks to buy, ETFs move to a premium and the ETFs are the buyers. Most of the market is longterm investors and is more influenced by what’s going on in the economy. Even during the Third Avenue crisis [in 2015, the well known Third Avenue Focused Credit fund blocked redemptions because it didn’t have enough cash], or during the energy selloff or Brexit, the high-yield market was very orderly because of the investor base and because most of the companies are public. Lots of different people can read 10-Ks and get up to speed and hedge in the stock market. The lack of liquidity is in the weaker credits. Where will the next land mine in credit come from? The direct private-lending arena is flashing red. An enormous amount of capital is inundating limited opportunities. As a result, lending standards have weakened considerably and yields have compressed. Looking past the seemingly steady returns, the vast majority of underlying credits are small companies with limited flexibility to cope with a recession, tightened liquidity, or other unforeseen circumstances. People also worry about land mines in retail and energy. Retail is only about 5% of the market, and a lot of that is auto retailers, which don’t have the same exposure to the internet. If it really got bad, you’d start seeing investment-grade bonds and retail real estate investment trusts run into issues, but we’re certainly not there yet. Energy is about 14% of the high-yield market. Two-thirds of this is riskier exploration and service companies. The other is steadier midstream and pipeline companies. Quality has improved from the summer of 2014, but the high-yield market seems to be discounting higher energy prices. So, energy remains a risk factor.

Tell us about your investment philosophy. We’re a bottom-up shop. Credit selection is the only thing that matters. We don’t index. We won’t own bonds in the index if they don’t fit our process. We take out bonds with a fair amount of interest-rate risk and that don’t offer much spread. We demand a cushion between what we call the asset value of the enterprise—basically what a buyer would pay to own the company—and the amount of debt it has. If a company is worth $10 billion, and it has $5 billion of debt, we say it has two-times asset coverage. We won’t buy a high-yield bond unless there’s a minimum of 1.5 times asset coverage. It keeps us out of trouble. We focus only on U.S. high-yield. We have a team of 10 investment professionals that have been in high-yield for decades. They know what’s happening with a company and what it’s worth. It is a very nonbureaucratic culture. We all love learning about companies and analyzing companies and trying to put the best bonds with the best risk-return in the portfolio. Where are you finding opportunity? One relatively large name is Carlson Wagonlit Travel, a global leader in business travel management. It and American Express [ticker: AXP] are the two largest. Carlson is closely held. From a credit perspective, it provides relatively predictable revenue, because it is based on multiyear contracts with corporate clients. They have an 85% renewal rate. When we look at credits, we integrate economic, social, and governance, or ESG, analysis to get a sense as to who we are lending money to. The Carlson family of Minnesota is a strategic owner with a sterling reputation. They also are quite liquid, as they recently sold Radisson and some other hotels last year. Another bond we like is Netflix [NFLX]. Netflix is burning $2 billion a year in cash as it invests in content and grows overseas, but has an enormous amount of asset coverage starting with the equity-market cap of $75 billion, compared with $5 billion in debt. Netflix garners substantial strategic value from its 100 million global customers. Is the new Tesla [TSLA] issue, which dropped the week after its launch, more attractive now? We didn’t purchase the new issue because of the lack of free cash flow, lack of covenants, and absence of yield for what is in

large part a technology company. Let me give you a different auto name. McLaren Automotive makes and races high-performance cars. It recently issued 5.75% senior secured high-yield bonds due in 2022 to finance the purchase of a minority holder’s stake. We were able to triangulate around the asset value of the company by looking at the price paid to the exiting partner, the value of the company’s hard assets, as well as its luxury-brand value. In addition, we got comfortable with the asset value of McLaren by looking at competitor Ferrari, which is three times McLaren’s size and sports a $23 billion enterprise value. McLaren is majority-owned by the Bahrain Sovereign Wealth Fund. It has a fair amount of operating momentum and a desire to deleverage. The order book is growing nicely. What are you avoiding? A lot of the recent CCC-rated issuers, which came in too tight with weak covenants and not enough asset coverage. So recently, Staples [SPLS] had a $1 billion issue that we didn’t participate in. We’ve been light in rural hospitals, because of headwinds and high leverage. We’ve been light in the wireline space—the copper wires that go into phones. Those companies are generating a lot of cash flow right now, but if you look at the terminal value and the strategic nature of the assets, they don’t fit our process. What do you think of high-yield, versus leveraged loans? The leveraged loan market has really deteriorated. It’s difficult to buy loans at par or below. Some new issuance has even sold at par and a half, even if they’re shortly callable at par. And because CLOs [collateralized loan obligations, which pool loans] are so dominant in the market, it creates distortions, such as causing weaker credits to trade at spreads that are too close to strong credits. Going forward, if we get hit with some kind of recession, that’s when people who overpaid for weaker loans will regret it. What causes the next recession? I don’t know. Right now, the economy seems OK from the reports our companies are giving us. Thanks, Andrew. n

This third-party article reprint is provided courtesy of MainStay Investments with reprint permission from the publisher. MainStay High Yield Corporate Bond Fund

Period ended 6/30/17

Share Class

1 year

3 years

5 years

10 years

Inception

Class A (NAV)

10.61%

4.33%

6.18%

6.18%

8.50%

Class A (max. 4.5% load)

5.63%

2.74%

5.20%

5.69%

8.34%

Class I (no load)

10.67%

4.59%

6.44%

6.43% 8.76% Fund inception 5/1/1986

Returns represent past performance which is no guarantee of future results. Current performance may be lower or higher. Investment return and principal value will fluctuate, and shares, when redeemed, may be worth more or less than their original cost. Visit mainstayinvestments.com for the most recent month end performance. Total annual operating expenses are: Class A: 0.95% and Class I: 0.70%. Before you invest Before considering an investment in the Fund, you should understand that you could lose money. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higherrated bonds. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks. These risks may be greater for emerging markets. Floating rate funds are generally considered to have speculative characteristics that involve default risk of principal and interest, collateral impairment, non-diversification, borrower industry concentration, and limited liquidity. Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and are more vulnerable to changes in the economy. The Fund may invest in derivatives, which may increase the volatility of the Fund's NAV and may result in a loss to the Fund. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner. Treasury securities are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity. Interest income on these securities is exempt from state and local taxes. Leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. A collateralized loan obligation (CLO) is a security backed by a pool of debt, often low-rated corporate loans. A payment-in-kind (PIK) toggle bond is where the issuer has the option to defer an interest payment by agreeing to pay an increased coupon in the future. With toggle notes, all deferred payments must be settled by the bond's maturity. The Russell 1000® Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. Brexit is an abbreviation of "British exit", which refers to the June 23, 2016 referendum by British voters to exit the European Union. A 10-K is a comprehensive summary report of a company's performance that must be submitted annually to the Securities and Exchange Commission. Typically, the 10-K contains much more detail than the annual report. It includes information such as company history, organizational structure, equity, holdings, earnings per share, subsidiaries, etc. A covenant is a promise in an indenture, or any other formal debt agreement, that certain activities will or will not be carried out. A leveraged loan is extended to companies or individuals that already have considerable amounts of debt. Lenders consider leveraged loans to carry a higher risk of default, and as a result, a leveraged loan is more costly to the borrower. S&P rates borrowers on a scale from AAA to D. AAA through BBB represent investment grade, while BB through D represent non-investment grade. Holdings mentioned in the article are not indicative of future holdings, which may change daily. MainStay High Yield Corporate Bond Fund’s top 10 holdings as of 6/30/17 were: Crown Castle International Corp., 5.25%, due 1/15/23 (0.9% of net assets), Virgin Media Secured Finance PLC, 5.25%, due 1/15/21 (0.9%), Exide Technologies, 11.0%, due 4/30/22 (0.8%), Micron Technology, Inc., 7.50%, due 9/15/23 (0.7%), Freeport McMoRan, Inc., 6.875%, due 2/15/23 (0.7%), Comstock Resources, Inc., 10.0%, due 3/15/20 (0.7%), IHS Markit, Ltd., 5.0%, due 11/1/22 (0.7%), Carlson Travel, Inc., 6.75%, due 12/15/23 (0.7%), MGM Growth Properties Operating Partnership, L.P./MGP Finance Co-Issuer, Inc., 5.625%, due 5/1/24 (0.6%), and Nielsen Finance LLC/Nielsen Finance Co., 5.00%, due 4/15/22 (0.6%).

For more information about MainStay Funds®, call 800-MAINSTAY (624-6782) for a prospectus or summary prospectus. Investors are asked to consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus or summary prospectus contains this and other information about the investment company. Please read the prospectus or summary prospectus carefully before investing. mainstayinvestments.com New York Life Investments engages the services of MacKay Shields LLC, an affiliated, federally registered advisor, to subadvise the Fund. MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. The MainStay Funds® are managed by New York Life Investment Management LLC and distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company. NYLIFE Distributors LLC is a Member FINRA/SIPC. Not FDIC/NCUA Insured 1748658

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