In this interview, Seth Meyer, co-manager of the Henderson Horizon Global High Yield Bond Fund, discusses some of the factors that are influencing the US high yield market as well as commenting on aspects of the fund’s positioning. Seth Meyer (based in Denver) co-manages the fund with Tom Ross (based in London), utilising the credit team resources on both sides of the Atlantic.
Question: How late cycle is the US, and is this causing you to favour issues higher up the rating scale (a higher quality portfolio)?
Seth Meyer (SM): Since the Second World War, the average economic expansion in the US has lasted around 60 months. The current expansion has already lasted 96 months, leading us to believe we are much closer to the end of the business cycle.
Age of post WWII economic expansion in the US (months)
Source: National Bureau of Economic Research, June 2017
As we conduct our fundamental, bottom-up credit research, we emphasise two key things, one qualitative and one quantitative. We seek management teams focused on deleveraging (the qualitative) and companies with free-cash-flow generative business models (the quantitative). When valuations get tight and we are near the end of the credit cycle, we are looking for stability of free-cash-flow generation.
While we are moving the portfolio up in terms of quality, it is less about ratings, such as favouring BB versus CCC, and more about seeking higher quality business models. We are emphasising names in healthcare, cable communications and food and beverage, and focusing less on areas such as retail and hotels.
Q: Has faith in an extended economic and credit cycle under Trump begun to fade?
SM: In our view, the most accretive economic event that Trump could carry out is corporate and personal tax reform. However, the hurdle is clearly higher now than it was in November 2016, and the administration’s inability to date to execute on the repeal and replacement of the Affordable Care Act creates doubt about Trump’s ability to accomplish any reform, whether that be in health care, taxes or infrastructure spending. That said, Trump has more cross aisle support in Congress for tax reform than he does for healthcare reform. We believe that if the administration can accomplish tax reform, particularly corporate tax reform, the cycle can be extended further. Failure to execute even a watered down version of tax reform would likely cause faith in the administration’s ability to extend the cycle to be lost.
Despite distractions and the administration’s lack of accomplishments thus far, the demand for US corporate credit remains robust. The insatiable demand for yield, in combination with positive gross domestic product (GDP) and employment growth, relatively strong company fundamentals and the potential for tax reform, creates ongoing investor interest in high yield. Spreads will widen if we see recessionary pressures or a turn in GDP, but markets are expressing extreme complacency that such an event will not happen right now.
Q: Although high yield is less sensitive to rate risk than investment grade, does monetary tightening by the US Federal Reserve (Fed) pose any risks?
SM: Fed tightening puts the most pressure on the front end of the yield curve. However, it typically leads to volatility in longer duration assets (including the 5-year part of the curve which high yield is most exposed to) and the most interest rate sensitive sectors. As you look lower down the ratings quality spectrum, issuers will be less correlated to a rate hike. With BBs – nearly 50% of the high yield market as represented by the Bloomberg Barclays U.S. Corporate High Yield Bond Index – being the most correlated to moves in interest rates, we expect a component of interest rate sensitivity as the Fed tightens but not to the same degree as we would see in investment grade.
Q: Does the tightening raise your interest in financials?
SM: The most recent tightening does not raise our interest in financials. Financials make money on a steeper yield curve. At the moment, the dampened outlook for growth and inflation is leading to a flatter curve, creating an unfavorable environment for financials. If, however, the Trump administration manages to successfully implement growth-enhancing reforms, the back end of the curve is likely to sell off, and then we would buy financials aggressively. In such an instance, the Fed would be behind the curve. It would take them a lengthy period of time to catch up, so we would expect financials then to benefit from a steeper curve for some time.
Q: Are there issuers you are avoiding/favouring at a sector level and why?
SM: We are looking for companies with stable free-cash-flow profiles. We continue to favor the healthcare sector, specifically hospitals. The societal need for hospital services leads to these asset-rich entities being attractive risk-adjusted opportunities. Some are selling assets, others are diversifying business models out of the pure acute care hospital and into higher margin businesses such as Ambulatory Surgery Centers. Furthermore, most US hospital issuers have opted to conserve capital and pay down debt as they consider the implications of still-undecided healthcare reforms.
While we are not avoiding anything in particular, we are generally shying away from retail, including fast fashion and most department stores. However, we do have targeted exposure in the retail space to business models that we believe can survive even as consumers shift their shopping online, such as Tailored Brands/Men’s Wearhouse, the distinct clothing retailer, and PetSmart, the pet supply retailer. The fact that both of these issuers have carved out a presence online should also be to their benefit.