Edward Meigs and Sean Slein Discuss Investing in High Yield
Q: Why high yield, and why now—particularly in today’s economic environment?
We believe that there’s value in high yield in today’s environment. An important fundamental concept about the high-yield cycle is that at every stage, investors are responding to the historical environment—what has been happening in their recent memory—not what is happening in the current environment. For example, the implied default rate at this point is somewhere in the six- to eight-percent area—versus the last 12 months’ default rate of approximately two percent.
So the market right now is factoring in a mild recession. With spreads as they are, we feel that we’re being adequately compensated for the investments we have in the portfolio even if a mild recession were to occur.
The environment for high yield today is a lot different than it was back in 2006–2007 —years when spreads were very tight. Companies have generally focused on repairing their balance sheets and also modifying their cost structure, so they’re in a much healthier financial condition. High yield issuers have generally been using the proceeds from the primary market to refinance their debt, not to leverage transactions. So general market leverage is a lot lower than it was a few years ago. You don’t have many synthetic collateralized loan obligation (CLO) or collateralized bond obligation (CBO) type of transactions as leveraged structures driving spreads tighter. So, in general, we believe the market environment is much better today than it was three or four years ago.
Q: How does your approach complement First Eagle Investment Management’s philosophy?
Like First Eagle, we are very patient investors. We also look to build our portfolio from the ground up on a fundamental basis, on a credit-by-credit basis, building what we consider to be a margin of safety into our investments. Our margin of safety is a little bit different than on the equity side, but philosophically it’s the same concept: We look at the margin of safety as buying a bond at an appropriate place in the capital structure, with an appropriate cushion of leverage to enterprise value. We try to find the attachment point in the capital structure at a level of leverage that gives us a fair amount of equity cushion or subordinated debt cushion below us.
High yield securities are rated lower than investment-grade securities because there is a greater possibility that the issuer may be unable to make interest and principal payments on those securities. High yield securities involve greater risk than higher rated securities and portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. There are risks associated with investing in securities of non-U.S. countries such as erratic market conditions, economic and political instability and fluctuations in currency exchange rates.
Bank loans are often less liquid than other types of debt instruments. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower's obligation, or that such collateral could be liquidated.