Tim Gramatovich, the chief investment officer at Peritus Asset Management, the firm behind the $260 million Peritus High Yield ETF (HYLD), says the junk bond market will do just fine as financial markets adjust to the end of the Federal Reserve’s quantitative easing.
Moreover, Gramatovich told IndexUniverse’s Cinthia Murphy that HYLD, the ETF world’s only actively managed high-yield fund, has extra flexibility to find parts of the vast $1.5 trillion junk bond market in search of yields that can reach as high as 8 or 9 percent.
IU.com:Walk me through how the junk bond market is likely to respond to the path of mean reversion as interest rates rise. Will it be a rough ride?
Tim Gramatovich :I’ve seen many cycles in terms of modern markets of high yield, and this is the first time we’ve experienced this dislocation as it relates to interest rates and duration—the rates are going up and everything is selling off.
But the selling was not restricted to high yield—it included other fixed-income securities and equities, too. That’s a misconception in the space, that if you’re looking for yield in the equities space, you’d somehow be protected, but nothing is further from the truth.
When we look at the high-yield market, we look for the real enemy, and the real enemy is defaults. At the end of the day, we look at whether we’re bumping up against ridiculous leverage metrics, and at what the environment is like.
Right now we’re looking at the risk/reward environment of our careers based on spreads and default risk. For the next three or four years, there isn’t much in the way of maturities in the high-yield market coming—we just pushed everything out through 2017—and it’s going to be a very benign environment irrespective of how the economy performs.
We are generating yields of 8-9 percent. So if in fact we see interest rates go up another 100 basis points, which could happen—we’re agnostic on the interest-rate game—we’re looking at a 2.5 percent yield on five-year Treasurys. There are still excellent values in the marketplace at those levels, so we’re finding the best risk/return of our careers.
IU.com:We hear so much about investors starving for yields. Yields of 8 or 9 percent certainly don’t sound so bad.
Gramatovich :The high-yield market has a massive $1.5 trillion, and what happens is that ETFs like JNK and HYG have gathered a lot of assets over the years and they’ve done a good job with beta trade, if you will.
But the problem is they eliminate about 60-70 percent of the market because they restrict their purchases based on the size of the bonds outstanding, which to us is crazy. We’re lenders—I’m lending money to companies by buying their bonds, so I only care if I’m getting paid back.
I’m looking for business that will generate some excess cash flow that gives me a margin of safety, and that can pay their bills. I don’t care how big they are; all I’m looking for is to make good loans, and that’s where the misinformation comes—that in high yield there isn’t any yield. There’s plenty of yield because this market is massive.
IU.com:Are there certain areas of the high-yield market, then, that are more easily accessed through active management?
Gramatovich :Most investors really look at bonds as an opaque market, and high yield is an over-the-counter marketplace, so it’s a bit obtuse, but what you’re looking for is no different than what equity investors are looking for:to identify undervalued securities as a value investor. And we do so in the bond market.
One of the things that Peritus does almost exclusively is focus on secondary market. We’re not primary markets, trying to flip a bond for a point or two. We’re identifying industries, themes, individual businesses that we believe have very attractive risk/return characteristics.
In essence, we’re getting paid very good yield for perhaps something that’s misunderstood or that has a very good margin of safety.
IU.com:How do you minimize costs of transacting in relatively illiquid bond markets?
Gramatovich :The thing about liquidity is that high-yield markets run like water compared to most of other markets. When you look at municipal bonds, or even investment-grade corporate bonds, these things are bought and put away. High-yield trades very actively, so the market is quite liquid.
Secondly, trade and execution is something we pride ourselves on, and execution is a big part of the business. We add value on the execution side of the business rather than see that as a cost.
IU.com:In HYLD, do you hold bonds until maturity?
Gramatovich :Here’s a funny statistic:in 18 years, we’ve had one maturity. The reason for that is that in high yield, if you’re getting the credit right, you’re looking at this and saying that given this interest-rate environment, what we are losing is bonds for their call. Somewhere between 75-80 percent of our historical purchases are called by the company at the very first call date, in essence refinancing at a cheaper rate than at what they were put out.
Another area we’ve had success with is what we call triggering a change of control covenant or a poison put. In other words, if a company gets acquired, we’re able to jam those bonds back to the acquiring company typically at 101.
That’s another area where we create value. Call premiums and put premiums are things we’re looking for all the time. Very, very few bonds in high yield go to maturity—they are generally refinanced well in advance of that.
IU.com:Should we expect inflows into these so-called fixed-income alternatives, such as high-yield bond ETFs, to remain strong because they still look attractive, even relative to equities, in terms of risk assets?
Gramatovich :That’s so accurate. You have choices, and people run these models to determine their asset allocation, and they are going to be, say, 40-60 percent in equities. I’m not an equities guy, so what I look at is the other side of the portfolio:the income, or fixed income.
Our product is not a levered trade on high yield or beta trade on high yield. It’s a product designed for retail advisors and clients who need consistent monthly income. That’s what we’re here to do.
Gramatovich (cont'd.): The high-yield bond market allows us to do that effectively and with much less risk than the equities market. We have nothing against yield equities, and this fund allows us a 10 percent bucket for equities on the yield side, although we’ve never used it, but if things were cheap enough we certainly would.
The problem with that is that even there, if you’re buying a stock and looking for its dividend yield, the credit work you have to do is immense because that dividend is not contractual. All that dividend is, is a promise by the board that it will pay it next quarter, and it can be cut or removed at any time. So we like the high-yield space because we’re taking less risk and gaining more income.
If rates continue to rise over a period of years, anything you’re buying today in the Treasurys market, the municipal market, in the agency market—in any of these high-grade areas—the best you’re going to do is your coupon, because you’re going to lose money in the principal trade in terms of rates.
So we look at leverage loans and high yield—they are $3 trillion together, and it’s a $7.5 trillion corporate credit market. We’re nearly 40 percent of the market between those two things, and people give us token allocations of alternative buckets of, say, 5 percent.
Why isn’t high yield or leveraged loans the new core fixed income? Because, in essence, both are very short duration, very interest-rate insensitive and generate a lot of yield. That’s what we think the asset class buys, and it comps well against anything in fixed income and against equities.
There’s a lot of yield out there, very short duration, I don’t understand why people think that in a very slow global economy equities are the place to be. I understand they have their place, but if you’re going to be in a muddled-along environment, as I think we will be, high yield should be in a sweet spot.
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