NEW YORK, NY--(Marketwired - Jul 9, 2014) - The U.S. stock market isn't the only way to invest in quality small- to mid-size companies. Carefully selected publicly traded bonds issued by carefully middle-market companies often present the opportunity for good returns with lower risks than stocks.
"There is an established market for small- and mid-cap stocks, which are perceived as offering greater return prospects than their larger brethren. There is a parallel opportunity in the high-yield market," says Phillip Schaeffer, senior portfolio manager at Scott's Cove Management LLC, an event-driven corporate-credit-focused investment manager.
"Approximately 28% of the U.S. high yield market consists of bond issues smaller than $450 million. In fact, because of their more senior standing relative to equities in a company's capital structure and their significant interest rates, these securities can offer an attractive combination of return potential and downside protection. With the rally in stocks now in its sixth year and showing signs of age, we believe that is a combination which merits renewed attention," he says.
Schaeffer distinguishes between smaller bond issues -- roughly $125 million to $450 million in size -- and larger ones. He points to Bank of America Merrill Lynch analysis showing that during most market environments, the yield-to-maturity of smaller bond issues is about 200 basis points higher than that of larger bond issues. In addition to higher yields, some smaller deals often offer the potential for capital appreciation resulting from improving operations, a company sale or other strategic developments or events. An ancillary effect from this higher yield is that these smaller issues are likely to be less sensitive to interest rate moves, he says.
Schaeffer points out that the yield advantage of smaller issues stems from inefficiencies in the markets, not a greater risk of loss. The high yield market is dominated by large institutional investors that frequently can't buy a sufficiently large amount of a small issue to justify the work involved; further, some small institutions and retail customers who might otherwise participate are prohibited by law from buying certain issues. Finally, broker dealers have cut their research staffs and the capital allocated to the market.
He points to several specific examples that demonstrate the potential for investors that smaller corporate credit issuers can offer:
- A paper company whose bonds have a yield-to-maturity ("YTM") of 9%. The company is over 100 years old and manufactures and sells coated paper and specialty paper products. The company's growth prospects, particularly in a subsidiary with a valuable and proprietary technology, could allow for an initial public offering in 2015 or 2016.
- A manufacturer of health and fitness equipment has bonds with a maturity of less than three years and has a 12% YTM. The company has over 2,000 employees and produces products under well-known brand names.
- An envelope, printing and labeling company has bonds with a three-year maturity and a YTM of 9%. The company has revenues of over $2 billion and is highly leveraged, but has been paying down debt through cash flow and the proceeds from asset sales. The company's management has been a buyer of its publicly-traded stock.
- A magazine company with popular titles has bonds with a maturity of less than four years and a YTM of 9%. The organization has recently developed licensing and product extensions of its brands, thus reducing its reliance on its magazines.
- A national restaurant company with a range of popular chains has bonds with a six-year maturity and a YTM of 8%. The company has been successful in acquiring and reviving mismanaged restaurant chains.
- A specialty retailer with a strong, and growing, national presence has senior secured notes with a YTM of 7% and senior unsecured notes with a YTM of 11%. The company is owned by a well-known private equity firm and is pursuing several promising areas of expansion.
"It's important to keep in mind that you can't simply buy any small high-yield issue and pick up extra returns. It requires discipline and a commitment to fundamental research," Schaeffer says. In his view, particularly in today's investing climate, successful investors may be best served by looking to:
- Minimize interest-rate risk by seeking shorter maturity, higher coupon bonds, which have relatively low duration.
- Focus on secured and senior debt to help protect against volatility and to mitigate the potential loss of principal.
- Search out "event-driven" opportunities, i.e., securities that will benefit from extraordinary occurrences or situations, such as restructurings, refinancings, asset/division sales, litigation, tax issues and so on, and whose price and performance are the result primarily of those events, not market or interest rate fluctuations. This can help investors reduce correlation with the overall markets.
About Scott's Cove Management LLC
Scott's Cove Management LLC (SCM) is an investment manager whose objective is to protect capital and generate compelling absolute returns over all market environments. On the long side, SCM focuses primarily on senior and secured debt of lesser-followed high-yield corporate issuers, with a particular expertise in distressed situations. On the short side, SCM seeks fundamentally overvalued and economically deteriorating issuers. SCM (including its predecessor firms) was founded in 1991 and is based in New York. For more information, please visit www.scottscove.com.
Any securities mentioned herein are for illustrative and informational purposes only. No inference should be made that these securities are held or have been held in portfolios managed by Scott's Cove or that they have been profitable to any of Scott's Cove's clients. The views described herein do not constitute investment advice.