Q: What is the history of the fund?
The Federated Institutional High Yield Bond Fund was launched in 2002 but is the institutional sister fund to a retail offering that dates back to 1977. Its purpose has always been to give pure high-yield exposure to institutional clients.
We generally play inside of the high-yield box, and do not venture outside the asset class to seek alpha. We do not invest in equities or in bank loans, or view cash as a strategic asset. The fund has few out-of-index positions and little in investment grade.
Our belief is that bottom-up fundamental analysis focused on the quality of an issuer’s underlying business has the potential to generate competitive returns over time. In high-yield, “quality” does not necessarily refer to balance sheets, but instead to strong underlying companies with market leading positions, good cost structures, and leading management teams. We simply want to identify the best companies among these.
Q: How do you define your investment philosophy?
Along with bottom-up analysis, our philosophy centers on finding companies and industries that can produce consistent, predictable free cash flow, because having it means they can hold a little more debt than the average high-yield company.
This fundamental belief—our willingness to enter into high-yield companies with greater debt but stronger and more stable businesses—often leaves us at odds with the rating agencies, where their focus is much more on debt leverage than on the underlying quality of the business. We think the ratings agencies have it wrong, and are less concerned about debt leverage if a company is stable and can continue to grow its way through a capital structure.
Historically, we are consistently underweight what the rating agencies consider high-quality credits and consistently overweight single-Bs and CCCs rated bonds. This does not make our portfolio low quality. In fact, it performs well in up markets and even a little better in down markets.
Q: What is your investment strategy and process?
We do not start with a macro view but view all the companies in our universe using a bottom-up approach.
If a company falls from investment grade we will look at it, but idea generation generally is driven by the new issuance calendar. Because high-yield bonds are not particularly long in nature, often callable within four or five years, we get a fairly consistent look at new companies as they come along.
The basis of our qualitative process begins by looking closely at a company’s products and franchise value. Are they market leaders either in a large global area, or do they have a strong set within a particular niche? Next, we examine the industry profile to understand its competitive dynamics, and then determine whether the company is a cost leader.
Finally, we focus on the management team and whether it can execute. At the time of a new deal, a call is set up to go over their business and gain an understanding of what they are looking for, be it a leveraged buyout, an acquisition, or a share repurchase. After that, we quickly set up company meetings typically with the CFO; each of our analysts visits on-site at least twelve companies per year, in addition to attending industry conferences.
Though we are not a quant shop, all of our models lead toward the same metric: the free cash flow a company can generate relative to its debt balance. Because we put a heavy premium on stability, the fund tends to be overweight more predictable sectors like healthcare, media, packaging, and consumer nondurables.
Conversely, we tend to be underweight areas with more volatile business structures, like companies in metals and mining, energy, and single commodity chemicals. It is not prudent to put significant debt on a company that already has so much operational leverage.
Q: What kind of opportunities do you seek to discover through your research process?
To a large extent, our research process focuses on identifying opportunities that will offer solid growth rates without requiring us to take the underlying risks. For example, in the restaurant space, leaning toward companies with lower volatility means we prefer licensors with solid brand names over companies that physically operate restaurants.
By focusing on licensing or franchising companies, we avoid direct exposure to much of the cost basis that restaurant operators have, like labor costs or raw material costs. We simply receive a percent of revenue off the total sales of the company. Also, we have considerably lower capital expenditure requirements since we are not physically building new restaurants.
Often, below investment-grade is a choice, not just a place we randomly fall. When a leveraged buyout gets a junk or CCC rating, it is no surprise. As long as our bottom-up analysis has determined there is a strong underlying business that can grow and create consistent, predictable free cash flow, we are willing to put our cash behind our beliefs.
High yield by design is a model we have followed many times. Take a public company which at the time may or may not be high yield. The sponsor decides a leveraged buyout makes sense, so they purchase the company, fund a sizeable portion of that with debt, and put their capital at the bottom of the structure.
If the story plays out as we expect, the company will grow, pay down part of its debt load, and maybe take a dividend at some point. Then it will go public again through an IPO and ultimately pay down the debt that was issued as part of the leveraged buyout process.
There is a certain stigma attached when a company gets a CCC rating, but that is a reflection of its leverage profile as it stands today. We are looking at this from a much more future-looking perspective. Frankly, we do not care whether the company ever gets upgraded. We just need it to be strong enough to grow and ultimately repay debt.
Q: Would you describe the types of companies you generally like to avoid?
For an example of the type of investments we tend to avoid, think about the newspaper industry five to seven years ago. These companies had been around for 100 years and were relatively low levered—two to three times—so the agencies rated them highly, generally BBB or BB. The problem was no one was buying newspapers anymore. The businesses were functionally going away; they had high single-digit subscriber declines every year.
When we looked, we saw a group of companies that were deteriorating in value. It was not a good place to be as a bondholder, in that ultimately a decision would have to be made about whether cash flow being generated would go to equity holders or debt holders. Many of those companies have since restructured.
Q: What is your portfolio construction process?
Our process itself looks much more like a small-cap stock process than an investment-grade bond process. We do a lot of industry comparative and upfront work, and continue to keep staffing necessary to unearth truly valuable positions.
Decision-making is bottom-up with our analysts using an internal one-to-five, risk-adjusted rating to communicate their highest conviction opportunities to the portfolio managers. Though portfolio managers have the final say as to what goes in the portfolio, they go along with their recommendations of analysts the vast majority of the time. Our focus is on bringing in experienced decision makers and following their decisions through.
The fund’s benchmark is the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index. While we are aware of the benchmark, we do not play to it.
If we like a credit, the fund may have a position of index weight to 50 basis points over the index. If we do not like the credit, we have no problem owning none of it. The larger benchmark positions would be the top ten or fifteen issuers in the index. The majority of the index is made up of much smaller issuers, with positions of 0-25 bps in the index. In those cases we don’t pay much attention to the index position, and size our holding based on our underlying belief in the credit. The portfolio is fully diversified with 200 to 300 names, and is limited to no more than five percent of any one issuer, and no more than 25% of any industry.
To a large extent, our sell discipline is built on the early identification of credits that are deteriorating. The entire universe of high-yield returns looks like a bell curve. Performance is often driven not by hitting the winners on its left side but by avoiding the losers that fall to the right. Early on, we want to identify those that may not be going our way and get them out of the portfolio—before they end up on the losing side.
Q: How do you define and manage risk?
Risk is managed in multiple ways, both internal to the High Yield group and external to it. The firm has a separate risk committee that monitors operating risks, and our CIO gets daily reports to monitor tracking error, value at risk, and other metrics.
Within our group, we actively manage risk based on our bottom-up security selection and our rigorous review of credits, meeting every day to review the market, any new issuances, or changes associated with a credit. During quarterly meetings, we walk through the portfolio line item by line item to determine what our best and highest convictions are, discuss whether the stories are playing out as expected, and decide which opportunities we may exit.
We also meet on an as-needed basis to do a further long form analysis of credits, often discussing stories that are not playing out well—the 80/20 rule about spending 80% of our time on 20% of the credits generally applies. The portfolio managers gather with analysts and everyone who is available and discuss two or three credits, spending 30 to 45 minutes on each. Together, we go through the issues, either defending a position or deciding to exit. It is a very collegial process.
