Q: What is the history and mission of the fund?
The Neuberger Berman High Yield group was founded in 1997 and consistently maintains its original investment philosophy, to outperform the benchmark over market cycles marked by periods of high defaults and recovery.
We seek to add value beyond our benchmark, the Bank of America-Merrill Lynch U.S. High Yield Master II Constrained Index, by avoiding credit deterioration and engaging in top-down rotations in credit quality and industries.
To accomplish this, we maintain a large research staff to proactively seek to avoid defaults. During periods where we don’t like the market’s risk/reward, we become more defensive, whereas when we think the economy and high-yield market are headed for expansion, we add risk. So, while we historically tend to add the most value versus the benchmark in times of credit volatility because we avoid deterioration, we have historically kept up with and often exceeded the market during times of expansion.
Q: Did the 2008/2009 credit crisis alter the fund’s investment philosophy in any way?
Despite some tactical shifts in the issuers and industries we own, our core philosophy remains the same. Anticipating certain of the problems of 2008/2009, we defensively positioned the portfolio to seek to avoid the ensuing defaults. Subsequently, we anticipated a better market for high yield, and expected defaults rates to decrease, and bought more CCCs in more cyclical industries.
Arguably, the biggest challenge since the crisis was the sharp decline in commodity prices the past two years, e.g., oil, metals, coal, and natural gas, followed by the inevitable increase in defaults.
To avoid defaults, we reduced our weighting in oil and gas producers, and as the oil market began to recover, we added some oil and gas, metals, and mining names, mostly by purchasing “fallen angels,” as names downgraded from investment grade to high yield often had better credit profiles than typical high-yield issuers.
Q: What guides your investment approach and philosophy?
Our clients want to invest in high yield. We seek to provide them downside mitigation with upside participation.
The type of credit we buy changes, depending on where we are in a cycle. Between 2006 and 2007, we grew concerned with leverage build-ups. Huge debt expansion arose across every asset class, debt service and coverage ratio were declining, and proceeds usage, vis-à-vis leveraged buyouts versus refinancing, was at an all-time high.
CCC-rated bonds, as a percentage of new issue, were also at high levels, so we reduced our holdings, increased our BB and BBB holdings, and reduced cyclical industry exposure.
In contrast, 2008 and 2009 saw us significantly reduce BB and BBB holdings in favor of CCCs, and rotate into more cyclical industries.
What is consistent is our focus on credits capable of surviving entire cycles—companies, often larger issuers, featuring consistent cash flows, flexible cost structures, and liquidity options. We don’t invest in smaller companies, or those with high fixed costs or unhedged currency exposure, and avoid companies with high tail risk where we believe sudden moves in a commodity or currency, for example, makes the credit untenable.
Q: What drives your investment process?
We have a credit best practices checklist, built and developed over decades of investing. Each analyst uses it in their due diligence to thoroughly explore the investment thesis for each portfolio credit and any underlying assumptions.
We start with a top-down analysis of the economy and where we are in the credit cycle, followed by an analysis of each company’s industry and where we are in that industry’s lifecycle. We look at the competitive landscape, the regulatory environment, analyze competitors, and, for each individual issuer, we focus on business fundamentals.
For example, we only invest in companies with long-term track records that have weathered a downturn and have the ability to de-lever their balance sheet, typically through free cash flow generation. We typically avoid companies whose operations expanded via roll-ups or acquisitions, as they often have integration and accounting issues. We seek organic growth.
As a high-yield bond manager, it is imperative to verify companies have sufficient cash to service their debt load. There can be no material discrepancies between income and cash flow statements. We do scenario analysis—financial projections and a base case, downside case and upside case—to make sure that even in a downside scenario the company can cover its debt.
We thoroughly analyze a company’s capital structure to establish how much secured and junior debt it has, what are the rights of that secured debt versus junior debt, whether it can strip assets from the company, and how permissive covenants are.
Companies often brag about having considerable liquidity in terms of cash and bank lines, yet, historically, where there have been problems with credits, it turns out that cash was dedicated to other uses. Perhaps it was restricted, or trapped in overseas subsidiaries, or is needed to run the day-to-day business. And they can’t tap bank lines if they don’t comply with covenants or lack sufficient collateral. We want to see sufficient liquidity available to pay us.
Lastly, we look at management systematically. We have identified eight variables, such as a management team’s ability to manage a leveraged company, what incentives management teams have, or the strength of corporate governance practices. We grade them, A to F, and only invest in those who score an A or B.
Q: How would you describe your research process?
We have a large research team that pays close attention to the actions of rating agencies, as that impacts how bonds perform. For example, when a bond is downgraded or upgraded, it affects the trading dynamics, resulting in possible capital gain opportunities, and may prompt us to exit or avoid a name. We also generate our own internal credit rating, which often significantly varies from that of the rating agencies, forming the basis of our relative-value decision.
Our research staff talks to management teams, and meets with them, which enables us to buy ahead of good developments or sell when problems arise.
In 2015, when the energy industry was hit hard by declining oil and natural gas prices, followed by widespread selling across energy sectors, we believed significant differences existed in the risk various sectors faced, as described below, and sought to exploit that.
In energy, there are exploration and production (E&P) companies and ones that rent equipment to them: offshore drilling vessels, onshore drilling rigs, etc. Midstream or pipelines companies transport oil and gas from the drillers to refiners or shippers and, in the case of natural gas, to utilities who sell to consumers, including chemical companies.
Securities in all three of these sectors were being sold. Our research staff determined that, by far, the highest risk lay with oil services companies, those who rent equipment, because if drilling stopped, so would their revenue stream.
The next level of risk lay in E&P, because even if prices fall, they still generate revenue. The least risky were the midstream companies because their revenues are based more on volume being produced than oil and gas commodity prices.
We added midstream names at some low prices, reduced ownership of oil service companies, and did a basin-by-basin analysis of E&P fields. We only invested in companies that could grow or maintain production even in a low oil and gas environment, and rotated out of names that weren’t in the best basins, even those with good credit metrics and low debt per barrel of oil in the ground.
In the first half of 2016, when oil prices recovered, we still saw heavy defaults in the energy sector but no midstream defaults. From a risk-adjusted basis, we purchased midstream credits at prices significantly below par, where we believed the risk of default was low, and dodged the defaults.
Q: How do you structure your research team and decision-making process?
Our research team comprises four sector teams: consumer, cyclical, telecom, and energy. Every analyst is dedicated to a specific industry and set of companies, and within their sector teams they engage in discussion and analysis, examine trends, and determine the best relative-value opportunities.
Before a portfolio manager can buy a bond, the research team executes a thorough analysis based on our credit best practices and prepares a full credit presentation, including the financial analysis of every scenario. Our research analysts are compensated in part based on how their picks do in the portfolio versus the benchmark.
The credit committee and portfolio managers on our loan and bond sides meet on every name before it goes in and receive continued updates afterward.
First, it must pass the credit best practices checklist. Second, our analysts make a relative value recommendation, whether it’s a good buy at today’s price, using our internal credit rating to establish its relative value and comparing it to other issuers, before the PM makes any buy decision. Finally, we re-examine it regularly to decide whether to keep it or sell.
There are typically two sell factors. One is when a holding reaches its full valuation or price target and we identify a replacement. The other is when something negatively changes our investment thesis. Are credit fundamentals deteriorating? Has there been an unexplained shortfall relative to financial scenarios? Any unexpected developments, like an unanticipated change in management, or fundamental problems developing at the industry level? If any of these occur, we don’t wait to find a replacement. We sell.
Q: Is it consensus-based or does veto power exist?
While the head of the group in charge of the non-investment grade team can overrule decisions, rarely is a buy decision controversial because all possibilities must pass our credit best practices checklist. Heated discussions tend to center on relative value.
For instance, is something a good buy at 97 cents on a dollar, or should we wait until it’s at 95? Should we sell today or at a certain higher price? It is very much a team approach.
Q: How do you construct your portfolio?
We focus on large and liquid issuers, companies with over $100 million of EBITDA or cash flow, and over $500 million of investable debt. We diversify, but not to where we mimic benchmarks. While there are about a thousand issuers in major high-yield benchmarks, we only own about 20%.
We invest in corporate debt, seeking to avoid equity-like instruments, like converts and common shares, and emerging market debt, and we don’t heavily deploy derivatives, including CDS contracts, or use leverage.
When we invest outside the benchmark, it’s a conservative move, like buying BBB bonds, technically investment-grade bonds, with high-yield return levels. We also invest in bank debt where we find value relative to an issuer’s high-yield bonds.
We deploy cash purely to effect transactions, not as a way to express a view on the relative attractiveness of High Yield as an allocation class.
Q: What represents risk for you, and how do you manage it?
In non-investment-grade credit, by far the biggest risk is default—nonpayment. Our credit best practices discipline seeks to winnow out credits unlikely to survive difficult environments. But there is market risk—where security prices will trade.
Our process is a combination of bottom-up, avoiding credit deterioration, and top-down rotation, in terms of credit quality and industries.
Our investors look at return, which is coupons and principal payments in the long-term but impacted by mark-to-market movements over shorter periods. We view that risk differently, depending on where we are in the cycle. If we think we are in a risky part, where risks are building and are not priced in, we take a more defensive posture.
If the market is priced cheaply relative to default risk, typically once many defaults occur and have peaked, we invest in riskier securities.
We have proprietary risk management systems to manage risk daily. Neuberger Berman is a significant asset manager, with over $250 billion of assets under management, including over $100 billion in fixed income, and our non-investment-grade debt group has about $40 billion.
Such scale allows the firm to offer considerable internal oversight in addition to the portfolio management team.
