Q: What is the history of the fund?
Invesco High Yield Fund has quite a rich history. Back in 1977, when the initial portfolio was launched, it was only the first or second public high-yield mutual fund. High yield was a new idea at the time, and like most new ideas, no one knew whether investors would latch onto it – but here it is 2016 and still going strongly.
We have a simple core belief: truth in advertising. Some of our high-yield peers will have an allocation to equities, or to bank loans, or to asset-backed securities, or convertibles. This fund does almost none of that. When clients hire us as a high-yield manager, that is exactly what we deliver – on average, 97% the portfolio is pure-play high yield.
Q: What is your investment philosophy?
We believe that credit cycles and business cycles change, and our job as managers is to modify exposures in advance of changing conditions and capitalize on them before our peers.
In high yield, it is recessions that generate negative returns or outcomes; since 1980, there have only been five down years and four were related to a recession. So it is important we anticipate changes in the overall economic health of not just the United States, but also Europe and Asia, and determine how they may impact confidence and consumption patterns, and what that means for the debt and equity markets.
For example, 2005 to 2007 was a busy time in the high-yield markets, but half of the new issuance was funding leveraged buyouts and corporate mergers and acquisition. History has shown us that when this occurs, defaults generally pick up a few months later.
This was our clue to start adopting a more defensive posture and get ready for an uptick in defaults, which we saw in 2008. Although this coincided with a recession and was a weak time for the market overall, our philosophical approach was to anticipate changes in the credit and business cycles and modify exposures ahead of them.
Q: What is your investment strategy and process?
Our process combines a thematic view at the macro level with bottom-up research that identifies a problem which will worsen, differentiates between good assets and bad, and marries those with relative value. We then adjust the portfolio to represent these views.
In high-yield, the greatest source of alpha is bottom-up security selection, so fundamental research is critical to long-term success. Just as crucial are our top-down thematic views, which we test through real-time economic data releases while always ensuring our macro team is in agreement.
For example, one of our themes in 2016 was we wanted exposure to sectors with strong ties to strength in the U.S. economy, so we directed the research team to sectors like automotive, wireless, consumer products, and select areas of retail, home construction, and building products. Within these sectors, we differentiated between the weak credits we believed would stay weak, solid credits with healthy balance sheets and attractive assets, and in-between credits that may have had good assets but were leveraged a little high.
Q: What is your research process and how do you look for opportunities?
Our investible universe is wide, representing roughly $1.3 trillion of securities. Fixed-income research experts from around the globe comprise each of our eight sector teams, which are tasked with alerting the rest of us to changing conditions – good or bad – in a sector. We believe our analysts know their sectors and names better than the portfolio managers; in fact, we want analysts to think of themselves as the portfolio managers for their sectors, and ask for their opinions on position sizes.
Internal credit ratings are used to differentiate between good companies and bad. We want to make sure that the covenants are written to our benefit as a creditor, and that companies have little chance of pulling value away from us. Especially in a leveraged buyout situation, we do not want an equity sponsor to reward themselves before paying down debt.
Critical to our internal rating is a company’s ability to generate free cash flow. While other investors may focus on the forward twelve months or the last twelve months, what is important to us is the normalized earnings power of a company through a business cycle.
Obviously, we want to clearly understand the earnings power of a business over time, but with normalized earnings power we try to determine financial risk and business risk. We look at what we call the issuer fundamental risk rating, which is based on default probability and recovery value if there is default.
As we go through tests within our credit process, we start to identify companies that may have okay assets but low leverage and perhaps a lower default probability. When companies have fantastic assets, we determine if their capital structure is over-levered, ask whether they have a high default probability, and look at recovery value based on where we are within the capital structure.
A typical underweight for us is a company that is over-levered with high subordination and a thin equity cover. We are highly likely to rate that issuer below where the agencies have rated it, and just simply avoid it.
Everyone here follows the same credit process and relative value framework. We try to avoid ending up with a portfolio of unintended bets because the team members are speaking a different language. This means if someone recommends a single B bond, it does not matter whether it comes from an analyst in gaming, healthcare, energy, or housing, because we all use the same standard measure of risk.
Q: Can you give an example of your research process?
For many years, we were overweight energy like many of our peers. In June 2014, the capital markets were quite open to energy. Oil and gas firms could raise almost unlimited amounts of debt – hundreds of billions of dollars to go out and drill. But our relative value framework identified a warning which made us quite nervous.
Using our credit process, we differentiated between energy assets in regions we liked, such as the Permian Basin of West Texas, and regions we did not like, such as the Haynesville in Louisiana and particularly the Bakken in North Dakota. There was a wide discrepancy between asset values in those regions, and we knew which companies had exposure where. But the markets were trading at a level that suggested on a relative-value basis, risk was being mispriced.
We decided to move from an overweight to an underweight, and for a few months that contrarian call did not look smart because the energy market continued to trade well. But in early autumn of that year, the bottom started to fall out. Though we did not know oil would go from $110 down to $26, we did know risk was being mispriced so we went to a strategic underweight.
Another example comes from the thermal coal industry. Eighteen months ago, there was tremendous pricing pressure on companies in that space. In the U.S. and in parts of northern Europe, they faced regulatory pressure due to focused efforts to move away from coal. Such regulation is frequently discussed by our macro team.
At the time, the fund owned a small number of coal companies. So we put them back through our credit process, and determined their normalized earnings power going forward was likely to be less than it had been. This led us to examine the capital structures of the companies; even though recent losses had been small, we believed they would grow much larger. In early 2015, the agreement of our macro and thematic views led to a timely exit of a number of names in that space.
Q: What is your portfolio construction process?
We use the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index as a benchmark, but also look at other U.S. high-yield indices like JP Morgan and BofA Merrill Lynch.
Typically, the portfolio has about 175 names in 35 different industries, with 75% to 80% of investments in U.S. companies and the balance in Europe. An average position size is 75 basis points. We limit overweights at both the industry level and the individual security level and will not exceed 5% overweight relative to the benchmark even if our view is favorable.
For us, diversification is a huge consideration – every single day, every single name – because of high yield’s asymmetric risk profile: if we buy a bond at par, the upside is generally 108 or 110 but the downside could be zero. Diversifying along different layers helps us avoid or minimize negative outcomes.
Liquidity has always been a key focus. We never want to own more than 10% of a company’s securities because we want to be able to exit with minimal impact on where the security trades should our opinion change.
We do modulate in credit quality, and own bonds rated BBs, Bs, and CCCs depending on the sector, the business cycle, and the credit cycle – these all play a role in portfolio construction.
Customization is another important part of the construction process for many of our clients. If we have an insurance client who does not want us to have exposure in the financial space, we can build them a portfolio that meets their unique needs.
Q: How do you define and manage risk?
Risk is about alpha, beta, tracking error, and delivering on client expectations – good market or bad – which is why we so firmly believe in truth in advertising.
Within the team, risk is managed in how credits are assessed. The firm also has a phenomenal risk management group, and every two weeks we perform a thorough, institutional-level check which runs portfolios through risk models. Internal and external models are used to show where tracking error is coming from. On the individual security level, we look at notional weight and excess weight.
Most importantly, we want to be sure the portfolios are exhibiting the themes we have discussed. For example, if we are favorable on energy companies, yet are underweight energy at some point, why would that be? Are the securities themselves that bad or is the theme not proving out?
