Many of the participants in the short-term credit market use it as a place to deploy cash while waiting for higher risk opportunities. For example, hedge funds often purchase bonds nearing the end of their life as a way to earn income on their cash to avoid fee erosion. Likewise, family offices frequently deploy available cash in the short-term bonds of companies they know through their core businesses while awaiting higher ROIs elsewhere.
Because they are holding these bonds as cash substitutes, they will sell them as soon as the markets present higher expected returns, even if they must take a small loss on the transaction. (This has happened frequently in the past few months, as yields have been rising across the maturity spectrum.) For these investors, selling a bond at a 0.25% discount is a small price to pay in order to access the opportunities on the other side of the trade, but that 0.25% on a bond which is expected to be repaid within 3 months can result in a 1% increase or more in the yield. This creates materially higher yielding opportunities for buyers of those bonds, and today’s market is among the most attractive in years. This is not just because yields are higher, however; it is because those higher yields come with largely unchanged fundamental metrics. Which means, the savvy fundamental investor can get paid more for the same credit risk. Put another way, fair value has not changed; the bonds have just gotten cheaper.
This dynamic can become even more exaggerated in certain circumstances. For example, when market participants expect a company to refinance imminently, those bonds often trade at the same yield as the refinancing expectations. However, refinancing events are subject to market conditions and do not always happen on schedule, so it is essential to invest in creditworthy bonds in case one ends up holding them to maturity. Often, with higher coupon bonds, this means investors can earn an even higher total return if a company chooses to wait a bit longer to repay their debt.
However, this is not a common approach in short duration high yield. Many investors see the short-term refinancing as the key driver of an investment thesis. For weaker issuers, if a company chooses not to pay down debt at the first available opportunity, it may be that the ability to refinance is called into question. In this case, that bond may be materially riskier than expected. However, even for stronger credits, the difference between a 3-month time to repayment and a 9-month time to repayment can undermine the thesis of some investors.
For example, in 2021, the market expected the bonds of Del Monte Foods (and other shorter duration bonds) to be refinanced in a relatively short timeframe in what was an issuer-friendly market. However, the impact of supply chain disruptions and inflation on margins led them and many other issuers to delay their plans into 2022. This delay spooked some market participants, who chose to exit such bonds from issuers that have since announced refinancings as expected, only a bit later. The difference is taking timing risk in lieu of actual repayment risk.
Right now, a particularly good example of this dynamic is The Fresh Market, a specialty grocery retailer. The company is privately held and has planned an IPO for 2022. Initially, the expectation was for this event to take place in the early part of the year, with a bond refinancing happening at the same time. Many investors, including a number of hedge funds, bought these bonds with a short-term horizon. These would be gone in 3 months, they reasoned. However, with the equity markets having been somewhat uncertain, the company has understandably decided to be patient.
This is a classic case of timing vs. repayment risk. The Fresh Market bonds experienced a decline in early 2022 because holders were impatient. They were expecting to get their principal back within a few months but now face the prospect of waiting longer for the IPO which will ultimately result in the debt repayment. As a result, the bonds found themselves under temporary pressure. The price only moved a few bond points, but the yield impact was significant, as seen in Figure 1. It is important to recognize that these yields look large, but because of the short timeframes involved, the actual price movements have been rather modest.
Again, therein lies an opportunity. Where other investors have short time horizons which require them to bet on the success of specific events (such as a near-term refinancing), investors who can take a more holistic view are in position to benefit. If a bond is attractive to hold whether the event takes place or not, and if there is a high degree of confidence that bond principal will be repaid but the uncertainty is simply a matter of when, that might be a trade-off worth taking. Right now happens to be a market rife with such opportunities.
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Venk Reddy is the Chief Investment Officer of Sustainable Credit Strategies at Osterweis Capital Management. Established in 1983, Osterweis Capital Management is an independent asset manager with $6.6 billion under management as of June 30, 2022. The firm provides investment management services to institutions and individuals through mutual funds and separate accounts, offering both equity and fixed income investment strategies. Learn more at www.osterweis.com.
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