In the face of what was the largest first half decline in the S&P 500 since 1970 and the worst ever start to a year for high yield bonds, short duration credit was not immune. Furthermore, a general concern for shorter-term bonds and a fear of recession has caused a significant shift in the term structure of yields in the short duration credit investment universe. In other words, shorter duration securities are often yielding more than longer duration securities, an observation not lost on several Wall Street strategists who have been pointing out the opportunities in the shorter end of the credit markets.
Within the high yield universe, gravitating toward those companies whose price declines can be explained not by a deterioration in fundamentals but rather because the bonds are getting cheaper in the face of stable, and in many cases improving, businesses, can be a more consistent approach than betting on unpredictable catalysts for price appreciation. While we have seen bond prices go lower with the market, we have seen the issuers of certain bonds post year-over-year revenue growth, increases in demand, strengthening liquidity and general long-term resilience. While the short-term moves driven by global economic impacts are real, such as lower margins from supply chain disruptions and inflation, such impacts are more transient than the very real gains of winning market share and demonstrating countercyclicality in a challenged economic environment.
In these times of ongoing market dislocation, it is worth highlighting a few fundamental points to give some insight into the opportunity we are seeing in the markets right now. Investor misunderstandings and ill-advised market timing can result in mispricings which present opportunities in the types of bonds that can be attractive for portfolios.
As an example, our long-standing observation from years of experience with the Michaels Stores credit profile warranted our observation that some babies get thrown out with the bathwater. Michaels released Q1 earnings which may have surprised some in the markets but not those in the know. If one spent enough time understanding the underlying business, customers, and dynamics of this company they would have had a good sense of the resilience Michaels demonstrated in past market declines and understood that it was repeatable. The Fresh Market is another example where the delayed IPO due to the tough equity issuance environment was misinterpreted by the market as not being able or willing to pay off debt. But they did redeem their bonds at the beginning of July, albeit a bit too late for some investors who sold the bonds at an inexplicable discount.
While these are two company examples, they are merely two of many similarly situated companies where misunderstandings have provided cheapness and opportunity. For example, it has not been uncommon for other bonds which have already been called to continue to trade several points below their call price even with redemption dates which are less than one month away. It is possible that companies change their minds and decide to leave bonds outstanding, but as long as the focus is on issuers and bonds you would want to own regardless of impending repayment and whose repayment has already been funded, the asymmetry of such investments is decidedly to the upside.
This last point is particularly important for readers to understand how a manager thinks about the holdings in a portfolio. Investing for the long-term, focusing on gaining a picture as to where an issuer will be not just when its bonds mature in a few years but also a decade or more down the road, can further position a short duration credit portfolio for long-term success. For most companies, a short-term bond is only as good as a company’s ability to issue new debt to repay it. A company with deteriorating fundamentals puts that thesis at risk, and while many such companies do manage to refinance their debt, it is important to differentiate the lucky ones from the ones that do not need luck.
In the current environment, both types of issuers have been punished, as they look the same to market indexers and other participants who do not do the deep dives into issuers.[1] But they are not the same, and the current earnings cycle is beginning to separate the babies from the bathwater more clearly. As we progress through the latter half of the year, those companies who have been able to leverage their fundamental strength to react to the current challenges should demonstrate their resilience through fundamental results. Being able to rely on facts to ultimately break free from market misperceptions is the benefit of a fundamental investor, with the caveat being that timing cannot be predicted. For a portfolio aiming to preserve capital, timing risk is always preferable to the risk of realizing losses, whether due to less selective holdings or due to poor market timing.
That said, a fundamental approach to security selection carries a lesson for all investors. Underlying issuer strength provides a level of confidence in the medium- and long-term which can help avoid short-term mistakes. When markets get skittish, the investor’s toughest task is to stay disciplined and to resist the urge to make changes for the sake of making changes, especially when those changes run counter to the core strategy and mandate of the portfolio. But having confidence over longer timeframes makes this task easier.
The same holds as true for those allocating to managers as for the managers themselves. While no one can predict what will happen over the next year, it may be easier to envision various outcomes over one to three years. It may be prudent to think beyond how one might try to outperform unpredictable market indices over the next several months. Focusing instead on how one might want to be positioned to do well in any of several plausible scenarios over the next couple of years may yield more clarity.
Short-term uncertainty is all around us. No one can predict if the Fed will manage to curb inflation with aggressive rate hikes; Russia will end its war on Ukraine; the economy will enter a recession; credit spreads will tighten as companies respond to supply chain constraints; or labor markets ease a little but not a lot. While positioning for any or all of these scenarios is difficult, the current market environment presents opportunities which can perform capably regardless of what happens. With the inversion of the credit markets, a carefully selected portfolio may offer characteristics which benefit investors in all of these scenarios: shorter durations for rate hikes; higher yields for a prolonged market recovery cycle; upside from a rapid tightening of credit spreads and a return to a normal upward-sloping yield curve; and issuers with pricing power to manage through temporary margin pressure and be beneficiaries of changes in the labor market. This is precisely the portfolio we aim to deliver for our investors. This is precisely the type of portfolio that a well-designed fundamental approach can deliver.
Important Disclosure Information
Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
No part of this article may be reproduced in any form, or referred to in any other publication, without the express written permission of Osterweis Capital Management.
The fed funds rate is the rate at which depository institutions (banks) lend their reserve balances to other banks on an overnight basis.
[1] This is not necessarily a criticism. Many investors do not see having awareness of an issuer’s fundamentals as their mandate. This is in large part due to the short-term relative performance benchmarking they are held to, as dislocated markets tend to reward short-term tactical trading over investing in long-term fundamental strength.
© Osterweis Capital Management
Read more commentaries by Osterweis Capital Management
