Margin of Safety in High Yield Bonds
RidgeWorth Seix High Income Fund
Author: Ticker Magazine
Last Update: Mar 08, 11:13 AM ET
|Investing in high yield bonds is always a research-intensive process. With the help of in-house analysis from industry specialists, Michael Kirkpatrick, portfolio manager of the RidgeWorth Seix High Income Fund, consistently applies a five-step approach when making purchases for the portfolio.
“One final potential advantage is that we take a longer timeframe, think about the valuation of the business and try to buy at a discount to our assessment of the company’s valuation.”
Q: Can you give examples from other sectors?
Specialty finance companies like Ally Financial Inc. (first purchased on 8/7/14), an underwriter of car loans, also fit well with our process. During the financial crisis, many people would default on a mortgage before they would on a car loan. Their thinking was even if they missed mortgage payments, they could continue to live in their home for a while, but if they defaulted on a car loan, that car – which they desperately needed to get to work – would quickly disappear from their driveway.
Ally, which in 2008 was known as GMAC, realized it was not charging enough for car loans to account for the expected increase in losses. It stopped underwriting, threw off a lot of cash, and used it to reduce debt – illustrating our margin of safety concept.
Nationstar Mortgage (first purchased on 12/6/13), a mortgage servicing company, is precisely the kind of investment we like to make. Not only is it a solid company that meets our five key investment tenets, but also it has an added margin of safety built in.
Though it does some underwriting of its own, Nationstar purchases the mortgage servicing rights from much larger banks, then collects a fee for servicing them – billing homeowners, collecting payments, distributing payments back to the mortgage holder, and working with homeowners in default situations.
Mortgage servicing is transitioning to a less capital-intensive business model in which the mortgage servicer is entering into a sub-servicing relationship. Historically, Nationstar has used its cash to purchase mortgage servicing rights. The company now earns lower fees, but there is less risk involved, and these companies can throw off significant cash flow through this transition which can be used to pay down debt.
Additionally, mortgage servicing rights can be traded and they can be sold. There is also an added layer of protection available through the sale of what is called an excess mortgage servicing right and entering into a subservicing relationship with a REIT.
If it faces unseen liquidity pressure, Nationstar has several levers it can pull. First is the free cash-flow generation thrown off in its standard business model. Second, it can sell mortgage servicing rights, and third, it can sell the excess mortgage servicing rights.
Nationstar is a great example of how we find potential opportunities in sectors our competitors avoid. Historically, the high-yield market is set up to analyze industrial-type companies, meaning the typical high-yield bond analyst focuses on debt-to-EBITDA and interest coverage ratios, metrics that do not work when looking at a company like Nationstar.
As a result, many of our competitors shun investments like these. But we are willing to go into controversial areas, get to know companies and business models well, and make seemingly contrarian investments.
For instance, currently healthcare and retail are areas of concern in the market, so we are spending a lot of time looking for potential opportunities there. We are going through each of the companies that are not held in the portfolio, and have benefited on a relative basis as a lot of those bonds have traded lower, but we have not yet found many to invest in.
Q: How do you construct the portfolio?
Our portfolios tend to be more concentrated, focusing more on our best ideas and making those the larger positions in the portfolio.
Generally, we have between 150 and 200 positions, though in periods of dislocation, we will likely be at the lower end of that range. In markets like today with little dislocation, we are at the upper end, because it makes sense to have more diversification.
We are benchmark aware, not benchmark focused, but do follow diversification principles. Our maximum in any one issuer is 5%, but in practice we rarely will go above 3% unless it is for something opportunistic and short-term. The maximum industry weight is 25%.
Investment decisions are a function of the size of the bond, liquidity in the market, conviction of the idea, and how well it meets our investment tenets. We compare the liquidity of a bond and our conviction of the idea. If we see enough value or see a price disconnect, and it meets our investment criteria, we will continue to add to the bonds as the high-yield market is selling.
Q: What drives your sell discipline?
Three reasons drive sell decisions. One is if it hits our relative price target. Second is if something changes fundamentally. We also have a discipline when a bond is purchased that tracks its price relative to its peers. Should the bond underperform its peer group by 10% or more, it gets flagged and we must re-underwrite the investment. In a normal market more times than not, we make the decision and exit a position. But having this discipline is helpful.
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