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Why High-Yield Spreads Should Grind Tighter

Michelle Ward, CFA

Michelle Canavan: Hi. I'm Michelle Canavan, mutual fund analyst with Morningstar.

I am here today with Michael Buchanan, the head of U.S. credit at Western Asset and lead manager on Western Asset High Yield.

Thanks for joining us today, Michael.

Michael Buchanan: Thanks for having me here, Michelle.

Canavan: The high-yield market posted very strong gains in 2012, and your fund was among the top performing. Can you discuss how the fund was positioned to produce such strong results?

Buchanan: We were, obviously, very happy with the results for 2012, and we felt like going into the year, we were really poised to have a good year, because if you look at 2011, it was really the large-cap, very liquid, actively-followed names that outperformed, and pretty much everything else got left behind. And we really felt like there was some great value in the market, and the disparity between the on-the-run, very liquid names as opposed to everything else, that gap just became too wide.

So, just based on our disciplined, fundamental, bottom-up research, we were really excited going into the year, and that's certainly what happened. If you look at our attribution, and where all the alpha was coming from, most of it was coming from just bottom-up issuer selection. So, there were quite a few names that contributed.

Beyond that, we did have a slight overweight to CCCs, which at the margin helped, as well as some pretty good tactical bets within certain industries. So, for instance, financials; we timed that one pretty well. We ended up going from an underweight at the beginning of 2012 to an overweight within, really, the first month of the year, and that really produced outsized returns as well.

Canavan: And, going forward, what's your near-term and long-term outlook for the high-yield market? And maybe tie that into how the positioning changed as a result.

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Buchanan: Sure. Well, I guess near-term, we do think the market is a little vulnerable right now, and it's really just based on valuations. We think we can have a little bit of a retracement. You've got yields probably right around 5.5%, spreads around 470 basis points over Treasuries. And although we would tell you, longer term, we think there's good value there and we do think the market is going to grind tighter over the next year, we just think in the near term we are a little vulnerable to a pullback, and that's how we're positioning the fund right now.

So, in terms of our longer-term outlook, really what we are doing is, we're trying to shorten up the portfolio a little bit. We are concerned with duration, and that's something that we typically don't talk a lot about, because duration tends to be the byproduct of our credit-selection process. But the market is pretty unique right now, and with a duration of four for the market, it's really divided between two different markets. You have, sort of, the new-issue market, that's a duration of six, seven and eight, and even longer, and you have almost 50% of the market, the other 50%, that is bonds that are trading yield-to-call that have durations of one and two. So very little actually has a market duration of four.

And we think that interest rate risk is something that a lot high-yield investors aren't paying a lot of attention to right now, and we think we can get just as good returns, in fact even better returns, with some of the shorter-duration bonds that are out there.

So, duration is certainly one way that we are trying to make sure that we get the most out of the market over the next year.

Also just like 2012, we still think there's a great opportunity in individual security selection. And even though that gap corrected, that I mentioned earlier, between the large-cap liquid names and those that aren't as widely followed, we still look at that, and we still see a disparity. And we know that through our research effort, we should be able to capitalize on that.

And then finally, we do have an overweight still to slightly higher beta securities. So we want to get a little more yield than the overall market, and we think that makes sense in an environment where defaults are going to be low, and we're going to give up very little of our return to defaults.

Canavan: Some are speculating that there is a high-yield credit bubble. Can you discuss your views on that?

Buchanan: We are not in the camp that there is a bubble right now. I understand the logic behind that, or at least I understand the rationale for saying that: You look at yields, and they are pretty much at all-time lows. Like I said earlier, the high-yield market is trading at 5.5% right now. So, if you just simplistically look at yield, and then you don't look at the other factors, I could see how you'd maybe believe that high-yield is in a bubble right now. But if you look at spread, at 470 basis points over Treasuries right now, that's about where we'd be in terms of historical averages.

So, what you really have to do, in our opinion, is you have to look at valuations, and you have to contrast those valuations with fundamentals, and fundamentals are still very, very strong. You've got default rates probably right around 2%-2.5%, and even for those few securities that do default, recoveries are well above historical average.

So, with a really strong fundamental tailwind, we would suggest that spreads actually should be tighter than historical averages. So, that really is the rationale for why, longer term, we believe that spreads are going to grind tighter, and that 2013 should be a decent year on a relative basis for high-yield.

Canavan: And you touched on this a little bit, but can you provide a little more color on the high-yield issuer fundamentals?

Buchanan: Yes, still very strong. I know there has been a lot of talk about some of the more speculative issuance that's been done recently--a lot of focus on, in the bank loan market, covenant light, and a lot of focus in the high-yield market on PIK, or what we call pay-in-kind, issuance. I think those have both been blown out of proportion a little bit. For one, when you look at the bank loan market, covenant-light, yes, in a perfect world we would love for every bond, every loan, to have very good, strong covenants. And we are definitely seeing an increase in covenant-light in bank loans.

But, at Western, we've never relied on covenants exclusively to make our investment decisions. It's sort of the second parachute. The first is just good, strong fundamental research. And the companies that are coming to market in the bank loan market and the high-yield market are still very strong. If you look at average statistics for leverage, for interest rate coverage, for free cash flow generation, this market is a lot different than where we were 2006-2007.

So, yes, we are starting to see some creep in terms of aggressive issuance, but I wouldn't say it's anything that's alarming to us. And just to jump back to the pay-in-kind, or PIK, issuance, that's still a very, very small part of the overall new issue market--probably right around 5%. So, again, that's not a trend that we encourage, but not something that we would call alarming.

In fact, I think the thing that we find most encouraging about the new-issue market right now is that, year-to-date, about 60% of the use of proceeds are going toward refinancing, and that's very healthy new issuance. Basically, companies are trying to take care of their amortization cycle and repay any near-term debt, and they believe that this is the right time to do it. You can lock-in low rate, longer-term financing.

So, in general, we would say that corporate fundamentals and new-issue fundamentals are still pretty healthy--maybe a little bit of fraying, and it's something we're watching closely--but no cause for immediate alarm.

Canavan: Well, thanks, it's been helpful today. We appreciate you joining us.

Buchanan: Thanks for having me.