The Opportunities in High Yield

Harry Milling: We are here with Ray Kennedy, and he is the former manager of PIMCO High Yield. And now he is with the deep value shop Hotchkis and Wiley. Thanks very much for being here, Ray.

Ray Kennedy: Thank you for inviting me.

Milling: The high yield market was really punished in 2008. Now it's just a bevy of opportunities. So why don't you first start by telling me where the opportunities are.

Kennedy: Sure. They're in a few different areas. Obviously what we saw in 2008 was probably a once-in-a-lifetime type carnage, but a lot of it was liquidity-driven. And the first thing we've seen already in the high yield market is what I characterize as a liquidity-driven rally. Now we're going to see more of a fundamentally-driven rally over the next two to three years. And so that's where your value is going to be found. In many instances it's going to be in the form of restructured securities. For example, we've seen already Harrah's start the process of exchanging one bond for another. And those restructured bonds quite often are more senior in the capital structure and maybe less leveraged.

Or in another trend that we're seeing that could be very interesting for investors is the issuance of secured bonds that are actually equal in priority to bank debt. Now that's going to be a very interesting, long-term opportunity for investors to get exposure to the senior part of the capital structure in a bond form, which means they get call protection and potential upside versus bank debt [where] you get priority but you don't get the upside.

And then of course we're going to see deep value in certain sectors. Maybe it could be in the auto supplier space where bonds are trading at 30 and 40 cents on the dollar, or maybe the higher-quality ones at 70 and 80 cents on the dollar. Those will provide great total return just from a fundamental credit improvement story.

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Milling: So those are the securities we expect to see in the fund. However, Hotchkis and Wiley is a much smaller company than PIMCO. PIMCO is, you know, the big gorilla. And this is the sole bond fund of Hotchkis and Wiley. So what are the advantages and the disadvantages of your fund versus a large fund like a PIMCO offering?

Kennedy: Sure. That is a great question. There are really a few ways in which you could answer that. One, obviously, from a liquidity standpoint. Being smaller provides you an ability to be more nimble, maybe be a little bit more creative from the standpoint that you can see the near-term opportunities that you can execute. Sometimes these opportunities could be $5 million to $25 million in size, whereas a larger fund, not only just PIMCO, but others would have a difficult time taking advantage of that.

The other thing is from a research standpoint. Because they have a small-cap deep value focus as part of their product offering on the equity side, I can take advantage of that research when I am seeking out opportunities within the high-yield market.

Obviously some of the negatives would be, having the size of PIMCO, you're a large buyer in the market, so in a bull market you clearly have buying power. But the negative of course is when things turn more difficult and you have a problem in your portfolio, it's very difficult to exit versus a smaller fund; it's much easier to exit.

Milling: So the unique part of this fund is that it's going to have some of the small-cap names that you wouldn't necessarily find in PIMCO high yield. Is that correct?

Kennedy: That's correct.

Milling: I know that when we met earlier you talked about the fact that your reputation, because you were the manager of PIMCO High Yield and you led up their global high-yield effort, that basically your reputation has really helped you out a lot with the start of this fund.

Kennedy: Absolutely.

Milling: Tell me a little bit about that.

Kennedy: Sure. There are a lot of facets involved in starting a new business. It ranges from anywhere from setting up their regulatory compliance side to the actual trading and execution side. Clearly from the trading, execution, and ideas side from the street they've been extremely helpful given my long-term ties with many of them, and especially on the capital market side as new issues come to the market. So that type of relationship will give us the opportunity to not only get allocations on new issues, but also help us in terms of ideas generation where we will get an opportunity to get to see them, sometimes maybe first.

Milling: And lastly, what makes this a good core bond holding in a portfolio?

Kennedy: I think all high yield really has a place in everyone's portfolio. It's clearly not an asset class that should be loaded 30% in a portfolio, but I think a modest range of 5% to 10%, depending upon valuations in a portfolio, makes a lot of sense. There are two other reasons why a high yield bond allocation makes sense, especially in this environment. Clearly the most obvious is the valuation. But the other thing is the focus on inflation and possibly the need for more income and near-term income.

This is an asset class that actually does pretty well in an inflationary environment because obviously these companies are leveraged. They watch their debt get deflated away or inflated away. But the second thing you have is you're getting a significant amount of current income that permits you to basically redeploy in a current interest rate environment.

So from that standpoint it has generally been a pretty positive contribution to a portfolio, especially in a rising interest rate environment.

Milling: Good. Thanks very much.

Kennedy: Great. Thank you.