Approach and Avoidance in High Yield

Andrew Gogerty: Hi, I'm Andrew Gogerty with Morningstar. Joining me today is Gibson Smith, co-CIO of Janus, and portfolio manager of the firm's fixed income strategies. Gibson, thank you for joining me today.

One of the areas I thought would be important to start is the rally in high-yield this year. Obviously, you know, from a mutual fund perspective, the returns are just enormous. And I wanted to get your perspective on that--just considering what happened last year. Is it truly just a bounce back from last year, or are fundamentals in these companies truly improving this quickly?

Gibson Smith: Yeah, great, great topic. 2008, obviously a very difficult year for high-yield and a nice recovery in 2009. We spent a lot of time decomposing the returns in the high-yield market on a year-to-date basis. And what we've seen is a real low-quality, high-beta rally in the high-yield market, where the companies that perform the worst in 2008 have generally been the best performers in 2009.

That has been a significant portion of the rally year-to-date. When you look at the return profile breakdown, triple Cs, the riskiest part of the high-yield market, are up about 82% year-to-date--so really, generating a majority of the returns in the high-yields space on a year-to-date basis.

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Gogerty: How about in terms of the opportunities that are still left? It sounds like a lot of the lower-quality stuff is what has rallied. So I can assume that some of the higher-quality stuff has been left behind from a fundamental perspective. Where is your team kind of finding some of the opportunities of what's been left behind this year?

Smith: Yeah. Well, we've entered an interesting phase in the market as I discuss the kind of lower-quality, higher-beta rally in the market. We've now entered a phase where security selection is vitally important to generating returns, and I think, will benefit us going forward. There are tremendous values across the high-yield market, by sector. But it comes down to individual security selection.

What we're really looking for are companies that are going through positive fundamental transformation with their capital structure. So, management teams that are paying down debt that ultimately benefits the equityholder of the franchise.

Gogerty: It seems like the more conservative positions, in terms of balance sheet--the more well-capitalized firms are those that maybe have lagged behind on a total return basis. And I know we've talked about J.C. Penney in the past. I wonder if you can give me a little insight onto what it is that your team likes about that credit right now?

Smith: A great example of a credit that we like--where a management team recognized the challenging economic environment that we were entering, started stockpiling cash on their balance sheet. And if you look at their cash balance versus the amount of debt outstanding, it's roughly 70% cash-to-debt outstanding.

The management team has been very conservative with their debt/capital structure, very focused on reducing leverage in light of the difficult economic environment we're in. As a reference, we're looking for these types of companies where management really understands how to use debt, and the importance of managing their capital structure.

Gogerty: What about areas that you're finding concern with right now, or areas that you're not investing in? I know ... you're not making broad macro calls, but are the concerns for companies not making your criteria, is it a matter of fundamentals? Or is it a matter of valuation or kind of a combination of both, right now? What's really driving what you're not investing in?

Smith: Yeah. I think it's a combination of both, actually, fundamentals as well as relative value. As we talked about the companies that performed the worst in 2008, have been many of the top performers in 2009. Many of these companies with highly levered capital structures and not great prospects in terms of a slower economic growth environment, we think that's a part of the market where there's a lot of vulnerability in terms of negative returns going forward. So we're paying very close attention to that.

Gogerty: I think one of the things we had mentioned before is the lack of economic growth, or the lack of top-line growth, but yet still this highly levered structure that may cause problems down the road. It seems like that seems to be a key driver of what you're not looking at right now.

Smith: Yeah. Well, we have to focus on businesses that have the ability to de-lever, not just say that they're going to de-lever. And so when you put the economic backdrop on top of the fundamentals of the business--and through our analysis, we can't get to a de-leveraging platform for the management team--we tend to shy away from those businesses because they tend to have more downside risk than upside potential for our clients and our investors.

If we really want to stick with our premise of investing of paying very close attention to the risk/reward profile of every security that enters the portfolio, obviously we have to think about the economic environment we're in. And we have to pay very close attention to the capital structure of these companies.

Gogerty: Well, thank you very much for your time. I really appreciate it. This has been Andrew Gogerty with Morningstar, along with Gibson Smith from Janus. Thank you for watching.