Time to abandon comfortable momentum for as-yet-unfulfilled promise of theoretical value, says portfolio manager
Abandoning comfortable momentum for the as-yet-unfulfilled promise of theoretical value is the way forward, according to one fixed income manager.
Geoff Castle, portfolio manager of the Pender Corporate Bond Fund, acknowledged that the latter stages of 2019 revealed some weakness in distressed debt, which the fund holds a portion of, and which over “reasonable time horizons” has delivered attractive returns.
Castle added that credit markets in 2019 have generally been a Tale of Two of Cities, with the apparent fireproof houses of highly rated issuers - including even the BB rated high yield issuers - rolling on to successive price highs with their spreads and rates ratcheting ever lower.
However, neglected and unpopular credits have languished as investors have shown an unwillingness to refinance maturing debt. He explained that while bonds rated “BB” began the year at 3.7% spread over treasuries and have compressed down to 2.2%, the opposite end of the credit spectrum has actually widened. “CCC” and below issuer spreads have recently pressed to new highs of 11.4% over treasuries.
Castle said: “In the past 20 years, the relative yield advantage of bonds rated CCC and below, in comparison to BB rated credits, has only exceeded the current ratio of 3.1x for a few months. And that period, which was late 2015 and early 2016, immediately preceded an excellent return for [our] fund and high yield credit generally.
“In an industry that lives by the trader’s maxim, ‘the trend is your friend’, it is not always easy to abandon comfortable momentum for the as yet unfulfilled promise of theoretical value. Yet, as the latter part of 2019 unfolded, that indeed has been our program.”
With that in mind, Castle highlighted a number of “stone cold” and “dirt cheap” sectors to drive portfolio returns through 2020.
Pharma and Biotech
“In 2014 you may recall that, once upon a time, biotech IPO’s flew off the shelves like umbrellas in a Vancouver rainstorm. Back then it took little more than a labcoat and a pitchbook to raise a billion dollar round from eager investors. Five years into a disillusionment cycle, sentiment in the industry has swung to the opposite extreme. Teva Pharmaceuticals, the world’s leading generic drug company, has seen its onetime $85B enterprise value slashed by as much as $50B in less than three years. Teva bonds issued at coupons of 2’s and 3’s some years ago now trade to yields in the high single digits. Even with its promising new antibiotic now approved and reporting growing sales each quarter, Boston-based Paratek Pharma’s business is valued at less than a tenth of its late 2014 start-up EV. Paratek convertible bonds currently trade around at 62% of face value, leaving them worth less than balance sheet cash. We believe an interesting turnaround has begun in this industry and have a few positions that look fruitful for 2020.”
Retail
“Even those who still get news delivered by pigeon post have, at this juncture, received the memo about Amazon.com and its inevitable steamrolling of all things retail. And yet stores, in many segments of the market, refuse to die. We are not cyber-deniers, just observers of the combination of continuing profitability and ongoing management adjustments being made by several retailers, particularly those whose products defy long-distance shipping and/or require a degree of in-store service. Rite Aid, with a stable cash earnings line, is emblematic of this group of credits. Priced at its historically minimum EV/Sales multiple, and with significant potential as an acquisition target, we like Rite Aid 2023 bonds trading to yield over 13% to maturity. Other retail credits offer similar potential.”
Engineering and construction
“We realize consensus earnings forecasts aren’t always reliable. However, it is still odd to see a large engineering and construction company like Tutor Perini having street estimates of over 30% for operating profit growth in 2020, while at the same time sporting valuation multiples of 6.5x estimated earnings and 0.5x book value. Bond spreads in this sector we believe are far too wide and it wouldn’t take an unreasonable re-rating to drive Tutor’s well-covered 2021 convertible notes into the money, given their $30 strike price. Similarly, McDermott International, an admittedly distressed issuer, has credit that is trading at a tiny look-through valuation in comparison to our estimate of private market value for this business.”
Castle also picked out telecoms businesses, Canadian rate reset preferreds, and profitable oil producers and copper miners as other areas of interesting credit value.
