Fish where the fish are – 2nd quarter, 2020
It is my humble opinion that if you write a commentary and haven’t gone out of your way to plagiarize some idea initially introduced by Charlie Munger, you’re just not trying. After all, he and his business partner Warren Buffett are legends in the world of investing. With that in mind, we’ll start this note with a quip that Charlie’s delivered in the past, although never so eloquently as at this year’s Daily Journal meeting, where he described how sources of excess investment returns can change over time:
I have a friend who’s a fisherman and he says, “I have a simple rule for success in fishing. Fish where the fish are.” You want to fish where the bargains are. It’s that simple. If the fishing is really lousy where you are, you should probably look for another place to fish.i
In fixed-income investing, we’re all fishing for income. But when risk-free interest rates are close to zero, there aren’t an awful lot of fish to go around. And so, to generate any income, we’re going to need to take some level of risk or we’re all going home hungry.
If we simplify the investable universe, our view is that we can group typical fixed-income risks in four different buckets. We can also say with some level of certainty that whatever balanced fund or bond fund you own, you’re taking at least one (and in most cases several) of these risks:
Complexity risk can generally be summarized as owning a bunch of stuff you don’t understand. Any time your bond fund is loaded with asset-backed securities, residential or commercial mortgage-backed securities, or collateralized debt obligations, it’s highly likely that very few investors have any clue about the creditworthiness of the borrowers or how the proceeds will be used from the thousands of individual loans and mortgages that are pooled in these vehicles. We don’t buy stuff we don’t understand.
Leverage risk involves borrowing money to enhance returns. This works until it doesn’t, and when it stops working the investment vehicle that employed the leverage will need to sell out of existing positions at rock-bottom levels or dilute existing investors by raising cash at bad prices, otherwise it will go to zero. The disappearance of liquidity in the darkest days of March 2020 saw a lot of levered fixed-income funds on the brink of collapse. We will never jeopardize the Portfolios with the use of borrowed funds.
Duration risk is the risk most prevalent in balanced portfolios. In fact, substantially all large balanced portfolios that have reported strong year-to-date returns are riddled with this risk. Duration risk involves buying bonds that don’t mature for many years, and whose price is ultra-sensitive to changes in interest rates. As interest rates declined so dramatically over the past 30 years, portfolios that held these securities benefited greatly. But an unfortunate characteristic of these funds is that they lock-in prevailing interest rates for the duration of the portfolio. Today, long-duration portfolios are a one-way bet that the lowest interest rates in history go lower still. With interest rates as low as they are, and management expense ratios of balanced funds as high as they are, it’s hard to imagine long-duration bond portfolios making any money at all over the coming decade.ii We invest to make money.
Credit risk involves the risk of lending money to businesses. This is the risk pool we at EdgePoint fish in. We do this because corporate bonds – particularly high-yield bonds – have offered outsized returns over the long term, and we think we can add meaningful value by picking the businesses we want to lend to. As business analysts, we know how to analyze and value a business, and from there it’s not a major leap to figure out which businesses can pay us back when we buy corporate bonds.
Volatility spawns opportunity, and there’s been no shortage of either through the first six months of the year. Within our balanced Portfolios, two-thirds of our fixed-income allocation remains invested in investment-grade bonds, and the stability of these issues has been a source of cash, allowing the Portfolios to take advantage of mispricing in the market. At the same time, our high-yield bond holdings have added significant value over time, and the volatility this year continues to provide rare opportunities. High-yield bond markets have staged a strong recovery over the past two months. But proclaiming the opportunity as “over” is the wrong way to approach the market. Beneath the surface, the fishing is still good for those willing to look where others aren’t looking.
|Yield to Maturity||Duration|
A tale of two markets
Most EdgePoint partners are familiar with our investment approach when buying a stock. When buying a stock, we’re buying a business. Of course, we want to be buying a high-quality business, but we also want to have a proprietary insight – a view about that business that isn’t shared by others. We use the very same approach when investing in high-yield bonds.
Proprietary insights – or unique views – are a lot easier to come by when fewer people are looking at a particular company. Naturally, this means we try to look where no one else is looking. This might mean we focus on smaller bond issues that trade less frequently and are underfollowed by other analysts. We also pay zero attention to credit ratings. In fact, we hold a significant position in unrated issues – these are bonds that no credit rating agency has looked at or provided an opinion on. These bonds are typically misunderstood by the market. The bonds we buy are often out-of-favour for some reason that has nothing to do with the long-term prospects for the company. And finally, any time we invest in a bond we make sure and that the return on our investment is attractive relative to other opportunities.
Coming into the year, our approach led us to several overlooked areas of the market. Below, the chart on the left suggests that at the end of 2019, BB-rated high-yield bonds – the highest-rated tier of the junk bond market – were trading at the most expensive level in history relative to investment-grade bonds. At the same time, the chart on the right shows that CCC-rated bonds – the lowest rated tier – were more attractive than ever relative to the broader high-yield bond market. By no means were we piling into CCC-rated issues, but certainly between the most expensive tier and most unloved corner, there were swaths of opportunity to deploy capital at attractive rates.
Source: Bloomberg LP.
*U.S. high-yield index is represented by the ICE BofAML US High Yield Index which tracks the performance of high-yield corporate debt denominated in US$ and publicly issued in the U.S. domestic market. Option adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account embedded options.
**Bloomberg Barclays Ba US High Yield TR Index Value Unhedged USD used to represent BB-rated bonds. Bloomberg Barclays Caa US High Yield TR Index Value Unhedged USD used to represent CCC-rated bonds. The Bloomberg Barclays US Corporate High Yield Bond Index measures the US$-denominated, high-yield, fixed-rate corporate bond market.
The first six months of 2020 have revealed what is quickly becoming a bifurcated market; the disparity between BB-rated bonds and lower-rated issues has only widened. It should surprise no one that these higher-rated bonds declined less than the overall market as the markets hit the bottom in March. A higher credit rating implies lower short-term credit risk, and the onset of a recession often causes investors to fear that rising defaults will erode the returns of lower-rated issues. The anomaly however began with the recovery from the market bottom on March 23rd. Since that date, incredibly, BB-rated bonds have continued to outperform lower-rated tiers, despite the rebound we’ve seen in markets around the world.
U.S. high-yield bond indexesiv cumulative total returns
Dec. 31, 2019 to Jun. 30, 2020
|Bond Index Returns||Dec. 31, 2019 to Jun. 30, 2020||Mar. 23, 2020 to Jun. 30, 2020|
To say this is a rare event is an understatement. The fact is, it’s never happened before.
As shown below, coming out of each-and-every high-yield market decline of 10% or more, it was CCC-rated bonds – the most out-of-favour corner of the high-yield market – leading the recovery. In each example, this outperformance isn’t merely by a couple of percentage points; rather, recovering from previous declines, the lowest tier of the high-yield market delivered returns that were often multiples of the return earned by higher-rated bonds.
|ICE BofAML US High Yield Index||U.S. commercial real estate crash v||Dot.com bubble||Financial crisis||U.S. debt downgrade by S&P||Oil price collapse||COVID-19 pandemic|
With respect to our equity Portfolios, we talked endlessly about the flight to safety that we have observed in stock markets around the world. We described a relentless bid for obvious growers and safety of companies that are clear beneficiaries of shelter-in-place orders. We’ve warned about these “consensus” names that are trading at prices that almost ensure poor returns over the long term, and that investing in “certainty” has proven to be a great way to destroy wealth in the past.
In the high-yield bond market this phenomenon is hiding in plain sight. While we’re looking for bonds issued by underfollowed companies, with misunderstood business models that are out-of-favour with other investors and trading at attractive prices, the market is looking for something else. The market today is paying a massive premium for large, liquid bonds, with a high credit rating, that everyone agrees they should own.
|What we look for||What the market looks for|
The year-to-date returns from large, liquid, highly rated bonds have created the illusion that the market overall has recovered to pre-recession highs and that attractive returns going forward will be harder to come by. But this recovery has been concentrated in the largest, most liquid bonds. As mentioned before, we still continue to see meaningful opportunities in many corners of the market.
The disparity in the market and the relative attractiveness of the ideas in our Portfolios are glaringly apparent in a side-by-side comparison of top holdings in our EdgePoint Global Growth and Income Portfolio and the top five constituents in the benchmark index. The flight to safety that has characterized all markets has seen the five largest names in the index bid to a yield of 3.8%, while our collection of what we would argue are better businesses yields 8.2%.
|EdgePoint Global Growth & Income top 5 positions||Portfolio weight||Bond rating||Issue size ($M)||Yield-to-worst|
|iShares US High Yield Bond Index ETFvi top 5 positions||Index weight||Bond rating||Issue size ($M)||Yield-to-worst|
Three of these top bonds in the index fall under the telecommunications and health care industries, and no doubt their perceived “immunity” to the impact of COVID-19 has exacerbated the bid for these bonds. But paying “any price” for safety creates its own risk. Pointing out the nosebleed prices paid for growth stocks often receives some counter argument that there’s still potential for earnings growth that isn’t fully appreciated. But with bonds, your interest payments are fixed for the lifetime of the bond. Still, investors are clamouring to get their hands on these bonds.
Our assumption when we buy a bond is that we’re going to be holding that bond to maturity. Said differently, we aren’t relying on anyone buying our bond other than the company we’re lending to. By investing this way, we’re committing ourselves to the yield-to-maturity available at purchase, and any opportunity to sell our bonds at a higher price along the way is gravy on the potatoes. And while our bonds have been slower to recover to their pre-COVID highs, earning 8.2% from our collection of high-quality businesses is a lot more exciting than earning 3.8% from a bunch of bonds that index-hugging investors feel they need to own.
Risk-free investing involves buying short-term government bonds. Today, short-term government bonds yield close enough to zero to call it zero. What this means for an investor is that to earn any return at all, you're going to need to take some risk. In fixed-income investing, the risks you can take are few, but you want to fish where the fish are. With interest rates as low as they are, long duration bond funds are fished-out and have a leaky boat, while fishing in complexity or with leverage is like fly-fishing for piranha. And while the rebound in corporate bond markets since the March bottom suggest the opportunity is behind us, that’s simply not the case. We continue to see plentiful opportunities for excess returns, and for those with a skillset in analyzing businesses, credit risk continues to make the most sense in a fixed-income portfolio.
Portfolio performance as at June 30, 2020
Annualized, total returns and in C$.
EdgePoint Global Growth & Income Portfolio, Series A
YTD: -10.39%; 1-year: -9.12%; 3-year: 0.81%; 5-year: 3.56%; 10-year: 9.33%; since inception (11/17/2008 to 06/30/2020): 10.46%
EdgePoint Canadian Growth & Income Portfolio, Series A
YTD: -14.14%; 1-year: -9.52%; 3-year: 2.22%; 5-year: 1.13%; 10-year: 5.59%; since inception (11/17/2008 to 06/30/2020): 8.09%
ii Morningstar Direct. Average management expense ratio is 2.28% and based on Series A expenses. Series A MER taken directly from fund websites. If not disclosed on fund websites, Morningstar was used. The universe of funds analyzed only includes funds with available duration and yield-to-maturity values, as well as a minimum AUM of $2 billion in the Global Equity Balanced category.
iii The ICE BofAML Canada Broad Market Index tracks the performance of investment-grade debt publicly issued in the Canadian domestic market.iv Indexes used are: U.S high-yield BB-rated bond index (Bloomberg Barclays U.S. Corporate High-Yield Ba Rated Bond Index), U.S high-yield B-rated bond index (Bloomberg Barclays U.S. Corporate High-Yield B Rated Bond Index) and U.S high-yield CCC-rated bond index (Bloomberg Barclays U.S. Corporate High-Yield Caa Rated Bond Index). Each Bloomberg index tracks the performance of US$-denominated, high-yield corporate debt rated Ba, B or Caa as listed.
v The early 1990s U.S. commercial real estate crash is attributed to the failure of savings & loan institutions in the late 1980s to early 1990s due to inflation of those properties. Source: Geltner, David, “Commercial Real Estate and the 1990-91 Recession in the United States”, Massachusetts Institute of Technology – Department of Urban Studies &Planning, MIT Center for Real Estate, January 2013. https://mitcre.mit.edu/wp-content/uploads/2013/10/Commercial_Real_Estate_and_the_1990-91_Recession_in_the_US.pdf.
vi The iShares US High Yield Bond Index ETF used to represent the high-yield market and is a market-capitalization-weighted ETF that provides exposure to a broad range of U.S. high-yield, non-investment grade corporate bonds.