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Finding Value Across the Capital Structure

31 October 2019   |  

One of my fundamental beliefs about investing in credit markets is it’s possible to find the best risk-adjusted return opportunities through fundamental credit analysis and value identification across the capital structure—flexing between high yield bonds and bank loans. I take a value investor’s approach to the below-investment grade market to look for opportunities tied to dislocation and mispricing.

My team and I deploy a rigorous, fundamental credit research process. We do independent work. We talk not only to company management, but also to suppliers, competitors, former employees and so on—and through those conversations, we’re able to triangulate independently what’s happening with a company. Based on our views that emerge from that research, we identify the piece of debt—bond or loan—that we believe offers the best risk-adjusted return. From there, we build a concentrated portfolio such that our best ideas can meaningfully impact performance through the cycle.

Key to this process is rigorous credit selection. Our fundamental and independent research allows us to form a view on the business’s trajectory. With that view, we anticipate how financial leverage will likely work through different parts of the capital structure. With each capital structure, we assess the maturity profile and the opportunities for the company to enhance its capital structure by performing a capital market transaction—and then, we identify a piece of debt with the best risk-adjusted return. In general, if we’re more constructive on material credit improvement, we’re likely to be more junior in the capital structure. Conversely, if we are less constructive on a company’s ability to improve its credit profiles, we’re likely to be more senior in the debt stack. 

Capital structures evolve, and as covenants have become looser, debtors have had opportunities and flexibility they wouldn’t have had 10 or 15 years ago. That flexibility sometimes allows junior capital to potentially become more senior than the bond indicates. So there are times when a junior piece of paper can actually be refinanced into a more senior piece of debt because documents generally are more issuer-friendly. While we’re doing our deep dive on companies, we also do a deep dive on the documents to understand what flexibility the issuers have. This is important and worthwhile because the market often doesn’t anticipate those potential transactions—which creates potential opportunities for us.

I also believe investing across the capital structure helps dampen volatility. On a risk-adjusted basis, by investing across the capital structure, you can have different outcomes among securities of the same company. For example, if a company were to test a financial covenant, that would be a negative event for a bond, but it could actually be a positive event for the term loan. So our ability to flex between bonds and loans gives us the advantage of a broader opportunity set across which to express our views.  This higher degree of investment freedom helps us build a better portfolio and create successful outcomes for clients. 

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