In a year when stocks and bonds have been hammered and some corners of the U.S. investment-grade corporate bond market suffered percentage losses in the mid-teens, perhaps one of the best things to say about the U.S. high-yield bond sector is that on the whole it performed slightly better, suffering only low double-digit losses while producing yields that were roughly three or four percentage points higher versus investment-grade bonds.

That sounds like a backhanded compliment, but it’s a bit ironic that the riskier corporate junk bond category held up better than the supposedly safer investment-grade variety, particularly those securities with longer-dated maturities. Then again, maybe it’s not so ironic.

“High yield is in the Goldilocks area of fixed income where there’s not too much duration and not too much credit risk,” offers John McClain, co-portfolio manager of the BrandywineGlobal High Yield Fund. “When looking across the fixed-income landscape right now, if you believe we won’t go into a recession, then high yield is the cheapest part of public fixed income.”

Despite the recession fears now that the Federal Reserve has hiked interest rates to fight inflation, McClain maintains that the high-yield sector offers some advantages for fixed-income investors.

“If you think rates will get out of whack and go much higher, two things will happen. One, traditional high-quality fixed income, the so-called less risky part of the fixed-income market, will continue to have a larger drawdown than the high-yield market. In addition, high yield going into and coming out of a recession does better than equities.”

But the high-yield debt market isn’t monolithic, and the trick is finding the right subsets as market conditions evolve. McClain and his partner, Bill Zox, have forged an impressive track record with a high-yield strategy that launched in limited partnership form in late 2014, and two years later went out to a wider audience when the BrandywineGlobal High Yield Fund launched.

The fund’s Class I shares have been a top-quartile performer in Morningstar’s high-yield bond category during the three- and five-year periods through June 15, finishing fourth overall in the three-year period among its category peers. Even better, Morningstar ranked it the best performer among 566 competing funds during the five-year period. Elsewhere, Lipper named the fund’s IS share class the best among high-yield bond funds based on risk-adjusted performance for the five-year period ending November 30, 2021. (The IS share class, which is aimed at pensions, endowments and corporate 401(k) plans, has a slightly lower expense ratio and slightly better performance numbers than the I share class available to investors on brokerage platforms.)

Part of the fund’s success lies in its nimble approach, including the managers’ ability to step into investment-grade bond territory when conditions call for it. The non-investment-grade (or high-yield debt) category comprises bonds issued by companies deemed to have a greater risk of defaulting on their interest payments or principal. Non-investment-grade bonds are rated lower than “BBB-” or “Baa3” by the major rating agencies. Because they’re considered riskier than investment-grade bonds, they have to pay higher coupons to attract investors. The higher the risk, the greater the yield.

According to a report by Morningstar analyst Mike Mulach, the BrandywineGlobal High Yield Fund responded to the 2019 credit rally by raising its investment-grade bond exposure to 20% by the end of that year, its highest level since the strategy’s inception. That positioning helped the fund weather the worst of the Covid pandemic fallout in the first quarter of 2020, and McClain and Zox upped the fund’s investment-grade exposure even further by quarter’s end.

But after the fund took advantage of the tailwinds from the Fed’s massive bond-buying program and the gradual economic recovery during the second half of 2020, Mulach noted that valuation concerns caused the management team to change course by allocating out of higher-rated, longer-duration bonds and into lower-rated bonds with shorter maturities and higher yields.

Offsetting Risk
The key risk components in fixed-income portfolios are interest rate and credit risk. And as interest rates began rising in 2022, McClain and Zox saw a chance to profit from it by taking on more interest rate risk. “But to offset that we took on less credit risk, so we started selling down the riskiest portion of the high-yield space, which is the triple-C part of the market,” McClain says. “Those are the types of business where if we went into a recession or had a material economic slowdown they would be the first to feel it.”

By the end of May, about 85% of the fund’s credit quality allocation resided in “BB-” and “B” rated bonds.

The fund’s managers say they seek an additional margin of safety for their portfolio by buying lower dollar-priced bonds. “If you buy a bond at 80 cents, you’re baking in additional downside protection,” McClain says.

He adds that lower dollar-priced bonds have been prevalent among longer-duration securities. Duration is a measure of a debt instrument’s sensitivity to changes in interest rates, so bonds with higher durations will be more affected by rising rates. That can result in lower prices, making them more attractive from a valuation perspective.

McClain says the fund had a reasonably short-duration portfolio going into 2022, but the duration has risen as the managers have sought more downside protection by buying the lower dollar-priced bonds. The fund’s effective duration at the end of May was 3.84 years.

As Zox summarizes it, “The direction we’ve been moving is up in quality, up in duration, down in dollar price.”

The fund’s recent top three sector weightings were in financial services, energy and retail. The vast majority of the holdings are in North America. Zox says the team is increasingly finding good value plays in the technology sector.

“Some technology companies have such strong balance sheets and huge capitalizations relative to debt that [their recent market declines are] entirely an equity issue and not a bond issue,” he notes. “Yet the bonds have reacted to what’s happening with the equities. Maybe the market cap is cut to $60 billion from $120 billion, but if you have $3 billion in cash and $1 billion in debt, it’s not really an issue for the debt.”

The fund this year was down 11.4% as of mid-June, trailing its Morningstar high-yield category average by 26 basis points. But it had outperformed the 12.2% loss of its benchmark, the ICE BofA US High Yield Index. The fund recently sported a 30-day SEC yield of 7.01%.

Long-Distance Relationship
McClain and Zox run the fund with assistance from research analyst Jack Parker. Until recently, the trio were employed by Columbus, Ohio-based Diamond Hill Capital Management Inc. In 2021, Philadelphia-based Brandywine Global Investment Management LLC bought Diamond Hill’s high-yield-focused U.S. corporate credit mutual funds. (Brandywine Global was previously acquired by Franklin Templeton’s parent company, Franklin Resources Inc., when it purchased Legg Mason Inc. and its affiliates in 2020.)

McClain, Zox and Parker remain in Columbus. While they call the shots at the BrandywineGlobal High Yield Fund, Zox says they frequently interact with the credit analysts on Brandywine Global’s fixed-income team.

“We value their global macro perspective, and especially at economic inflection points like we’re facing now, that global macro perspective is really helpful to us,” Zox says.

Indeed, these are trying times for the financial markets, including the high-yield bond segment. In a recent report, UBS senior fixed-income strategist Leslie Falconio said the combination of higher interest rates, slowing economic growth and continued inflationary pressures will likely affect the high-yield debt market. She noted the high-yield area is more economically sensitive and carries higher debt loads relative to earnings than the investment-grade group, and this could have a negative effect on the cash flows of lower-quality issuers within the high-yield market.

As McClain mentioned, he and Zox have pivoted away from the lower-quality regions and toward the higher-rated portion of the high-yield spectrum. He posits that high-yield companies on the whole had very good interest coverage coming into this year, meaning they can sufficiently service their debt because they borrowed money over the past 18 months at very low rates.

“Leverage was fairly reasonable coming into the year,” McClain says. “These companies are in a position to where I think you’ll see a low default rate environment on a go-forward basis. So you’re getting compensated at a healthy rate relative to investment grade.”