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.”