MAGGIE LAKE: Hi, everyone. Welcome to the Real Vision Daily Briefing. It's Monday, April 18th, 2022. I'm Maggie Lake. And here with me today is Bill Zox, Portfolio Manager at Brandywine Global. Hi, Bill, welcome to Real Vision.
BILL ZOX: Thanks. Glad to be here.
MAGGIE LAKE: Yeah, I'm we're glad to have you. Kicking off this week, I think a lot of people are slowly rolling out of what was a holiday week here. Maybe volume's a little, a lot of kids on spring break and stuff. We may have some participants out of the market. But looking at a pretty muted start to the week, we had some mild buying but turned into a mild selloff across US equities, we've got the 10Y bond yield anchored at 286 at last check.
Oil up, gold up, crypto mix, so a little bit of you get the feeling everyone's trying to figure out how they want to position here. And now that we've wrapped the first quarter. Before we dive in a little bit, Bill, though, why don't you tell us about your focus area and the approach you take to investing in this environment?
BILL ZOX: Sure. I'm a high yield bond portfolio manager at Brandywine Global on a team of three in Columbus, Ohio, but we work very closely with our colleagues, most of whom are in Philadelphia, a few in London, Singapore, Montreal. And we're value investors long only right now in high yield, two mutual funds, Brandywine Global High Yield Fund and Brandywine Global Corporate Credit Fund, some institutional accounts, and as I said, value investors, but liquidity is very important.
We want to be liquidity providers and get paid for providing liquidity to the market. That execution edge is a very important part of what we do. And we want to get this cycle right. That means we want to hold up better than most of our peers during down markets and capture our fair share of up markets. And if you put the two together, we should rise to the top over time.
MAGGIE LAKE: Yeah, and I think that's so important right now, because there's a lot of discussion about where we are in this cycle. And there's not a lot of agreement, and certainly no consensus on where we're heading. Where do you see things? What is the framework that you're operating on in terms of where we are with the factors that matter to you making that right mix in terms of timing the end and leaving some room on the upside? Where are we in the cycle?
BILL ZOX: Yeah, I think the market cycle or the credit cycle, I would describe as being late cycle. This is a very unusual cycle, of course. And that's not all that helpful, though, because late cycle, sometimes that's a year, sometimes it's three years. But what I think is important is you need to stay away from the fringes of extreme credit, stay away from the CCC part of the high yield market, for instance, which has done the best this year and did the best last year.
I think that's a dangerous place to be, you should be steering away from CCCs and looking for value elsewhere. And I think it happens to be a very good time actually to move up in credit quality in the high yield market and add some duration. We came into the year very late on duration, but we've been closing that gap steadily all year as rates have moved up so much.
MAGGIE LAKE: Yeah. We've probably got a mix of people listening. And I'm so glad we have the opportunity today to talk a little bit about this part of the market, because we tend to-- the focus is on Treasurys and some of the instruments around that. And we breezed through equities. We don't always sit and focus on corporate bonds, and certainly not on high yield bonds, so I'm really happy to have this opportunity.
Some of our listeners are going to be very familiar with what you're talking about, because we do get a lot of questions on HYG. So clearly, some people have this portfolio, but I think there are other people may be, it might be in their portfolio, but it's not a space that they're well-versed in.
Let's clear one thing up, when you're talking about high yielding corporate debt, this is commonly referred to-- used to be commonly referred to as junk, which I think can carry its own conceptions about that. Maybe give us your definition of what are we talking about high yielding debt, you just mentioned that credit quality, so this very much linked to ratings, the ratings on the viability and ability for these companies to pay back debt.
The higher the yields, I'm assuming and the lower the rating, the riskier it is. Doesn't mean they're not going to pay back but the more at risk they are and the more you get paid for taking a chance on that. And then the reverse happens as you get higher up the food chain in the safer instruments. You can do that in debt, and then you move right in from high yield into investment grade. Is that an accurate description of the corporate bond market?
BILL ZOX: Right. And I'm focused on the US high yield market, which is about 1.5 trillion. It's that BB ratings and below.
MAGGIE LAKE: As far as risky, is it risky companies in there? Are they small companies? Who issues in that high yield debt market? What would the issuer look like? And is it what we think when we hear junk?
BILL ZOX: Well, no. It used to be that way. But over time, the market has become much higher quality. As one example, the BB portion or the highest rated portion of the high yield market was about 35% during the Global Financial Crisis, that's now over 50%.
And there's a number of public companies, many of them are new entrants into the high yield market over the last couple of years, they did have public market caps in the $10 billion, $20 billion, $30 billion, $40 billion range and up. That's very unusual. It used to be more private companies, private equity, sponsored companies, without public equities and the businesses just weren't as good. You can think of old economy businesses.
Now we have a lot of technology companies. They don't need the capital, but they're accessing the high yield market early on just to establish a presence in the corporate bond market, so then they can move up into investment grade over time. It takes time, the ratings agencies are very focused on tenure in the market and size.
MAGGIE LAKE: That's so interesting. This is what we would consider future earnings, right? A company that doesn't have, even if it's public, that doesn't have a long track record, or what we would consider in the equity space future earnings, they might find themselves in the high yield bond market.
Why high yield? What puts them in high yield, as opposed to investment grade if they're better capitalized, more substantial companies? If I'm hearing you correctly.
BILL ZOX: It's generally not the non-earners. Most of these companies to access the high yield market are generating earnings, positive free cash flow, not everyone, but in most cases. But they're high yield, just because your first bond issue is very unlikely to be investment grade rated. Unless maybe if you were spun out of an investment grade company, you might get an investment grade rating.
But just let me give you one example this year, Roblox. They accessed the high yield market last year for the first time. And the market cap right now is about $25 billion, a tad less, it was as high as 75 billion at one time, $3 billion of cash, about a billion dollars of debt, and $550 million dollars of free cash flow last year. That's a high yield company. I think over time, it will migrate up to investment grade.
They don't need this capital at all. These companies, you might see this with Meta at some point in the near future. You saw with Apple a few years ago. Eventually they just accumulate so much cash. They all of a sudden borrow a lot of money to buy back stock, there's still very strong credits. But one day, we'll probably wake up and Meta will borrow $50 billion to do a stock buyback.
That's years down the road for something like a Roblox but to be in a position to do that, you want to access the corporate bond market earlier. Other examples would be Twilio, Elastic, Twitter's a high yield issuer. Netflix was, Tesla was. Some very good companies start out in the high yield market right now. These are not tiny, old economy businesses necessary.
MAGGIE LAKE: That's so interesting. And that's certainly different than I think what would have been maybe in the past, years ago, what would have been typical in high yield. Certainly, when I was first aware of it, and believe it or not, had to cover it for a bit in a former life. Now, I think that's a great layer of understanding for us all now when we're talking about a market that has changed and morphed over the years.
What is your base case for high yield bonds over the next six months? You did mention that you think it's going to get a little bit-- it sounds like you're going to have to be a little judicious and then maybe move up in investment grade, but how do you think high yield bonds are going to perform? And what are you advising clients if you look out over the next six months?
BILL ZOX: Sure. First of all, this is a tough environment for all financial assets. You have interest rates moving higher, and higher interest rate volatility. That puts pressure on all financial assets, that the Fed is trying to tighten financial conditions to get inflation contained. The Fed is working against us, that's very unusual for the owners of risk assets for even longer Treasurys.
We're not accustomed to that since the Global Financial Crisis, except for that one year, late 2017 to late 2018, the Fed has been solidly in the business of suppressing volatility and financial assets. Now, the Fed needs to see more volatility so financial conditions tighten, and we can contain inflation. But with that backdrop, what do you do?
I think it's dangerous to say, I'm going to sit on the sidelines with 8.5% inflation until it's clear to me that we're at the end of this process. That's a very dangerous thing to do. I think let's look at how high yield stacks up compared to your other alternatives. And right now, we have a 6.5% all in yield in high yield. That's the yield to worst. We were at 4.3% at the beginning of the year.
I think that's starting to get the attention of investors, that 6.5% yield is pretty attractive. We don't know where inflation will level out. That's very uncertain. But I think looking out two years, three years, four years, when inflation is under control, that 6.5% starting yield will look attractive relative to inflation.
Here's an opportunity to generate a reasonable return above inflation. And it's moved up over 220 basis points. Year to date, that's quite a move, much more attractive today than it was beginning of the year.
MAGGIE LAKE: That's so interesting. I have many questions about how you navigate that, but before we do, when we're talking about the relation with the Fed, an excellent point, we are in this different regime that we haven't seen some people who are investing, some people who are trading haven't experienced this before.
And it's unclear, there's a lot of disagreement, as I mentioned at the top about what's going to happen with the Fed. Raoul Pal interviewed James Aitken for the platform and they talked about the Fed and the fact that Aitken's suggesting maybe things are different this time around. Let's have a listen to that clip and then we'll pick it up on the other side.
JAMES AITKEN: We have been trained that central banks cannot hike interest rates much. And we penciled in that for the Fed, at least, the best they can ever hope to do is somewhere just over 2%, maybe a tiny bit higher. All right? And then something breaks. And then we go down the cycle again rinse and repeat, they're cutting rates, they're buying bonds, and round and round we go.
This time has a bit of a different smell to it for me, a bit of a different smell. We've broken the ice on fiscal. I think that's a big deal. We've broken the ice via direct transfers to households, which is why uniquely in the global pandemic shutdown of 2020, household disposable income went up. And if household disposable income is rising, it's no surprise that everyone sits at home and consumes at home and keeps tapping away on Amazon or whatever.
If you've broken the ice with fiscal transfers in the pandemic, then you're going to need to support households during what will be a very expensive transition, renewable transition. The cost for UK households, which has a pretty old housing stock, of retrofitting homes to be climate fit, immense, immense, and largely not discussed by people in Downing Street, but who's surprised?
My bias here that as much as we've been trained that this thing called R* is going down, meaning there is some natural limit, not far above 2%-ish as to how the Fed can rise, I'm starting to wonder if that's in play. And to be clear, it doesn't mean, oh my gosh, they're going to hike to 5% or 6%. I think that's a stretch.
But my bias which I'll continue to evaluate, of course, is that this Fed's going to keep hiking and hiking and hiking, and we could still be some distance from things breaking.
MAGGIE LAKE: That full interview is available to Essential Plus and Pro members on the website. Bill, every time we talk about the trajectory for the Fed, it usually contains a sentence, them breaking something, which is, I think the stress we're all living under. Talk to me a little bit about how this series of rate hikes and a rising rate environment will impact the high yield market. What do we need to understand about that dynamic?
BILL ZOX: Yeah, I think that is the right way to think about it, something will break in the financial markets. I think this will play out in the financial markets probably before we see the Fed do as much as even discounted in the market today. We'll see it in the financial markets first. And definitely, we'll see it there before we see it in the real economy.
I think that is the right way to think about it. I don't think that we're going to see high yield be the canary in the coal mine, or that high yield will feel the stress first. Now, from about Thanksgiving on, there has definitely been pressure on the high yield asset class because macro players or market timers thought this was late cycle the Fed is trying to tighten financial conditions, high yield should bear the brunt of that.
But what I think will happen this time is that equities need to bear the brunt of it. In part because equities have done so well since the bottom, March 23rd of 2020. Equities are up over 70 percentage points more than high yield, equities are up over 100%. High yield's up a little bit over 30% since that bottom. When equities do that well, that really supports high yield. That means that that equity cushion supports the credit quality of high yield.
It also means that high yield companies have had fantastic access to capital for all of 2020 and 2021. And they're not accessing the market so much this year, but they still have access to capital in the high yield market if they need it. I think that something will break. I don't think it's going to be high yield. But I'm also not seeing any market signals that suggests to me that we priced in too much for the Fed.
I think equities would be down a lot more, credit spreads would be a lot wider. The yield curve would be inverted again, and significantly so. I don't think we've reached that point yet. But we seem to be heading in that direction.
MAGGIE LAKE: If something breaks, it sounds like you think that the fallout will be sharpest in equities just because they've rallied more so further to fall. How does high yield not get taken out and hit if you've got a total risk-off environment? Because we what we've seen is these extreme reactions in the market.
Is that a concern? Do equities have to fall in an orderly manner for high yield to be able to hold up? Does it all get taken down? Are we just talking about the bounce? How does that work? Because that confuses me.
BILL ZOX: Yeah. Well, I think one, let's start with where defaults right now are, well below 1% in the high yield market. And they average over long periods of time, maybe 3.5% to 4% default rates, we got up to 6% during the pandemic. It used to be in recessions, you would think 8% to 12% for defaults, we're below 1% right now.
That's one thing to keep in mind, how wide can spreads go if defaults are really low? And then I just want to use an example, a very extreme example of Tesla accessing the high yield market in 2017. I think their market cap was like 40 to 50 billion at that time, maybe they had a couple billion dollars of debt. And you could say, wow, that's a big equity cushion.
But if that equity, some people thought it was dramatically overvalued at that time. If that equity is down 80%, you've got to think about it. Well, now Tesla has over a trillion dollars in market cap. At a certain point, the equity cushion is so large that the odds should not be sensitive to a down 20% move in equities, down 30% move in equities.
And I think broadly speaking, we're closer to that point in the equity market overall that even a 20% drawdown in equities across the board would not necessarily mean that the probability of defaults in the high yield market would increase much at all.
MAGGIE LAKE: So interesting. And again, it sounds like that circles back to the nature of who's issuing in high yield now, as opposed to say a couple of decades ago.
BILL ZOX: Right.
MAGGIE LAKE: Very interesting. We've got some great questions coming in. And I'm going to ask this one first from Michael on the RV site, because I think it's what's on everyone's mind. 40% of retirement is in various bonds, some government and some international. I am retired. Should I change these out? This, of course, I'm going to, before you to answer, say, like, we don't know what your situation is, Michael.
Anytime anyone asks a specific question about their portfolio, it's almost impossible for someone like Bill or any of our guests to answer that, because it's such an individual question. But I think it does raise an important point of like, what is the risk profile you should have? I think if we broaden it out, we