Aug 11, 2020
When it comes to buying fixed income, it’s a pretty difficult environment right now. And when we think about buying fixed income, we look at it through the lens of buying a diamond. When people start talking about buying engagement rings, they talk about cut, clarity carat and color, so if you want a really big diamond, or in this case a really high yield bond, you’re probably going to give up on quality or color. You’re not going to find humongous, clear, clean and well-cut diamonds for a cheap price. Ultimately it comes down to learning how to manage those different pieces. And that’s how you approach the bond market. If diamond values are determined by carat, color, clarity, and cut, then these are the five determinants for buying bonds.
1. Price – “Odd Lots”
First is the price. You really make your money on bonds when you first buy them. You lock into your yield-to-worst or yield-to-maturity based on the price you pay and the cash flows available to you. There’s been a huge encroachment on the ownership of bonds by large ETFs and mutual funds over the last few years, and what that creates is an anomaly called odd-lot theory. Within this theory, we’re building out client portfolios with smaller lots of bonds that are unattractive to these large funds. They’ve got huge inflows, they’ve got to put big money to work, and they’re buying millions of bonds at a time. And as a result, these little pieces that fall off the big piles are identical to the larger lots that funds buy, but they trade much cheaper. What we attempt to accomplish is picking up incremental yield over an entire bond portfolio just by picking these individual bonds that are just being left by the wayside by big funds.
2. Credit – “Story Bonds and Fallen Angels”
Managing credit right now is extremely difficult. With the Fed stepping in and buying investment-grade corporates, they’ve sucked a lot of the value out of the corporate market. With high demand for taxable munis and high demand for tax-exempt munis, we’re really having to look for opportunities in credit. And right now, the largest area in the bond market is BBB corporate bonds. Within the BBB space, there’s a lot of oversight, demand, and action. We are looking for “story bonds,” which are essentially bonds from smaller or lesser-known companies that may be overlooked by the credit rating agencies. They might be rated BB, but they’ve done a lot of legwork in the last few years to clean up their balance sheets and they have not been re-rated. However, they are trading like a high-yield bond would. We go out and look for these story bonds that other people simply aren’t looking for. At the end of the day, we’re picking them up a little bit cheaper because we’ve done the legwork and the credit story may look a lot better than the rating agencies are willing or able to admit.
3. Structure – “Floats, Sinks, Convertibles”
The bonds in highest demand are the ones with the most certainty of structure, which is to say, you know exactly how much you’re getting paid and for how long. So we’re looking for opportunities in bonds that don’t have this level of certainty. We’re looking for floating rate bonds, where the coupon could fluctuate based on an index. We’re looking for sinking bonds, which are bonds that have an undefined maturity so that pieces of the bond will slowly come off at par over the period of time we are holding it rather than all at once like a typical bond. You can find opportunities there because investors eschew sinking bonds due to the uncertainty of the holding-period duration. The third category would be convertible bonds, which have been in the headlines lately due to companies like the airlines issuing a lot of convertible bonds. These are pegged to the common stock associated with the bonds. So say that Delta stock has been beaten up but they need to raise debt, they can issue a bond that is tied to their common stock so that when the stock price rises, so do the value of the bonds and eventually you can convert those bonds into equities for a nice gain. When you don’t have the defined maturity or the defined holding period, and when you don’t have the certainty that the price is going to rise on the bond or equity, we can often find price dislocations or opportunities in these areas.
4. Maturity – “Opportunity Depends on Time Horizon”
When it comes to buying bonds, you want to have a continuous return of capital through the use of short bonds, medium bonds, and long bonds. There are different opportunities in each space and right now on the short end, agencies are probably the best. You’re essentially receiving a government-backed bond inside of 2-3 years and you might get 3-4 times what a treasury would pay, while still maintaining a government-backed AAA or AA+ rating. In the medium horizon, this is really where the story bonds come in. You’re taking a little bit of credit risk, but you’re not taking a lot of duration risk. And on the long end, that’s where we’re starting to see less demand for taxable and tax-exempt munis, and opposite to the story bonds, those are going to be much cleaner and will have more secure cash flows backed by General Obligation or Essential Service Revenues (Water, Sewer, Power tax revenues). If we’re going to go out on the long end, we’re going to want to avoid default risk as much as possible.
5. Sector – “Corporates Show Historically Poor Value”
Finally, we’re looking at different sectors. There are various sectors within corporates, taxable munis, and regular munis. Due to the fed stepping in and buying BBB corporates, we’re at all-time historically poor values. Right now, you’re looking at under 2% yield on a 10-year bond incorporates which is really not what you want to be getting. When I first started trading bonds, you wanted to get between 300 and 500 basis points over a comparable treasury, right now you’re getting less than 100, and so you’re not really getting compensated for your risk. As an overarching theme regarding corporate bonds, if we’re not doing a ton of legwork on them and we don’t know the full story in and out, we’re avoiding them altogether.
Please see our General Disclosure.
Director of Fixed Income, Portfolio Manager
Tom joined the Narwhal team in the fall of 2018. He has a bachelor’s degree in Finance from Kennesaw State University. Tom has spent his career trading fixed income on both an institutional and retail level, specializing in Municipal Bonds. He holds Series 7 and Series 66 Licenses. Tom lives in East Atlanta Village with his wife, Maeve. When he’s not in the office, he enjoys playing rugby, traveling and watching Tennessee football.
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