Size Matters, But Not in the Way You Might Think
At Intrepid, we prefer to operate in less efficient areas of fixed income markets where our skills as credit analysts have the most potential to consistently produce excess returns.
For several reasons which we’ll explore below, small-capitalization high-yield bonds, our area of focus, are a greatly underappreciated source of compelling risk-adjusted opportunities for investors looking for equity-like returns with potential lower volatility. As a boutique manager with a flexible mandate, we’re extremely well-positioned to take advantage of opportunities in this space.
Smaller Issues Are Off-limits for the Big Guys
Let’s begin by looking at some of the tendencies of the larger players who operate in the high-yield space. Compared to the investment-grade corporate and Treasury markets, there is a relative lack of liquidity in the high-yield market, particularly among smaller-sized bonds, that inordinately dictates the behavior of many investors. For example, high-yield mutual funds and ETFs are often constrained by charters that, for liquidity reasons, strictly require holding investments that are on the larger end of the capitalization spectrum. Even for those not subject to charters, illiquidity remains a significant concern for most managers, who fear they won’t be able to sell a large position in a less-liquid issue without significantly moving the market. Furthermore, bigger firms don’t want their analysts to devote time to smaller issues in which they won’t be able to commit enough capital to satisfy their typical position size.
These constraints from large bond managers create a more inefficient marketplace at the smaller end of the high yield-market, and present opportunities for Intrepid to pick up higher yields for the same or lower credit risk.
PMs, Like Everyone Else, Are Prone to Laziness
It’s relatively easy for analysts to develop opinions on issuers that are household names, where they can easily obtain sell-side research, consultant studies, and evaluate comparable bonds. When investors are already well-informed about an issuer and new issues are often close substitutes for existing bonds from the same issuer, more efficient pricing occurs, eroding the value of active management. On the other hand, with fewer interested parties, there is significantly greater dispersion of value among small caps. Smaller issues, particularly those in less followed industries, require a deeper analysis, which also adds an additional “uncertainty” premium to yields. At Intrepid, we embrace small companies that are either overlooked or considered to be “too risky” simply because they are small, less liquid, and lacking readily available research coverage or comparable issues.
A Closer Look at Liquidity Concerns
Returning to the topic of liquidity, there are several widely held misconceptions about the liquidity of small-cap issues. For one, the size of a given issue is not the most important determinant of its liquidity. One must instead evaluate the size of the position to be moved in relation to the overall issue size. A large manager looking to sell a $100 million block of a $1 billion issue, for example, will likely incur a greater liquidity cost compared to a manager looking to move a $5 million piece of a $150 million bond. In addition, potential buyers of said $100 million block are likely to be concerned that the larger manager possesses relevant information that they aren’t aware of.
We believe investors tend to overvalue liquidity in the high-yield sector. Some of this can be attributed to the growing use of exchange-traded funds driving higher demand for liquidity in larger issues. To our benefit, this situation creates a liquidity premium in many small-cap bonds.
In addition, managers who underwrite their analysis to hold a position through maturity have a lesser need for exit liquidity. As a result, they will generally incur lower indirect trading costs and retain more of the “excess” yield than those who trade actively.
At Intrepid, our emphasis on shorter duration issues, which we’ve outlined in another blog, further enhances our ability to avoid unnecessary trading costs and take advantage of higher yields in less liquid, small-cap issues.
If you’d like to learn more about our team and our process, please reach out to us with any questions. We remain incredibly excited about the opportunities in small-capitalization, high-yield credit.
To learn more about our process and how it benefits investors, contact us to schedule a phone call.