In many investment circles, the high-yield bond universe has little nuance: it’s viewed as an asset class comprised of debt issued by companies that need to pay higher interest rates because they fall short of rating agencies’ definition of investment-grade creditworthiness.
The reality is much more complex.
Aside from the difference between the assorted BB+ and C-rating levels, the size of both an issuer and the specific issue being considered must be weighed to assess how much risk is assumed in exchange for the higher yield.
But since the small stuff tends to get short shrift from the massive investment industry leaders, it tends to carry even higher yields.
For flexible money managers willing to put in the work finding and analyzing investment-worthy deals, that translates into abundant opportunities to find solid risk-adjusted returns.
Small Companies Aren’t Automatically Poor Credit Risks
One of the largest unmined areas of the high-yield bond market is small capitalization companies, or those with market caps of less than $5 billion.
Much of the limited interest in such companies stems from the economics of large bond fund managers, who must set minimum thresholds for investment levels and company sizes.
Portfolio guidelines also generally lead to:
An aversion to smaller or uncovered industries. Mainstream managers’ focus on mid- and large-cap companies in broad, well-defined industries ignores pockets of the business world that feature steadily performing niche industries or include a large number of private companies.
The complete disregard of unrated companies. Few large bond investors will invest in a holding that doesn’t have a third-party assessment of its credit rating. Getting a credit rating, however, is an expense that the issuer must bear. Some small companies would prefer to invest such funds back into their business.
Yet, within these largely neglected swaths of the bond market live companies with robust balance sheets featuring higher cash balances than outstanding debt or ample free cash flow to pay down their loans.
That’s right. Beneath the usually higher yields and nonexistent institutional interest exist small cap companies with credit quality similar to investment-grade enterprises.
Which tend to make for solid risk-adjusted returns.
When a Bondholder-Friendly Mindset Prevails
Further eroding the myth that bonds from small companies are automatically more risky is the prevalence of well-run businesses that potentially mitigate the related risks through:
- Success in a niche or mature industry that has few players and sustained cash flow—even companies with limited growth prospects can be excellent credit risks.
- Prudent financial managers who insist on profitability structures and balance sheets that are on par with much larger blue chip names.
- Large individual or family owners (often founders) who are heavily incentivized to preserve their equity value and avoid excessive leverage or reckless risks.
- Executives who have grown up in the company and will do anything that’s needed to preserve the firm’s viability with existing lenders, its standing in the community, and their entire personal network and identity, which are tied up in this life-long investment.
Ultimately, these companies know that they are more at risk from getting cut off from the credit markets than a multinational such as IBM. So, they carefully manage their balance sheet and cash flow while allowing for the current realities of their industry and keeping an eye out for a turn for the worse.
Sometimes, it’s a Structural Thing
The average size of the high-yield bond issues within the ICE BoA US High Yield Index is $721 million. The low end of consideration among large money managers, who hold liquidity paramount, is generally understood to be $500 million.
Along with the liquidity requirements, smaller issues can also be problematic for a large investor because they may end up holding a substantial portion of the outstanding debt, which they wish to avoid.
With the big firms out of the picture, issues that are smaller than $500 million attract fewer potential investors, which tends to reinforce the market’s sense that small cap companies should be avoided.
But where it gets interesting is with issues that were originally larger but have been paid down below that $500 million cutoff.
Affectionately known as “stubs,” such issues could belong to a large company that initially borrowed $1 billion and has paid down $900 million over the years. With a maturity date that’s less than two years out, the company may intend to simply pay the coupon until maturity, but at $100 million, many large investors won’t touch it.
As demand ebbs for the stub, the price can falter, pushing the yield to an even more attractive level than a virtually identical issue that came to market from the same company at the same time but wasn’t paid down – thus maintaining its appeal to larger institutional investors.
And that translates into a truly better risk-adjusted return potential for nimble portfolio managers who aren’t afraid to wade into the smaller-issue waters.
In a similar vein, busted convertible bonds are hybrid investments that no longer appeal to their initial investors.
More specifically, convertible bond investors tend to be equity-minded as the issues offer future conversion into stock while paying a coupon in the meantime.
When volatility sweeps through the stock market, however, the promise of future equity isn’t as attractive, so such investors frequently ditch the busted convertible issue, sometimes at a price that translates into an attractive yield.
Keeping Alert for Low-Profile Opportunities
Admittedly, tracking down under-the-radar bonds can be challenging—both in terms of finding the opportunities and then completing the credit analysis work required to discern whether it’s worth making the investment.
Frankly, it’s that possibility that a smaller issue won’t make the cut after running deep research on it that scares away another cohort of bond investors—those that insist on getting a return on the analysis investment they put into it.
But if a smaller company doesn’t seek the blessing of a ratings agency, it’s got little third-party support. And if it’s cost-conscious, it may have a limited budget to spread the word that it’s looking for lenders.
As a result, it’s rare that many people are digging into a smaller company with an unrated bond issue to get to know it better and learn the intricacies of its business, much less supporting it by buying the company’s debt.
Known entities, however, are a different story.
Consider a current investor in a small company’s bond. That investor is regularly monitoring the health of the company, meeting with the management team, and creating a relationship. Then, when the company needs to refinance the deal or bring a new debt issue to market, it frequently turns first to that investor and other existing backers, who tend to be easier to access than brand new investors.
At Intrepid, we’ve seen such situations lead to a seat at the table where the financing need is being discussed. We’ve helped companies looking to refinance debt understand what the market is looking for in addition to what they need.
And frequently, if the terms on the refinancing or new issue are attractive, we’ll extend the relationship with a fresh investment.
Mutually beneficial relationships may also form with bond brokers who specialize in smaller issues, whether they come from large, medium, or small companies. In essence, it’s a boutique broker helping a boutique firm.
Still a Question of Risk
Ultimately, the fundamentals of bond investing are company and size of issue agnostic.
How much cash vs. debt does the company hold? Does it have access to additional liquidity if needed? Does it have noncore assets it could sell off to raise funds? Does it have the capacity to sell equity if needed? Is the management team on top of the business or are key people distracted by the next opportunity—for the company or themselves?
At Intrepid, we refer to many of these factors as levers that a company may pull to keep risks at bay. And help ensure that it keeps its creditors happy.
That could include a healthy company with a market cap of $500 million that’s offering a new secured debt issue or a $20 billion multinational that’s repaid all but the last $200 million on an outstanding issue that matures in 18 months.
Yes, with regard to smaller bond issues and issuers, the research and analysis required is usually more time consuming than bigger issues from rated entities, but considering the potential reward found in the higher yields, we believe the extra legwork is usually worth it.
Free cash flow, or cash flow, represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets.
ICE BofA U.S. High Yield Index tracks the performance of US dollar-denominated below investment grade corporate debt publicly issued in the US domestic market.
Credit quality ratings assigned by a Nationally Recognized Statistical Ratings Organization (NRSRO) range from AAA (highest) to C or D (lowest) and are subject to change. Credit Ratings are ratings systems designed to determine the likelihood of a creditor to default on its obligations. Standard & Poor’s is a major credit rating provider. A Standard & Poor’s BB- rating represents a speculative grade rating for a creditor that is deemed less vulnerable in the near term, but faces ongoing uncertainties and exposure to adverse business, financial, or economic conditions. A Standard & Poor’s B- rating represents a speculative grade rating for a creditor that is more vulnerable than BB-, but currently has the capacity to meet its financial commitments.
Mutual fund investing involves risk. Principal loss is possible.
Investments by the Fund in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher rated securities.
The Funds’ investment objectives, risks, charges and expenses must be considered carefully before investing. The prospectus contains this and other important information about the investment company. Please read it carefully before investing. A hard copy of the prospectus can be requested by calling 866-996-FUND (3863).
Intrepid Capital Management Funds are distributed by Quasar Distributors, LLC.