Q:† What is the investment philosophy behind Summit High Yield Bond Fund?
A: Our philosophy is based on the relative value principle. We start with the premise that there are no bad bonds, only bad prices. That means that we consider the entire bond universe and we are willing to look at any idea, unlike many investors, who place themselves in a box and would only look at bonds with certain ratings or in specific industries.
To select the bonds that we are interested in, we value the particular bond versus other bonds in the universe. We look for bonds with asset coverage as weíre trying to limit the downside in the liquidation cases. We also look for companies with free cash flow, which gives them the ability to repay debt and some financial flexibility when the economy turns south. In general, we tr y to find bonds and companies with improving economics that are in the right part of the cycle, having the wind at their backs.
A particular strategy that we employ is to look for upgrade candidates. If a bond is below investment grade today, it may become an investment grade bond a couple of years later and thatís one of the ways to make money in the fixed income market. Another way is to look for yield. There are companies that arenít getting better or worse; they are just companies with asset coverage and an attractive yield for the risk associated with the investment. Such companies may not be upgrade candidates, but they may have stable free cash flow. We also tr y to find companies that are reducing their debt through free cash flow, equity issuance, spin-offs of non-strategic businesses, etc.
Finally, we look at special situations and corporate events. For example, when General Motors sold a portion of its financial subsidiary GMAC, that security moved up and down based on the progress of the event, rather than moving up and down with the market in general. We tend to have 10% to 20% of the portfolio in such special situations.
Q:† How do you research the bonds and the companies in each of those strategies? Could you give us some examples?
A: In the debt reduction strategy, a good example is Lyondell Chemical, a highly leveraged company in the chemical space. About three years ago it announced a plan to reduce debt by using all the free cash flow. It managed to execute that plan over the last couple of years, and the leverage of the company came down dramatically. The management team recognizes that it cannot operate a highly leveraged company in a cyclical business, because when the cycle turns down, you are in serious trouble. Now they are using the positive cycle and the millions of free cash flow generated to reduce the debt during the good times.
Lyondell is an investment thatís related to several strategies because when the leverage is coming down, the rating agencies like the profile better, and it becomes an upgrade story as well.
A good example for an upgrade candidate is Williams, which was a really stressed company a few years ago. At one point their debt was downgraded to Caa1, and in 2002, some of their debt was trading at a yield near 30%. It could have gone bankrupt but it didnít. Warren Buffett invested in the company, and they managed to continue paying down debt using the free cash flow generated by a good business. Obviously, they had to remove the high-cost loans to avoid bankruptcy and have come a long way since 2002. They could be an investment grade company a couple of years from now. Of course, they may choose to use their free cash flow for capital expenditures and for growth, so they may not get all the way to investment grade, but the credit story remains sound.
In terms of the special situations, everyone in the marketplace is aware when they occur. Obviously, when the debt starts trading down from 80 cents on the dollar to 50 cents, that price action deserves attention. But we wouldnít typically jump in if we donít know where the bottom is. Weíll simply wait and see what happens.
In the case of Williams, the involvement of Warren Buffett was a positive factor and you could see their financials stabilizing in 3 months or 6 months. There is a clear path of liquidity and avoiding bankruptcy. Ideally, you should know your price objective. We bought Williams Company shortly after their crisis, with the idea to hold them until they reach investment grade status. Weíre pretty close to reaching our objective because the bonds are trading almost like investment grade at this point.
In terms of the yield plays, Ford Motor Credit in the automotive space is a good example. Ford has a lot of problems as it is losing market share to companies with lower labor, pension and healthcare costs, like Toyota or Honda. We had no intention of investing in Ford because we donít particularly like the company, but our analysis of the liquidity profile of the Ford Motor Credit subsidiary showed it could repay its short maturity bonds even if Ford continues to lose money and has reduced car sales. With the high quality assets in the financial subsidiary, they can make it through to 2008 or 2009 without the liquidity shortage that ultimately causes bankruptcy.
Unlike General Motors, Ford decided not to sell its financial subsidiary even though itís worth billions of dollars. They prefer to keep the jewel in the crown that makes a lot of money for them. So in yield plays, the goal is to get paid back, and to have good protection in the case of being wrong.
Q:† How large is your universe? For example, how many companies have bonds on the market and how many of the high yield bonds eventually make it all the way to investment grade?
A: There are thousands of issues on the high yield market, which is a pretty fragmented market. In the auto sector, Ford and General Motors were investment grade bonds, which were downgraded to below investment grade. They became a large part of the market, but the rest of the market is very fragmented. The small-cap companies with $200 or $300 million in sales by definition are below investment grade even if they are great companies. There is never a shortage of deals to choose from and there are always new companies to look at.
Regarding the transition to investment grade, the upgrade/downgrade ratio over the last 20 years has been decidedly negative as corporate America has become more leveraged and the average corporate bond rating has declined. Back in 2001, the upgrade/ downgrade ratio was 6:1 in favor of the downgrades, but a more common number is 1:1 or 2:1. Bonds that are moving up to investment grade are more difficult to find; there are probably fewer than 50 companies on the verge of getting upgraded to investment grade. It is a much smaller universe but upgrades do happen.
Q:† What is your view on the airline industry, which is historically part of the high yield market, and has gone to the bankruptcy route? Do you exploit turnaround situations as part of your idea generation?
A: Yes, we do look at them because, as I said, there no bad bonds, just bad prices. We have an investment in United Airlines, but not in unsecured debt. United Airlines recently came out of the bankruptcy that it filed in late 2002. When we invest in airlines, we tend to avoid unsecured debt because it has little value in bankruptcy.
We tend to buy Equipment Trust Certificates or Enhanced Equipment Trust Certificates, which provide a claim on an airplane. If the company files bankruptcy, they either give you the plane, or you renegotiate your lease with them. We have played in a little prebankruptcy and a little post-bankruptcy of United Airlines. Within the EETC structure, you can buy more senior or more junior debt, so we invested in more senior securities with collateral. Those have been very successful investments for us but the airline industry is a challenging industry.
Q:† What are the other situations in which you avoid unsecured lending?
A: The airline industry is a specific area, where you can get secured and unsecured bonds and we tend to invest in the secured area. Our strategy is to get senior in the capital structure in companies with low ratings, and the airline industry is a good example of that strategy. It is rated triple C in many cases. If we have a higher-rated credit and we are not worried about bankruptcy, we may take a more junior position.
Q:† Would you describe your portfolio construction principles? How many bonds do you hold and how do you determine the range of the holdings?
A: We tend to have about 50 names because we want to have big enough positions that have an impact on the overall portfolio. I believe that 50 names are enough for diversification by individual security and industry, as well as enough to have an impact on the portfolio. We tend to limit the positions to less than 5%, and typically, the positions would be in the 1% to 3% range.
Q:† How do you control risk at the portfolio level?
A: We control the number and the amount of bonds that we put in the portfolio and weíre very cognizant of what the portfolio looks like versus the index. Our benchmark is the Merrill Lynch High Yield Master II Index, which is a pretty good gauge. We make sure that we are in line with the index in terms of overall duration. Not that duration is big part of high yield investing, but we donít want to have a portfolio thatís 10 years in duration when the index is 4. We tr y to build a portfolio thatís similar to the index in terms of ratings with a little higher spread and a little higher yield.