It's time to tread cautiously in the high-yield bond market, says Rex Chong, lead manager of the $553-million Trimark Advantage Bond .
"On a macro basis, a slowing global economy would be a headwind for high-yield bonds, and all risky assets, in fact," says Chong, vice-president and head of fixed-income investments at Toronto-based Invesco Canada Ltd.
While noting that there are concerns about slowing growth in the U.S. and Europe, "our reason for treading carefully is valuation," adds Chong, 45, head of the four-person fixed-income team at Invesco. "High-yield bonds are yielding about 500 basis points (bps) above U.S. 10-year treasuries. In relative terms, that is pretty well average for the long term."
Last summer, spreads widened moderately, reflecting increased credit risk. Should they widen to around 600 or 700 bps with no change in the economic climate, Chong and his team would become more aggressive.
"We're always defining the risks relative to the price we pay. At 600 to 700 bps, we're being paid sufficiently to take on the risks in front of us, given the economic climate," says Chong. "We're not getting out of high yield, however, because you are still getting paid a decent risk premium at 500 bps."
Given the economic climate, Chong has been asked if he is raising the quality of the portfolio, in terms the average credit rating. "We are raising the 'familiarity' factor. We understand the companies we own, and what the volatility could be," he says. "We are shrinking the number of names that we own. That makes it more concentrated. But we're comfortable with what we own."
One long-time holding is Iron Mountain Inc. The Boston-based firm provides document-storage services for more than half of the Fortune 500 companies, and many leading Canadian corporations.
"It's a steady, visible business that is very predictable," says Chong. "It has market-share leadership and strong cash flow," he adds, noting that the 2017-dated bond is yielding about 7%.
Another holding is WMG Acquisition Corp. Better known as Warner Music Group, the world's third largest music publisher has an extensive music library that features albums by big names such as Led Zeppelin, Madonna and the Red Hot Chili Peppers. The 2016-dated bond is yielding 7.7%.
"What's the commonality to these holdings?" says Chong. "Market leadership, low-capital-expenditure businesses and sufficient cash flow to reinvest in the business, repay debt or buy back shares."
A Toronto native, Chong began working on the sell side of high-yield finance. After graduating in 1988 with a bachelor of business administration from Wilfrid Laurier University and earning an MBA from Michigan State University, he joined the corporate-finance arm of Bank of Montreal in 1990.
"I immersed myself in understanding how these deals were constructed and was also involved in the syndication of the deals," recalls Chong, who was occupied with higher-credit-risk transactions that included leveraged buyouts.
In 1996, Chong moved to the formerly named Trimark Investment Management (now Invesco Canada). He was recruited by Patrick Farmer, the then lead fixed-income manager, who developed funds that could tap the high-yield market. The focus was on credit analysis, as opposed to interest-rate anticipation.
Besides managing the Canadian high-yield fund, Chong also oversees the flagship $1.6-billion Trimark Canadian Bond and the $112-million Trimark Global High Yield Bond . The latter invests solely in high-yield bonds.
Chong's investment approach includes intensive analysis of prospective companies, examination of credit profiles and debt indentures, and determining relative value. About 40% of the exposure of Trimark Advantage Bond is in non-Canadian currencies, although currency exposure is partially hedged.
Chong, who limits single holdings to about 7%, owns about 50 companies in Trimark Advantage Bond. Launched in December 1994, the fund is not a pure high-yield play, since it generally has a 65%-35% mix of high-yield and investment-grade bonds. When valuations were very cheap in early 2009, the mix was slightly more aggressive at 70-30.
Over the last five years ended Aug. 31, the fund was in the fourth quartile in its peer group. "We were early being defensive, and left some returns on the table," admits Chong. "We took some money out of the market because the risk-reward was not to our liking." Over 10 years, the fund is a second-quartile performer.
Today, Chong regards the high-yield risk-reward equation as "fair." And he cautions investors that should global economies slump badly, the asset class will be hurt since it is tied to corporate profitability. "But we can make an educated decision to weigh in on one side, or the other, as valuations change," Chong says.