Top Canadian Junk Bond Manager Marshall Sees Rally Ending
CI Investments Inc.’s Geof Marshall, the second-biggest Canadian manager of high-yield debt, said the four-year rally in below-investment-grade bonds is coming to an end as companies begin to take on too much risk.
“The high-yield rally is long in the tooth,” Marshall, who manages $6.8 billion as head of high-yield investments, said in a Feb. 20 interview at his Toronto office. Investors can expect “coupon-like returns” this year, he said. The Bank of America Merrill Lynch High-Yield Index gained 18.8 percent in 2012, beating the returns of investment-grade corporate debt for the third time in four years.
After using junk bonds to propel his Signature Diversified Yield mutual fund to the top 10 among Canadian balanced funds last year, Marshall is cutting holdings of the securities to 35 percent, from 40 percent in the middle of 2012. Following four years of balance-sheet repair and cost-cutting, many issuers are shifting their preference back to boosting return on equity, while the re-emergence of debt-laden takeovers such as Dell Inc. (DELL) and HJ Heinz Co. (HNZ) will undermine confidence, he said.
“Companies can borrow cheaply, shareholders are clamoring for returns, so to the extent that high-yield companies can borrow for growth or to increase dividends, I think you’ll see more of that,” Marshall said. “The quality of high-yield issuance probably begins to deteriorate in general.”
The C$3.3 billion ($3.2 billion) Signature Diversified Yield fund returned 12.3 percent in 2012, beating 94 percent of competitors and placing it seventh among 636 so-called global neutral balance funds tracked by Morningstar Inc. CI Investments is the second-biggest Canadian investor in high-yield debt after Royal Bank of Canada, according to Morningstar.
Silver Lake Management LLC’s proposed plan to take over computer maker Dell with $13.8 billion of debt marks the biggest leveraged buyout since the financial crisis. Berkshire Hathaway Inc. (BRK/A) and 3G Capital’s acquisition will saddle ketchup-maker Heinz with $14.1 billion of borrowings and denuded it of its investment-grade rating by Fitch Ratings.
“The Heinz and Dell deals are very topical,” Marshall said. “That’s an example of new high-yield debt that will be in general lower-quality than the bulk of the market because those are leveraging transactions as opposed to deleveraging transactions.”
Marshall joins KKR Financial Holdings LLC, the credit unit of the private-equity firm run by Henry Kravis and George Roberts, which cut a portfolio of high-yield debt by 39 percent in the second half of last year. Loomis Sayles & Co.’s Dan Fuss said last month that the market for junk bonds is “overbought” with “ridiculous” valuations.
About $506 billion of dollar-denominated junk bonds are trading above the price that their issuers may buy them back at later, limiting potential gains, Morgan Stanley data show.
Leveraged loans and high-yield bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- at Standard & Poor’s.
Elsewhere in credit markets, the extra yield investors demand to own the debt of Canadian investment-grade companies rather than that of the federal government narrowed one basis point yesterday from a day earlier to 126 basis points, or 1.26 percentage points, according to a Bank of America Merrill Lynch index. Yields fell to 2.97 percent, from 3 percent on Feb. 20.
Government bonds rose, pushing the yield on the benchmark 10-year note down one basis point to 1.97 percent at 8:40 a.m. in Toronto. The price of the 2.75 percent securities maturing in June 2022 gained 12 cents to C$106.60.
In the provincial bond market, the spread to government benchmarks narrowed one basis point to 73 yesterday. Yields fell to 2.65 percent, from 2.69 percent, the index data show.
Canadian corporate bonds have returned 0.2 percent this year compared with a loss of 0.9 percent by Canadian government bonds and the 1.1 percent decline in provincial debt, according to Bank of America Merrill Lynch data.
Canadian high-yield debt returned 1.16 percent since December as of Feb. 20, compared with a gain of 1.51 percent for the Bank of America Merrill Lynch Global High-Yield index.
Marshall forecast relative yields would continue to narrow in April 2012 even as speculation mounted Greece would be banished from the euro, destabilizing the banking system and triggering sales of risky debt. Instead, efforts by central banks around the world to ward off recession kept key borrowing rates low and spurred unprecedented demand for junk bonds.
Marshall’s Signature High Income Fund was named best global neutral balanced fund over three, five and 10 years by Lipper Inc. this month. Marshall runs the fund with Ryan Fitzgerald and Joe D’Angelo.
“What we’re doing is very gradually letting the high-yield weight fall” in funds including the High Income fund, where junk is mixed with other assets, Marshall said. “As we get inflows, the marginal dollars are being invested in equities as opposed to credit.”
Apart from equities, Marshall is boosting bets on U.S. dollar leveraged loans, which pay similar coupons of about 6 percent to U.S. junk bonds and get paid first in bankruptcies.
“The value gap between loans and high-yield bonds is greatly diminished,” he said.
That gap vanished in September, when U.S. speculative grade yields fell to one basis point less than a measure of what’s being paid by senior secured loans, according to JPMorgan Chase & Co. (JPM) Junk bonds paid an average 103 basis points more than loans over the past three years, JPMorgan data show.
Marshall is also boosting returns by buying subordinated debt of insurers including Lincoln National Corp., Hartford Financial Services Group Inc. and Lloyds TSB Group. Some of the securities still trade below face value after steep mark-downs in the wake of the financial crisis, increasing yields for investors.
“We’re at the cusp of transitioning from a market that’s driven by systemic, macro challenges, risk-on, risk-off, to a market that’s going to be more idiosyncratic,” Marshall said. “I don’t think the high-yield trade is over per se, I just think that returns are going to be lower going forward.”
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