Editors' Note: This is the transcript of the video we posted last Thursday. Please note that due to time and audio constraints, transcription may not be perfect. We encourage you to listen to the video as well as a combined podcast featuring two other interviews along with this one, embedded below, if you need any clarification. We hope you enjoy.
Daniel Shvartsman: I’m Daniel Shvartsman, the Director of the Seeking Alpha Marketplace, continuing our video series around the coronavirus market. I’m joined today by Jeremy Lakosh, author of High Yield Digest, a service on the Seeking Alpha Marketplace, where you can track 2,000 high-yield securities, with dashboards and in real-time portfolio.
Listen and subscribe to the Marketplace Roundtable on these podcast platforms:
The conversation with Jeremy runs from :30-24:00 minute mark.
So Jeremy, good morning. Nice to see you.
Jeremy Lakosh: Good morning, Daniel.
DS: So fixed income has been a really interesting place, in general. There was some immediate dislocations in March and then the Fed really stepped in, in a big way. And that’s arguably where they’ve stepped in the most. I’m curious how you see that, especially in the high-yield end affecting the opportunity set. Are you still seeing bargains? Are you still seeing opportunities?
JL: So the Fed has created some pressure in terms of – I like to buy things when there are, especially if you see stresses like this, I like to get things cheap. And the Fed, by coming in and buying investment-grade corporate bonds, has kind of created a bubble that’s pushed up against the high-yield market.
So I do feel like there is some dislocation there in terms of pricing. It is not occurring on the energy side, the energy side still remains heavily distressed. But most other areas, I believe, pricing is still a little high. But fortunately, for somebody like me who likes to hunt for value in high-yield, I believe like some of the other presenters that you’ve had on that there’s more market volatility to come. And since the high-yield market does track with the stock market, I think that some of that’s going to get pushed aside for a period of time.
One benefit for high-yield investors such as myself to the Fed doing what it’s doing, is it’s making large private investment firms more comfortable with new lending in the high-yield market. For example, AMC Theaters (AMC), they’re not open right now. They just did a huge private placement bond deal, I believe, the interest rate on it was 10%.
But that kind of deal doesn’t happen if you don’t have the Fed’s presence in this market, there’ll be too much fear to do new debt deals. So for investors like me, they can feel a little more confident that that companies that are able to refinance will have that source there to do it.
DS: Right. So there – it’s – there’s going to be an ongoing churn of new opportunities and, like you said, of refinancing, which provides that underlying stability.
JL: Yes, yes.
DS: Okay, great. So what are you looking for an issue in companies? I mean, AMC, for example, as a company that was in a tough position beforehand. What are you looking for when you’re scouring the current high-yield universe?
JL: So high-yield investing gives people the opportunity to diversify. The high-yield debt exists in every industry, even exists in banks and financial companies. So you have the opportunity to diversify your portfolio and also collect a decent amount of income. My current portfolio is yielding 8.4% of income to the costs that I put in.
So when I look at a company and see something, let’s just say, I’m looking for the first time, I immediately go to the cash flow statement. I want to see how the company is managing cash. And in particular with bonds, I want to see that the company is generating a positive free cash flow that tends to either be stable, maybe increasing, or it’s in a trajectory that I feel when the bond I’m looking at comes due, the company will either be able to refinance it easily, or in some cases, pay it off entirely with cash.
So free cash flow is huge for me. I usually will pass on companies that are negative free cash flow. There are companies out there that are negative from an operating cash flow standpoint. And I won’t touch them, mainly just because negative cash flow from operations essentially insinuates, you’re burning through cash just to stay open. So free cash flow is huge for me.
I also will listen to management comments when they provide guidance for the fiscal year that they’re in or the forward fiscal year, because management will tend to tell you not only where they see the company performing from a free cash flow standpoint, but their priorities.
I like it when a management company says, “We’re looking to delever or pay down debt.” That’s good for people in my class. It’s not always good for shareholders, because that doesn’t create a lot of shareholder value. But if I hear management saying things like, we’re looking to pay down debt or deleverage or positioning ourselves to refinance something that’s two or three years down the road, that gives me comfort that I can invest in that company and get a decent return.
DS: Are you looking at the maturity dates, because one of the things that we’ve got a lot of uncertainty on the one hand, near-term maturity date, and I’m going to talk beyond my depth here. But the near-term net [ph] maturity date, you might have a call option or whatever else or redemption option. On the other hand, longer-term maturity means, they have – you don’t have that refinance risk. So how do you think about the length of the bond?
JL: So duration is a great question. And especially when a black swan event like COVID-19 occurs, and there’s a lot of fear in the high-yield market, you’ll see near-term maturities really take a beating. And that’s because people aren’t sure whether or not the company will be able to refinance.
So right now, the sweet spot for me when it comes to duration is looking at bonds that come due between 2022 and 2024. And the – and these are companies that don’t have any other debt due prior to that. So right now, they’re in a situation, where as long as they’re generating cash, they can ride this out for a couple of years.
And so I’m looking at the next maturity on that list, whether it’s in 2022, 2023, or 2024. And I believe that buying in that point is going to give the company time to refinance and you brought up the call options. Usually, a bond is callable at par at the value in which it’s worth two years prior to maturity. So in 2022, that would be this year, it’s callable this year.
So the company has two years to figure out how to essentially refinance. So that’s kind of why I have come up with that window. And I do believe that those areas, in my portfolio, will probably be getting refinance starting in the third or fourth quarter, with interest rates being lower, as long as the operation is holding up and for reasons we’ve already talked about. So that area tends to be the area I’m most interested in.
DS: Okay. You also mentioned a specific area that I was curious about, which was BDC baby bonds, which BDCs, business development companies are quite popular with investors, because they give you a steady income flow, and they’re exposed to a wider array of companies.
But those companies are also small businesses, which at a layman’s level have seemed like the most affected by what’s going on. The baby bonds often trade publicly, you could buy them on your brokerage. And so what’s your take on how the current situation? Why do baby bond stand out to you as an interesting opportunity set?
JL: So I think it’s important for people to realize what baby bonds are. They are debt that trades on an exchange that has a ticker symbol. Most debt trades in $1,000 increments, and you need to have a CUSIP number in order to buy that debt. Well, most baby bonds trade with like four ticker symbols like OTC:LTSH, which is Ladenburg Thalmann. And they’re trading $25 par increments. And that makes it easier for a retail investor or a smaller investor with a smaller portfolio to invest in debt.
Baby bonds, in this market right now, are trading at a discount to traditional bonds. And I believe the reason that’s occurring is because of their exchange-traded nature. They’re more fluid, they’re more liquid, they’re being traded more. I think that’s the simple reason for. In the BDC sector itself, I actually don’t own any baby bonds yet. But I’ve changed my focus to them with all of this volatility, because – and this is the same with mREITs, Mortgage REITs right now.
When a company has to preserve cash, let’s say, they have common shares, they have preferred shares and they have baby bonds, and all are paying high yields. When they have to preserve cash, management at any time can suspend common shares, dividends, preferred share dividends, they can say at any time, we’re suspending these. And obviously, volatility in pricing comes with those suspensions.
With baby bonds, the only way you can suspend those interest payments are through restructuring, which means you file for Chapter 11 bankruptcy, or there’s a specific provision in the prospectus with allows for you to skip a few payments. That’s very, very rare. Usually with baby bonds, if you’re skipping an interest payment, you’re filing for bankruptcy within one to three months.
So the threshold for income loss in baby bonds is much higher than it would be for common or preferred shares. And BDCs have such a track record of holding up in terms of solvency through tough economic times, that that asset class has become particularly attracted to me. I think these companies have good relationships with the small businesses that they are invested in. They take very secured positions with those investments. And I think they’re going to step in and help their customers survive this crisis.
So while I do see, obviously, pressure in that area, I see some companies probably suspending common share dividends. I don’t think it’s going to get to the point where there’s widespread restructuring. So that’s why I’m attracted to the baby bond asset class in that space.
DS: Interesting, because the way you described that the dislocation is precisely, because they are exchange-traded, retail-owned and easy – more easily in and out. And so people may have that perception. I also think it an interesting implication here is, a lot of people will look at preferred shares and baby bonds both often, let’s say, five letter symbols are so. They’re longer symbols, they feel the same. They often trade at the same par level. And it’s an important distinction you drop between the baby bonds, where there’s less opportunity to suspend the payment and a preferred share where even if it’s cumulative, you can stop or whatever else so that’s interesting.
JL: Yes. Yes.
DS: So I want to get to some specific pics if you have some of mind. But before we do, you argued in the Roundtable we did a couple of weeks ago that you view high-yield as a more attractive class. You also said earlier here that high-yield like stocks will probably track the market as a whole. So what is your case for high-yield as a whole beyond? Is it just what you said with baby bonds? Or how do you think about high-yield as a category?
JL: So we’ll talk about high-yield debt, really, because that’s an area I got into, because I saw the stock market carrying some lofty valuations over the last five years. And it’s not like I just sold everything and went to high yield debt, I just slowly transitioned into that space. Understanding that when moments like this occur, I’m going to take some losses, there’s going to be valuation drops.
During the financial crisis, the S&P 500 fell by approximately 50% to 60%, the general equity markets debt, high-yield debt as a whole fell by 26%. So while you don’t have total capital protection in high-yield debt markets, you have some. You also have, again, unless there’s restructuring constant income coming in.
And when you have income at 8% or 9% of your portfolio, you can thin your cash down just a little bit to take part in buying opportunities and then kind of hold and watch your cash position grow back up as those interest payments are coming in.
Again, though, you’re still taking risk. You have risk for bankruptcy and restructuring that occurs. But if you look at the default rates, the default rates have been rather tame. And even at a 10% default rate, a well diversified high-yield portfolio will have 90% essentially of its investments still producing income.
So I got into this space as still understanding I’m going to take risk, but preserve enough capital to get on the other side and ultimately participate in the bull market, I believe that the high-yield market in the first year to 18 months of a new bull market outperforms the stock market.
But at that 18-month window, once you have pretty good recovery in your bond market, that’s the time then to start allocating capital towards stocks and value plays and maybe even some good common share dividend plays. So it’s a cyclical type deal for me, where you preserve capital through the push down and then you ride the recovery up, because again, the safer asset classes recover quicker than the riskier ones. And then you switch over and participate in the bull market.
DS: So you’re talking about sort of a steady income, let’s use your 10% number, steady income from 90% as well, capital appreciation, because they do selloff to in the downturns, so you get that capital appreciation. And it’s not literally a one-to-one switch. But once the capital appreciation has gone, that’s the point in the cycle where it becomes more interesting to look back in equities and upside there?
JL: Yes. And I’ll even put it – I’ll even set this expectation for members of my marketplace. They will see me, over the next 12 months, looking for volatility, I think, there’s way more volatility to come. And using that to buy additional high-yield debt, possibly a few preferred shares.
But then when we do reach a period of recovery and start to see genuine economic growth and healing, they’re going to see me dip more into the common share side and look for either current high-yield dividends or potential dividend borrowers that can bring both capital appreciation and income.
DS: Got it. Very interesting. Okay. So even with the volatility coming up, what do you have in mind? Any high-yield debt plays that are interesting to you right now?
JL: So I’m keeping a very close eye on the entire energy space, mainly because I see a parallel between high-yield energy debt here in 2020 and where bank debt was trading in 2008/2009. I’ll give you an example.
Nelnet, which is a student loan servicer, they’ve got a bond out there and I don’t know when it matures. But at one point during the financial crisis, it was trading at $0.08 to $0.09 on the $1. And that bonds still exists today, still trading. It’s probably in the $0.80 to $0.90 range right now. But the entire energy space is starting to look like that.
I’m seeing energy companies that are relatively healthy, with debt trading between $0.40 on the $1 and $0.70 on the $1. And I think that if we use Nelnet as an example, that distress stayed in that market for about 12 months. So it’s not something I need to buy today and get on board with – and I’m not under the pressure to do something right now. I’m going to watch that space carefully.
And if I see energy companies, again, with maturities that don’t need to be addressed for four to six years, who have hedged some of their positions against low oil prices, those companies are likely going to have an opportunity of $0.30 to $0.40 on the $1 to buy their bonds, and I probably will select a few to buy.
So that’s my longer-term. More as in today, what could I purchase today, I have taken an interest in industrial material companies that produce products. Again, their debt also is trading at a deep discount. And I think that a lot of these companies will survive this pandemic that we’re in.
I’ll give you an example. I haven’t bought this share, but I’m watching it. Ford has a long-term debt bond out there, I believe, it’s about a 20-year down the road. It’s got a 7.7% coupon on it and it’s trading at about $0.65 on the $1. So if you buy that in the company doesn’t file for bankruptcy, you’re going to collect really good income and really good yield to maturity for a long period of time. So Ford, I’m keeping my eye out on that.
I wrote about Donnelley Financial last week, which is a technology company. They’ve got a 10% yielding bond that matures in 2024. So, again, it’s – I’m looking very broadly at bonds that yield between 10% and 13% maturities and looking for good opportunities there.
DS: Okay, fascinating stuff. And it is an area that, especially for Seeking Alpha readers, I think, there’s – it’s harder to follow than it is to just look at DFIN or Ford and just see the common stock. And so by nature, if it’s harder, there’s chance that there’s more in efficiency that you can root out if you’re nowhere to work, so.
JL: Yes. And with my Marketplace, I have company-specific dashboards. And within those dashboards, I will track every debt instrument that a company issues. And for some, there’s only one or two, but for others, there may be four or five preferred shares in four or five bonds. And you’ll see some of that dislocation. You’ll see yield some maturities front loading. There’ll be an 18% yield to maturity in 2021 and 14% in 2026. And for me that that indicates an element of fear, where if the company, again, is generating positive free cash flow, there’s definitely a buying opportunity there.
DS: Absolutely. I think everybody is – whether they’ll generate free cash flow for the next 12 months and then within over the next 24 months, that’s sort of the game here. But obviously, the more margin of safety you have in terms of the historic cash flows, the better off, especially a debt instrument will be?
JL: And one indicator that I’ve started to look at more closely, sort of a stress test of free cash flow, if you will, is I look at free cash flow as a percentage of revenue. So I know companies are going to take revenue hits and I know it’s going to be bad. But what does that mean for free cash flow?
Well, and again, in a perfect world, it would bleed over dollar-for-dollar, it’s probably not. A good competent management organization will probably be able, if they lose $1 of revenue to preserve at least $0.25 of free cash flow out of it. But I want to be conservative and I want to be fair understanding that this hit us very suddenly.
So if I see a company that has 20% free cash flow to revenue, I understand that and at that point that, there’s a healthy margin of safety there. And as long as revenue really doesn’t plummet, it should be okay. And as a teaser, I will tell you, one of the companies that I feature in my Marketplace only has 70% of its revenue generating over to free cash flow. So that’s a situation where investors should – I mean, they shouldn’t feel totally safe, but they should feel like okay, there’s a lot of funding here to support my invest.
DS: Got it. Okay, really, that’s definitely an interesting place to leave. So if you’ve been watching, you can check out Jeremy Lakosh on Seeking Alpha typing in his name, follow his free content, but also High Yield Digest available on the Seeking Alpha Marketplace. I suppose you have no positions, because you mentioned issues that you’re looking at for the future. Is that correct?
JL: Yes, yes, I mentioned Ladenburg Thalmann earlier. I do own their baby bonds. And I purchased those as they dipped right before their acquisition. Let me see if I – and I own Donnelley Financial’s. 2024 debt.
DS: Great. Okay. Well, Jeremy, thank you so much for taking your time this morning and best of luck to you in the market and otherwise just staying safe and healthy.
JL: Thank you, Daniel, for the opportunity. I appreciate it.
This article was written by
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Jeremy Lakosh is long LTSH and Donnelly Financial's 2024 bonds.
Nothing on this video should be taken as investment advice.