How Neuberger Berman is capitalising on the high yield upgrade cycle

James Marlay

Livewire Markets

What do Ford Motors, Rolls Royce, Carnival Cruises and Royal Caribbean have in common? They’re all examples of issuers in the high-yield bond market whose operations took a hit from the Covid-19 market dislocation.

As the earnings outlook for these companies became unclear agencies, such as S&P and Fitch, downgraded their ratings from investment grade to sub-investment grade. In effect, pushing their cost of capital higher to reflect the greater level of risk in their operations.

For Joseph Lind and the team at Neuberger Berman, an opportunity exists to capitalise on so-called fallen angels as economies reopen and business conditions improve. Lind says he and his team are working hard to identify companies that have the potential to be upgraded so investors can benefit from higher yields and capital appreciation.

“Our internal views are that a lot of the CCC names we own aren't CCCs. And a lot of the B names can go to BB. And we also anticipate that there'll be a big wave of names that get upgraded to Investment Grade. I think that the hard work and flexibility and willingness to adjust is something that really helps.”

In this interview, Lind explains how the team at Neuberger Berman is capitalising on the ratings upgrade cycle and where some of these opportunities exist today. 

Watch the interview by clicking on the player or read an edited transcript below.

About NB Global Corporate Income Trust (ASX:NBI)

The NB Global Corporate Income Trust (ASX:NBI) was listed in late 2018 and is one of the few ways investors can get exposure to the global high yield market on the ASX.

NBI is targeting an FY22 distribution yield of 4.75% paid to monthly to investors. For more information please click here.

Edited transcript

Could you tell readers about your background and what has shaped the way you think about investing?

I am American; I've lived in Boston for most of my life and moved to Chicago a few years ago to join Neuberger Berman. I've been in debt investing my entire career. I started investing in distress debt and was a portfolio manager for another investment manager for about 12 years, then joined Neuberger Berman in 2018 as a senior portfolio manager. I'd known the team for more than 14 years before I joined. We had a common philosophy and approach to investing, so it was an easy transition, and I've really enjoyed the culture and process, and size of the team that I get to work with at Neuberger.

Having started out in distress debt and seeing in the late 90s and early 2000s how there were four straight years of record bankruptcies, it was really helpful to think of how things could break, even when we're investing in higher quality bonds that we don't anticipate could default.

Can you outline the asset class you invest in?

We invest in non-investment grade debt across the world. These companies have credit ratings that are below investment grade. They have more debt and are often smaller than the large investment-grade names you've heard of, like Apple or ExxonMobil. 

These businesses require more research and there's a higher risk of loss, but we feel that by doing a lot of fundamental research and having a big team that's meeting with all the companies, we can find investments that won't default and pay much higher interest rates than investment-grade companies. 

We can offer yields that right now are more than triple what the investment grade bonds offer. 

We haven't had a default in the listed investment trust (LIT), and that's really the core focus: making sure we'll get paid back when we lend money.

NB Global Corporate Income Trust
Global Fixed Income

What is your team debating right now and why is it important?

We ask the team a lot of questions. One of the big things we're focused on now is how persistent is inflation. We're hearing from companies that their costs are going up. Anyone who has gone to restaurants bought food or tried to book services is finding it a lot more difficult now. Prices are higher and wages are going up. We're trying to understand how much of that is just the difficulty of restarting and how much is structural inflation.

How much of this is just really healthy demand? Are prices higher because there's massive demand and growth? We're seeing a lot more growth in demand than we're seeing inflation pressures and cost pressures. 

Over the summer we contacted every company we cover and asked them what inflation pressures they were seeing and what they were doing about it. A common thing we heard back was that costs were up, often eight or 10% more than expected. But these companies can't yet meet the demand they see and they expect to grow profits. 

For us, in the high-yield space, seeing profits grow, and seeing companies generating cash and being able to pay down debt is a lot more important than an effect of inflation.

So, those bonds are, in essence, getting safer because they're growing profits. So far the scale has tipped towards demand, but in every meeting, our discussion probably touches upon that debate in one way or another.

What are some of the conclusions you've come to from an investment perspective?

We always want the portfolio to reflect what we think will happen on a macro basis, but really that's a sum of all the small decisions we've made through the analyst team, and what that means for positioning. If you look at the portfolio, you'd see that we own more lower-rated issuers. 

There are really three broad categories of ratings. In non-investment grade, there's BB, B and CCC: higher quality, mid-quality and lower quality. 

We're overweight B and CCC, because those businesses are the ones that will benefit most from that growth. We also think that the rating agencies are a little stale. We've seen a lot of upgrades.

As an example, I'll use a couple of upgrades that have happened in the LIT so far this year. One was in real estate brokerage. People want more houses after the pandemic, and we're seeing real estate transactions move a lot. That was downgraded because of the pandemic but they're having a wonderful year and have paid off 10% of their debt. Realogy is the investment. It's been upgraded from CCC to B.

Theme parks have also been upgraded. Obviously, they should have been downgraded when COVID hit, but this summer they generated cash. Their ticket prices are at all-time highs. Concessions are at all-time highs. Even with 85% of the visitors, they're making just about as much money. They are being upgraded back to B. As other investors recognise, this is good enough for those businesses — the world doesn't need to get better. We all hope it does. Then that's where those spreads are: the yields of those bonds decrease and the price goes up.

So is it effectively an arbitrage opportunity, based on the ratings upgrade cycle, that you're able to get ahead of?

I wish it was as easy as arbitrage, but I'd say it's more that we have one of the largest research teams in the business. We have folks all over the world looking at businesses and meeting with companies. We think we adjust our internal views on credit ratings a lot faster. Our internal views are that a lot of the CCC names we own aren't CCCs and a lot of the B names can go to BB. We also anticipate that there'll be a big wave of names that get upgraded, even to investment grade. 

I think hard work, flexibility and willingness to adjust really help. And we benefit when we're right. 

I think some of the credit rating agencies get a little concerned about having too high of a rating. In 2008 they were criticised for being too slow to downgrade. I think we're seeing the opposite effect now — that they're being a little slow to upgrade.

What are some of the names you hold in the NBI?

A lot of fallen angels have come into our market, such as Ford Motor Credit and Rolls Royce. Rolls Royce makes a lot more aircraft engines than cars. Other names include cruise lines such as Carnival Cruise and Royal Caribbean, which used to be investment grade. Largely because of COVID, they were downgraded into high-yield and non-investment grade. We were able to invest in businesses that are a lot bigger and often have a lot of different divisions they can use to access capital. 

We were able to invest in very high quality businesses. These businesses can handle even a few years of disruption before they really damage their balance sheets.

Other names are often smaller or provide something you touch a lot of. Examples include food distribution companies that deliver groceries to schools, supermarkets and restaurants. A lot of hospitals are in the high-yield space. They normally have very predictable businesses, so they can handle having debt on their balance sheets. Strangely enough, most hospitals almost went bankrupt because of COVID. That business is really about getting your appendix out or your knee fixed, not about global pandemics. A lot of people stayed away from hospitals.

Our job has been to work out which things are temporary and which are permanent. 

We've been avoiding traditional broadcasting companies because we're seeing viewers move away from live TV, where commercials pay the bills. We're moving away from a lot of other traditional media and businesses like retail. We're seeing big changes in those sectors, and it's difficult to know what ultimately will happen. We're not sure how many malls, at least in the US, might need to close. So we're trying to avoid mall-based businesses.

It's hard to know how much e-commerce will affect the world in the next five or 10 years. We probably won't make a big investment based on getting that right. But with theme parks, we're pretty sure that 10 years, 20 years, 50 years from now, people will want to get some popcorn and ride a rollercoaster. We spend our time trying to understand long-term behaviour.

For people considering high-yielding bonds, what risks should they be aware of?

In non-investment grade, the question everyone needs to ask is: will I get paid back? Defaults should always be the main concern for investors. So far this year, defaults have totalled well under half a per cent. If you think of investing in a portfolio of high-yield bonds, then you lend money at, let's say 5%. If 1% of that portfolio goes bankrupt and you lose half that value, then you get four and a half per cent at the end of the year. 

With our LIT, the net asset value of the units is higher than it was we issued them, so we haven't had net credit losses.

That's really what we spend our time doing. We have analysts who have been industry experts for decades. Their job is to avoid situations where we don't get paid back 100 cents in the dollar. 

In the capital markets right now, companies can borrow at pretty cheap levels relative to history, and the economies are growing. There's talk about that growth possibly slowing, but that's still growth. We think the default outlook for the next couple of years is pretty low and 2021 will likely stand as a record for low defaults in the market. That's a pretty good tailwind. 

If very few companies are getting into trouble, you're much more likely to get the yields you think you'll get.

About NB Global Corporate Income Trust (ASX:NBI)

The NB Global Corporate Income Trust (ASX:NBI) was listed in late 2018 and is one of the few ways investors can get exposure to the global high yield market on the ASX.

NBI is targeting an FY22 distribution yield of 4.75% paid to monthly to investors. For more information please click here.

NB Global Corporate Income Trust
Global Fixed Income
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James Marlay
Co Founder
Livewire Markets

Livewire is Australia’s #1 website for expert investment analysis. We work with leading investment professionals to deliver curated content that helps investors make confident and informed decisions. Safe investing and thanks for reading Livewire.

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