Anne Greenwood

Welcome, everybody. Thank you for joining us today. My name is Anne Greenwood. I’m an institutional portfolio manager here at RBC, joined by Tim Leary, who is the US head of high yield and a senior portfolio manager on our leveraged finance platform at BlueBay, U.S. fixed income. So, Tim, great to have you here. Let’s talk some high yield markets.

So, I think first and foremost, probably one of the biggest questions on investors’ minds right now is, you know, are they getting paid in credit markets to take potential risks or, you know, more building uncertainty around leverage market metrics, macro uncertainty, energy prices, what have you. I know there’s a number of things we’ll talk about today, but just wanted to get your thoughts on current valuation environment.

Tim Leary

Sure. Thanks for the question. Okay. It is easy to say spreads are tight and that they’re not reflective of wider times in the market. But when you really dig underneath the surface, you can see why spreads are tighter than they have been historically. And this is specific to high yield, right? The reality is the rating profile of the US HY benchmark — the 990 or so companies in the index — are better rated today than they ever have been in the history of time.

They’re also larger cap structures. There’s more public companies, i.e. public equities in the market. It’s a larger, more liquid market than it’s ever been. And the reason for that, in part, is because of the growth in other parts of the leveraged finance market, principally private debt and leveraged loans. You might ask, well, why is that the case?

And the reality is that boils down to what the use of proceeds are for the types of deals that have come to market over the last few years. And the reality is direct lending and private debt — as part of private debt, direct lending and leverage loan markets — have taken the lion’s share of LBO financing. So sponsor activity, dividend deals, you know, recap, equity recaps, sponsor to sponsor LBOs — the majority of that type of use of proceeds, which is lower rated, what we would think of as triple, you know, legacy triple C LBOs — have gone to that market to a much larger degree because sponsors want the flexibility.

Callable debt in their cap stack, and callable debt meaning that they can prepay it without paying meaningful call premiums north of par. And so what you’re left with is a market that has about 60% or so in Double B’s, less Triple C’s than at any point in time in history. Sub 9.5%.

And, you know, for a number of reasons — technology growth and, you know, the way that high yield bonds are traded today, as well as just the larger cap stacks with public shares outstanding — you’re seeing more of a variety of different types of buyers, more buyers of a variety of different types. And so there’s probably 500 or so different accounts across the globe that will buy high yield bonds.

There’s probably only 20 or 25 or so that will buy loans. And many of those buyers of loans are actually high yield accounts that are buying loans in their sleeves.

Anne Greenwood

That’s great. Very helpful. I think one thing you mentioned in there, talking about kind of the growth of the private credit market — obviously software has been something very topical right now in leveraged finance. Where is AI creating opportunities and risks that you’re seeing?

Tim Leary

Great question. And in the time we have today, we’re not going to be able to touch on all of it. But again, starting from just the numbers of what’s in the benchmark, what’s in the universe — about 3% of the market is in software. A lot of that software are larger companies that are integrated into hardware, whether it’s for security purposes.

Financial institutions use, you know, names like Citrix, where you log in from home or from work. And, you know, we have a large user base where the sanctity of and protection of that data is incredibly important. Then you’ve got — in the high yield market — you also have the growth in, you know, compute power and funding for compute power, or the CapEx spend on data centers, primarily, that are, you know, being built out and the build-out is effectively guaranteed by investment grade rated technology companies in the Mag Seven who need to increase the ability to generate their AI services.

On the flip side, within leveraged loans, about 15% of that market is software. And when you factor in the fact that the software companies in those markets are, by and large, smaller companies that are more niche providers, you run the risk in those particular issuers of having AI completely disintermediate their business model. Said another way, if you’re a small, niche software provider and one of your clients determines that they could use AI to build out or write code or do some of the software services that you’re currently paying for, they don’t need you anymore.

And so what the market is really digesting now is who the winners and losers are — who has staying power, who doesn’t. Now, one of the other things about the loan market is because 70% of the loan market is owned by closed or structured vehicles that have ratings triggers and don’t mark to market to the same degree that public funds are.

You have, you know, ratings-based triggers that will drive some of that price action when you have forced sellers — we’re not there yet. Right? Because, you know, every rating agency is giving these companies some time to sort out their business models, but they’re starting from a higher leverage point. And so they’re already B3 corporate family rating names.

You know, with quite a few adjustments in their leverage stats that you really can only get away with in the private markets that the public market would reject. And so all told, if you have 15% of that market in software and let’s just say 5% of it no longer needs to exist in 3 or 4 years — they’re not going to be able to refinance their bonds or their loans.

And so private debt is even worse, right? In addition to the fact that you’ve got certain private debt funds that exclusively focus on technology and software, you also have a large component of holdings — upwards of 20% in many private debt funds — that are software related. And the reason they did that is because they were sponsor driven.

And indeed, you could sell a deal to these institutions — or originate a deal for these institutions — that had, you know, projections based on recurring revenue models that may or may not come to fruition, as opposed to cash flows and EBITDA over the last 12 months, which is far more typical for high yield and broadly syndicated loans.

Anne Greenwood

And so when you kind of take a step back and you think about, you know, that it is an important part and a large market — but when you think about sort of the broader global fixed income markets, it might not be as systemic of a concern. But one thing that I do think a lot of people are talking about is, you know, the impact of potentially more persistently high rates.

And I don’t think that just applies to some of these smaller companies. But your point on, you know, more leveraged smaller companies — my gut is that higher rates for longer impacts them more, but probably impacts the whole high yield market as well. So how do you think about those macro risks today?

Tim Leary

Sure. Well, so we’re not a macro fund, right. We have other strategies within the firm that are macro specialists. But regardless, interest rates are higher today than they were a year ago. And that means that for floating rate payers — highly leveraged loans and private debt — you know, some of it is swapped out to fixed, but the majority of it is floating.

They’re going to have higher interest expense year over year relative to years past, unless they’ve repriced their debt through amendments to reduce the coupon. Now the flip side of that coin is on high yield — those are fixed rate bonds. So the bond price will go down as interest rates go up. But if you haven’t allocated to high yield, that’s not your problem yet.

Once you allocate — if you were to allocate today — you’re actually entering at a higher yield environment. Even though spreads are a little bit unchanged on the year by and large, you know, you’re entering at a lower dollar price, higher coupon, higher yield. Or for private, same coupon, higher yield — with a pull to par where you’re actually buying a bond at a discount that will come out at par, you know, 99 out of 100 times.

And that 99 out of 100 times is reflective of the actual default rate in high yield. Default rates are really, really low. They can really only go up because they can’t go down any further than they are. But the reality is the bond math works in two ways. One, the interest expense for companies goes up, and two, depending on where you enter the market, you’re either entering at a good point — where it would be a positively convex asset that can go up in price when interest rates normalize or come down — and then floating rate, because of the nature of that market, so much of it trades close to par.

There isn’t much upside in dollar price. But you benefit from the insulation from rising rates, in the sense that you don’t necessarily see your bond trade straight down. But by the same token, your credit quality is degraded because, really, companies only go bankrupt for one of three reasons: they can’t pay their interest because their interest costs are too much, they can’t refinance their debt because the market’s not open to them, or there’s some exogenous business shock.

And so you should think about software and loans as being right in the eye of the storm. You’ve got an exogenous business shock and high interest rates. And being able to refinance that maturity wall in 2028 — where that maturity wall for much of the market is actually being rerated and needs to get refinanced — is a real challenge.

So it’s not a great technical from that perspective, though CLO creation continues at a rapid, robust pace. And so there haven’t been any forced sellers from that broadly syndicated loan market yet. You are starting to see more and more redemptions for private debt funds. And those assets do need to find a level and need to find a home.

And so the question then becomes: all right, well, how many different buyers of that asset are out there, and what’s the price that they’re going to command when they show a bid?

Anne Greenwood

So how do you and the team think about positioning portfolios today? And you know, what do you think differentiates your approach and how you think about markets? To wrap up here, just to give a little insight into what your edge is and what our edge is here at BlueBay.

Tim Leary

Sure. So we’re just different in a number of different ways versus the peer group, right. So I think about it — you can buy passive funds that look and behave just like the index because they’re buying bonds that are in the index, and you’re getting diversity and you’re buying the beta of the market. ETFs are a great example of that.

We don’t look anything like the benchmark in the sense that we have 150 or so issuers at any point in time that we have exposure to, and our ability to say no to certain names that we don’t like — either because of valuation, or because of the sector and markets and the trajectory of the fundamentals — is a pretty liberating experience. Right. We just, you know, we’re fully invested long-only strategy investors. But by the same token, we don’t need to own everything in a benchmark like some of our peers do.

Anne Greenwood

Great. Thank you. Thanks for your insight.