In High-Yield Bonds, Look Closer at Active Management

Apple Inc., for instance, is one of the largest index constituents in the S&P 500, and boasts a strong balance sheet, ample free cash-flow generation, and a dominant market position in its industry. Community Health Systems Inc., on the other hand, is one of the largest weightings in the High Yield Index but is saddled with more than $13 billion of debt with a market capitalization of around $500 million. The company has historically burned cash as a weak competitor with limited access to capital.

Large ETFs and large actively managed high-yield funds seemingly pay up for the perceived liquidity offered by the largest borrowers. The investable passive alternatives have also not kept up with their highly liquid benchmarks because of expenses and transaction costs.

The unique characteristics of distressed high-yield bonds also make index replication difficult. This part of the market fluctuates in size but has ranged between 1% and 30% of the high-yield market. These bonds have credit-specific fundamental issues and can be difficult to source when ownership transitions from traditional asset managers to hedge fund managers.

We believe capacity discipline is critical to delivering strong returns, and a long-term view is key to exploiting opportunities resulting from overreactions to short-term noise. Active managers can outperform by concentrating more in the less liquid and often more attractively valued portion of the high-yield market. Managers should not fall victim to evaluating an issue based on whether it’s in an index or its weight in that index. What’s important is analyzing the business, understanding the risks involved in the company and the bond, and determining whether there is more than adequate compensation for risk.

Since the financial crisis, we have seen an explosion of assets into the high-yield asset class, with assets concentrated among the largest managers. But the overreliance on the most liquid parts of the market has created opportunities for managers with the conviction to stray from the index. Portfolio decisions should come down to a fundamental understanding of what you own and why you own it. It is a common-sense approach to investing that is surprisingly uncommon in the high-yield market.

John McClain, CFA, is co-portfolio manager of the Diamond Hill High Yield and Corporate Credit Funds for Diamond Hill Capital Management, Inc., an independent investment management firm headquartered in Columbus, Ohio.