David Breazzano from Polen Capital Credit on High Yield Investing and Rising Rate Environments

David BreazzanoHe co-founded Polen Capital Credit, 1996, and has over 41 years of experience with special situations, high yield, distressed and other types of investing. He oversees the investment team at Polen Capital Credit as well as the Investment Review Committee. He is also a member on the Operating Committee for Polen Capital Management (the parent company to Polen Capital Credit). 

Russ Alan Prince: Tell us more about Polen Capital Credit. Where are you getting income in this current environment?

David BreazzanoDDJ Capital Management was formerly Polen Capital Credit. It was founded in 1996 to invest in the high yield bond market and the leveraged loan market, also known collectively as the leveraged credit markets. Before founding the firm, my previous experience as a high-yield portfolio manager at T. Rowe Price and Fidelity was invaluable. I noticed certain inefficiencies within the leveraged credit market that larger investors missed. 

Polen Capital Credit has been investing in attractive opportunities for client portfolios for over 25 years using the same bottom-up, fundamental, and legal analysis. We have found that the lower-tier segment of the high-yield market is the most inefficient.

At Polen Credit, we construct concentrated portfolios, position-by-position, to provide a yield, or income, advantage compared to that offered by the broader leveraged credit market. We are looking for quality businesses that can generate a steady stream cash flow to pay their debt obligations. When we find an investment that has these characteristics, we tend not to sell, but to buy-and-hold. Our clients get a portfolio that reaps the compounding effect of these holdings over time.

Our investment strategies have one key difference: the ability to invest across asset classes in the leveraged credit market. This flexibility has been a key factor in the success of our strategies, and it is helping our clients to thrive in the current environment. 

Today, several “macro” factors, such as inflation and rising interest rates—to say nothing of the dire situation in Ukraine—have resulted in considerable volatility within the leveraged credit market. This volatility has allowed you to both add to your existing positions and to make selective investments in high yield bonds as well as leveraged loans. 

PrinceInvesting in high yield can be a good idea when interest rates are rising.

BreazzanoHigh yield bonds are a hedge against rising interest rates by spreading tightening, because credit spreads (or the premium earned for taking credit risk) tend to decline when rates rise. These bonds have a shorter duration and a lower coupon than investment-grade bonds. High yield bonds have done well in rising rate environments. However, not all high-yield bonds are created equal. A deeper look at the market will reveal that some bonds perform better. 

High yield market data has shown that CCC-rated bonds offer a substantial hedge against rising rates relative the higher-rated ones. Rising rates often reflect better economic conditions. CCC-rated issues are typically the most credit-sensitive in high yield markets. On the other hand, BB-rated bonds, which do not offer the same credit risk premium as CCC-rated bonds, tend to be more interest-rate sensitive as a result of their higher quality, as they are “almost” investment grade in creditworthiness. Because their spreads don’t tend to tighten as much and so do not offset the rate rise to the same degree that their lower-rated peers, BB-rated bonds are less risky than CCC-rated bonds.

To avoid historical default losses, the CCC-rated segment in the high yield market must be carefully analyzed for each credit. Therefore, given Polen Credit’s expertise and experience in finding higher yielding opportunities in the CCC-rated segment of the high yield market, we believe that we can provide our clients with an additional benefit in the form of a natural interest rate hedge. Importantly, this natural hedge benefits our client’s overall fixed income allocation without exposing the client to undue levels of credit risk. 

Prince: Both senior bank loans and high yield bonds are attractive because of their higher yield-generating properties, but which one is more compelling today?

Breazzano: Our investment strategies are unique because we can invest in high yield bonds as well as leveraged loans. No matter whether the high yield bonds come with fixed coupons or floating coupon payments that reset at different rates, our research process is designed for finding the best risk-reward opportunity. 

We do not make asset allocation decisions in our portfolio based on the relative values of the broad high yield bond or leveraged loan markets. Instead, we use the flexibility of our clients to find the most attractive investments position-by-position. Our ability to choose between loans and bonds based on their relative attractiveness is a benefit to our client portfolios. This allows us to add value for our clients based upon changing credit cycles and market opportunities.

With this in mind, the initial sell-off that began the year was driven by rising rates and fears of inflation. These fears placed a heavy burden on the highest quality segments of the high yield market. They are more sensitive to rate rises, as I mentioned earlier. For the reasons I mentioned earlier, leveraged loans have a lower interest rate sensitivity and fared well. 

As the devastating war in Ukraine has unfolded, concerns about its impact on global growth and supply chains, together with heightened geopolitical uncertainty have resulted in a broader “risk-off” mentality that has finally seeped into the leveraged loan market, albeit to a much lesser extent. We have reduced our exposure to certain leveraged loan positions, and correspondingly, added higher yielding bond portfolios to our portfolios. These investments are made in businesses that, according to our research, are stable, well-positioned and able to withstand current market uncertainty. They also offer attractive yields. Through these actions, we remain committed, as Polen Capital’s fourth, and newest, investment franchise, to achieve the firm’s mission to preserve and grow client assets to protect their present and enable their future.

RUSS ALAN PRINCEHe is the Executive Director for Private Wealth magazine (pwmag.com), and one of the most respected authorities in the private wealth sector. He consults with family offices and wealthy entrepreneurs as well as select professionals. Connect with him at LinkedIn.com.