Russ Covode: no hiding in high yield
The hedge fund buyers are long gone, replaced by a new breed of high-yield investor. Neuberger Berman’s Russ Covode talks hot money, company blow-ups and why he’ll never hide in cash.
by Chris Sloley on Nov 21, 2012 at 07:05
Russ Covode is an old hand, a veteran investor by his own admission.
This comes to light when the high yield specialist unwittingly enters the conference call during some light chat about a recent Citywire feature called ‘Young Guns’.
After being brought up to speed on the concept – which showcased some of the youngest managers running the largest funds – Covode adds with a knowing chuckle: ‘Oh no, I wouldn’t fall into that category.’ Covode draws on more than 20 years’ experience from across the financial industry.
After stints at Bank of America and private equity firm Banc One Mezzanine, he joined Neuberger Berman in 2004. Upon arriving at the Chicago-based outfit Covode slotted into the bond team alongside existing managers Ann Benjamin and Tom O’Reilly.
Ticking the boxes
The team has now been in place for more than eight years and Covode says the trio has used that time to refine and improve its working practices on the $7.7 billion Neuberger Berman High Yield Bond fund. This incorporates a quite literal tick-box approach.
‘We all agree upfront what makes a good fixed income investment and that knowledge is captured in what we call our credit best practice checklist’ he says, ‘Ann began that when she started in the business over 30 years ago.’
Covode says this approach has served them well over the fund’s 15-year history and has only exposed them to one default. ‘It was a healthcare company called HealthSouth and it was in 2004, so we are going back over eight years,’ he explains.
‘This was our only unexpected default and it was fraud related. They were cooking the books, and if a company can fool their auditors and attorneys, it is going to be very difficult for us to identify that as well.’
While they took a minor loss in the portfolio, the Neuberger Berman managers did not chalk it up as an unfortunate mistake to sweep under the carpet.
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They took away every available lessons, studied what had happened and used any signals they could to inform how they approached their analysis in the future. ‘Following that incident, an analyst relayed that some management had, how shall I put this, “behaviour issues”. But we hadn’t captured that upfront,’ he says.
This led to the development of a five-point scorecard for management, applied to all positions held by the team – even those they have held recently and may be interested in re-investing with.
‘It is no longer good enough to say we met the management team and they seemed like good people,’ he says.
Don’t do things by default
Avoiding defaults and blow-ups is a recurrent theme for Covode when outlining the team’s investment process and they apply some fundamental filters to their investible universe from the very start.
Their universe is the Barclays US High Yield 2% Issuer Cap, which is comprised of 1,000 companies with a combined market value of $1.1 trillion.
‘Our companies have to have at least $500 million in publicly traded debt outstanding and at least $100 million in EBITDA. These would be minimum threshold levels – on average we invest in much bigger businesses than that.’
There are also a host of no-go areas: ‘We exclude sectors where we know the bankruptcy risk is too high and recovery values are too low.
‘So we don’t buy unsecured airline paper because airlines restructure too frequently and it is always at the expense of unsecured creditors and the equity. Restaurant companies and highly leveraged retailers are also off the menu.’
This narrowing of the field means Covode’s team tracks around 500 issuers, while investing in between 125 and 150 names at any one time. In order to diversify the portfolio, he explains, they may own a number of differently-dated bonds from any one issuer.
‘We select the most attractively priced security within that issuer’s capital structure. That may be in the shorter dated, more secure part of the capital structure, or we may want to take a more defensive position in some of the more leveraged capital structures.
‘Alternatively, if we like a company we may want to go for the cheapest bond, which may be the longest dated, lowest dollar bond outstanding.’
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What makes an ideal investment for Covode and his team are what he calls ‘rising stars’ – higher quality junk bonds that can attain investment grade status over the next year with all things being equal.
‘We are not forced sellers once they actually hit investment grade but we are waiting for the bonds to meet our target spread level and once that happens then we start to sell. Ford is a good example – it had been our largest weight in the portfolio for some time.
‘We expected the company to go investment grade and it did earlier this year, but we still own Ford because not all of their bonds have migrated towards investment grade levels. We are still holding bonds that we think are cheap given the rating.’
Looking back into the portfolio’s past performance, Covode says an investment in steelmaking giant ArcelorMittal neatly encapsulates not only the type of company they favour but also the circumstances they like to approach them in.
‘Arcelor was trading in the 15% range during the credit crisis. It was the largest steelmaker in the world, BBB-rated corporate, yet was trading in line with double Bs at the time and that is the kind of bond we like to buy,’ he says.
At the time of writing, BB-rated bonds make up 50% of the Neuberger Berman High Yield Bond fund, which is an 8% overweight to the benchmark allocation. This compares to underweights in both single B and CCC-rated bonds.
‘On the face of it we are now positioned defensively but our stance is driven more by relative value considerations rather than a fundamental view of the market.
‘If we were defensive on the market, then our CCC weights would be under half of what they are today because that is how we get defensive – by moving into BB and BBB-rated securities and investment grade rated bonds. We are always fully invested, we don’t hide in cash.’
Hungry for high yield
The Neuberger Berman High Yield fund has returned 80.2% in US dollar terms since its launch as a Ucits-compliant vehicle in May 2006.
This compares favourably with its Citywire benchmark, the BofA Merrill Lynch US High Yield Cash Pay TR USD, which has risen 71.3%. It is also nearly double the average US high yield bond manager’s performance of 43.5% over this period.
Figures like these go some way to explain the increasing appetite for the fund. According to Lipper data compiled for Citywire, the fund was the 15th best-selling Ucits fund across all asset classes in July 2012, attracting €283 million of inflows.
Further Lipper research into 2,000 of the leading European third party fund of funds investors shows 42 are currently invested with Covode and his team. This equates to €177.8 million in fund of funds assets and makes it the third most subscribed to high yield bond fund across European and US high yield markets. Covode is not surprised by the interest.
‘The investor base has shifted back towards traditional, long-only credit pickers like us and that has given our market a lot more stability,’ he says.
This return to stability has been aided by a number of the leveraged buyers, such as various hedge funds, falling off the map, Covode says. ‘Hedge funds and other leveraged vehicles were very active in our market prior to the crisis and they aren’t today.’
Covode says while they have noticed a big influx of money into the US high yield sector over the past four years, they are not overly concerned about absorbing the increase. The team still feel able to direct the money prudently and much of it has come from institutional clients who tend to be relatively sophisticated, longerterm investors.
‘Since the credit crisis, there has been $75-80 billion that has flowed into our market, which represents about an 8% inflow. That’s a significant amount of money but it is still relatively small given the market’s overall size.’
In an attempt to bring context to discussions where $80 billion can be deemed ‘relatively small’, Covode says the high yield market generates around this amount alone just from received coupons each year, all of which needs to be reinvested.
The overall response from Covode and his team is therefore one of calm. The inflows bring no inherent risks to their approach and, unsurprisingly, the high yield manager welcomes the increased interest in his area of expertise. ‘Where we have seen more significant growth is offshore – European, Asian and South American investors are relatively new to the market.
‘The growth of our institutional business has been significant and high yield has become a very well accepted, well respected asset class within many managers’ fixed income allocations.’
However, when discussing Europe specifically, Covode says the continent offers little investment interest despite having indirect exposure to German, French and British names in his portfolio.
‘We don’t own European high yield, either because the companies are too small or they are in sectors in which we do not invest, such as traditional banks and insurance companies.
‘Or they are issued by companies located in countries where we have no idea how we would be treated in a restructuring and if we don’t understand our rights and remedies under a restructuring then we don’t invest.’
When asked whether the interest from Europe could prompt Neuberger Berman to get to know the region better and perhaps launch a dedicated high yield fund, Covode’s knowing chuckle returns: ‘No. Not today.’
Management check list
The five questions Russ Covode and his team bear in mind when dealing with any company’s management team:
- What drives the management’s decision-making
- What are the key factors in their discretionary compensation packages?
- Are they more creditor friendly or shareholder friendly?
- Are they experienced at operating in a leveraged environment?
- How accessible are they to the fixed income investment community?
The short story
Off the back of the interest from investors, Covode and his team once again united to launch the Neuberger Berman Short Duration High Yield Bond fund in December 2011.
Operating within the same investible universe, the fund is designed to target the same quality of bonds but with half the duration of the High Yield Bond fund and one-third less volatility.
The fund, which has raised $250 million AUM so far, was created to fill a niche Covode says was caused by investors seeking lower volatility than the existing High Yield Bond fund but who were constrained by regulation.
‘Historically, we had pointed our investors towards the bank loan market because we had thought that space was the best way to get short duration high yield exposure – through high quality and low volatility.
‘But as we built the business up we heard time and time again that there is a part of our client base that either cannot buy loans for regulatory reasons or they won’t buy loans because they have no experience of the market. So they continued to push us for a bond alternative.’
This article originally appeared in the November issue of Citywire Global magazine.
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