Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name's Stewart Foley, I'll be your host. As you all know, bond yields have surged dramatically over the past year, and we're here to talk about leveraged credit, specifically the high yield bond market with Paul Massaro, head of Global High Yield Franchise, and a member of the senior management asset allocation committee at T. Rowe Price. Paul, thanks for being on. Thanks for coming back.
Paul: Stewart, good to be with you today.
Stewart: You are a veteran of our podcast and I'm thrilled to talk about fixed income with you. I think a lot of people are not aware of the 50-plus-year history that the T. Rowe Price has being a powerhouse in the fixed income market, and as we know, it's been a challenging macro environment year to date. We've got lots to talk about, but before we do too far, what is the town that you grew up in, today let's go with high school mascot, and what makes insurance asset management so cool.
Paul: So I grew up in Pittsburgh, New York, which is a suburb of Rochester, New York, Western New York, and the mascot was the Pittsburgh Sutherland Knights. And it's funny you mentioned that. Tomorrow evening I am headed to the 30th high school reunion back in Pittsburgh.
Stewart: Wow, that's awesome.
Paul: On the insurance asset management... Look, I think it's a really different way of looking at our investments, which I find really interesting. The concept of book yield being very different than a total return mandate. I think one of the coolest things is our conversation with clients trying to understand how they're looking at it and really trying to take advantage and pounce on those small windows of opportunity the market usually gives you to lock in that great book yield, but that's something that I think we don't really deal with as much in our total return mandates. But it's really interesting in our insurance accounts.
Stewart: That's really interesting. And I will say this, someone summed it up for me and said, "It's the externalities that make insurance so complicated." And I think that really sums it up, right? There's a whole host of them, we just put together a slide that has a litany of externalities, but you're not just trying to beat the capital markets. You've got to beat the capital markets with an extensive list of other considerations, right? It's been a challenging macro environment year to date, we're weathering the regional bank crisis as well as persistent recession concerns, given the Fed's aggressive rate tightening campaign and slow growth to tame inflation. However, leveraged credit has surprisingly outperformed traditional fixed income markets. So if you would, can you refresh us on the overall high yield bond market?
Paul: So the high yield bond market about $1.4 trillion in size, and this has traditionally been dedicated to fixed trade unsecured bonds. And the issuers in this market really would be rated some investment grade by the credit rating agency. So anything from, let's call it double B, all the way down to triple C rated. Typically, the maturities in this market would be anywhere from five to 10 years and would have a non call period of roughly half of the length of the bond. Use of proceeds for all these bond issuances would be anywhere from M&A to CapEx, dividends refinancing, it really runs the gamut. But the market has shown really well over time and has really solid risk adjusted returns over the long term. It's really shown to be very resilient. It's diversified by credit quality and by industry. Some of the larger sectors would be energy and cable, but a lot of recognizable names.
So names like Ford, SiriusXM, Charter Communications, Royal Caribbean would all be in the high yield market. But I think, Stewart, one of the more appreciated aspects about today's high yield market to me is just how high quality it is and how that mix shift has changed over time. If you think about those ratings categories, BB, B, CCC back in 2007, pre-GFC, we were looking at a market that was about 37% rated BB, at least one agency. And over time that has really shifted much higher. Now we're about 60% of the whole market is rated at least BB on one side. So I think that's something that really can affect forward default rates and forward outlooks given that mix shift has been so powerful over time. It's an asset class that's still economically sensitive of course, so you really need to get that credit selection right and have good active management and great credit research, but over time there's really a lot to like about this market.
Stewart: So one of the things I think that every insurance CIO is concerned about, is diversification, right? How in your mind do high yield bonds enhance portfolio diversification? And the high yield market was down significantly in 2022, I just want to wrap that together into this question.
Paul: Yeah, so one thing I didn't mention around the trace of the asset class over time was in addition to all the income that you get, if you think about it on a Sharpe ratio basis or risk adjusted basis, over the last 20 years, it's got a better sharp ratio than anything else in fixed income and it's got a better Sharpe ratio than the S&P 500. We think that's really impressive, and if you think about adding this to your portfolio construction in terms of diversification, not only do you get something that's liquid, it can be sold at any time, but it's got one of the highest levels of income out there, of course in all of fixed income, but it also has the best risk adjusted return. So when you think about correlations, it's got a negative correlation with treasury market, a low positive correlation with U.S. AG. So you think about constructing a broad, diversified fixed income portfolio, this is going to enhance that overall piece.
And in terms of the performance last year, not a lot worked last year in 2022, right? We had equity markets and bond markets really taking a meaningful hit. But I think the durability of the returns over long periods of time for this asset class are impressive. If you think back and look at the calendar year returns in this asset class over time, there's actually never been two consecutive calendar years of negative returns. And that has a lot to do, of course, with the companies involved, but also just the bond structures and the convexity. At this point, we started the year in 2023 with an average dollar price in the mid-eighties, and that natural pull to par is a really compelling trade of the asset class. And that convexity is really going to help us this year. So the asset class is up mid to high single digits already. We should be in line for breaking that streak again, of not having two negative calendar years of total return in the asset class again.
Stewart: That's really helpful and great context. So the broader market has been preoccupied, calling for the next recession ever since the Fed has started on this unprecedented quantitative tightening cycle, which initiated in early '22. I guess my question here is, where are we in the credit cycle? Seems like we're late, and what's your outlook for earnings across high yield issuers and maybe add in your team's outlook on defaults, because as we all know, bonds are an asymmetric payoff and avoiding losses is a key part of anyone's strategy, right?
Paul: Of course. Yeah. So you could see us as overweight given where the Fed is on hiking rates of course, but when we take a look at our individual companies from the bottoms-up and the earnings that we're seeing, it's really been largely better than feared, even better than expected in the last couple of quarters. So we see continued strength led by the consumer, particularly in things like spending on experiential services, travel, entertainment, lodging, cruises of course would fall in there. Think about the macro support there around pretty strong labor market, which we've seen pretty consistently all year. The inflation figures on the headline side have been steadily coming down. And yeah, most economists, I think that were calling for recession earlier in the year have at least either pushed those calls out or taken them off altogether. And then when you take a look at the fundamentals of our market, no major stress in the energy sector, which is a very large piece of the high yield market and typically would lead a default cycle.
The high yield maturity profile is very well in hand. Less than 5% of the market coming due the next couple of years. Cash balance is still very strong, and our default expectations are definitely up but not dramatically so. So, we take a look at each individual line item of the indices, analysts go through one by one and estimate whether or not those names are going to default in the next 12 months. And of course we're up because we're coming off of basically zero the last couple of years, but more towards a normal long-term average type environment, which again, is very manageable for us.
We continue to like the absolute return potential of the asset class. And again, that gets back to the dollar price that we're entering into at this point. There's a lot of talk in the market, of course, of just high yield spreads overall. And high yield spreads, given where rates are today, don't jump off the page, but it's not just about spreads to us. You got to look at the total return potential. You got to look at that pull to par potential. The absolute yield, this is over nine at this point. So there's, I think still a fair amount to go here and the fundamentals would actually be pretty supportive in terms of the earnings of our companies.
Stewart: That's really helpful. And let me just shift focus just a little bit. So you sit on your firm's asset allocation committee. How is the board thinking about the high yield allocation within fixed income? And I'll give you some data points and obviously the other aspect of this is the equity market. Our readership is ranking equities, public equities at the bottom of their relative value assessment. Curious how the asset allocation committee at T. Rowe Price thinks about this?
Paul: Yeah, no, that's a good question. And it's a debate constantly in our meetings of course, but a lot of interest. I think in fixed income overall, there's seemingly a lot to do. I mean, think about, we're even seeing today over 460 now on the 10-year treasury just this morning. So just the risk-free rate, starting to get pretty interesting here, investing grade credit and all the way down to high yield. So at this point in asset allocation committee, we are overweight the high yield sector within that platform. Really a lot based on a lot of the factors we discussed previously that would contribute to that. But also to your point, given those equity market valuations, I think the committee has also considered that and used the asset class as somewhat of a substitute risk asset for the equity market, given you are at yields over 9%, and at that level, it really starts to get into a long-term equity return type territory.
So whenever we have these conversations, particularly with my equity colleagues on committee, we are always, I think, intrigued with the fact that every bond here has a date with par and at 86, 87 cents on the dollar every day we get closer to that par payout and that accretion, and that is an attractive feature when you think about it versus equity. So at this point, we are overweight, our high yield asset class on the committee, but overall, I think the other important thing to recognize is we think about this as very strategic allocation over time.
Stewart: That's really helpful, Paul. T. Rowe Price has been a player in the insurance market for a lot longer than a lot of folks really know about, right? So you have significant mandates across leveraged credit. I think that you have some bond ETFs that just received NAIC ratings, which is very helpful to insurance companies. It allows them to get looked through to the underlying holdings in those ETFs, and I think that's important. Clearly understand what it takes to manage insurance money. So what are some of the key investment portfolio considerations for insurance clients, when you think about things like credit quality, book yield, bond maturities, et cetera?
Paul: It's a very different approach within our insurance mandates, and book yield tends to be of course the primary objective with total return up there, but a secondary consideration. And that does drive the decisions on the same securities that are different between mandates. The big thing we have to think about is what the book yields are in the existing portfolio and what can we replicate in the current market per each ratings category? A lot of our insurance clients have pretty strict mandates around guidelines on credit quality, around issuer exposure size, and even sector exposure overall. But we're happy to navigate within those tighter bands versus an otherwise total wide open total return mandate. I think some of the more robust conversations and the insurance mandates is really when the market sells off and working with them to get new capital invested quickly and at the right levels.
And I think that's just so important these days, given how short some of these windows are of these selloffs. If you think just even back to the COVID time period, and compare that to what we saw versus the GFC, the GFC, it took about four or five months for the high yield market to widen out about 500 basis points and have that real opportunity to capture really attractive book yields. Think about what we saw in COVID, that same spread widening of about 500 basis points. It took nine trading sessions to get there. It was really fast and the velocity on the way back was really fast as well. So really just being able to capitalize on those opportunities when they're available and really dive into those windows and capture those book yields and have the trading and execution available to capture those book yields when they're out there, I think is really key for those accounts.
Stewart: And so do you have any preliminary thoughts on the regulatory proposals that might relax statutory capital, i.e lower reserves against higher rated BB high yield bonds as an example?
Paul: Yeah, look, we're optimistic in general on that. I think if you look back at the BB default experience over time, it is so much lower than what you see in the rest of the market. BB default experience is less than 0.5%. So I think we're optimistic there could be meaningful relaxation here. I think the biggest implication there, is really the overall demand for that higher quality aspect of the market is just going to be much higher than what we've seen in the past. So not a lot more to report there yet, but I'm optimistic.
Stewart: I think T. Rowe is known for its fundamental company research discipline, right, like in the trades we would call bottom-up. What differentiates your firm's leverage credit investment process that a potential, somebody looking for a high yield manager, would want to know?
Paul: Yeah, so I think it's a number of things. Of course, we've got a long tenured team. It's been together a long time with an excellent research staff of analysts, very robust team of 17 people dedicated to 7 investment grades. That's really the lifeblood of the research effort. Got of course a strong track record of managing these seven investment grade portfolios through various credit cycles, a durable and repeatable proprietary research process with a risk adjusted focus. And if you look back through the numbers, you'll see a really clean default experience over time. We've got one team that covers both sub investment grade markets, high yield and loans. I think that allows us to capture the inefficiencies between both markets, particularly with the number of secured high yield bonds that there are in the market these days. But Stewart, I think the biggest thing that we focus on is really that differentiation comes from the collaboration internally.
We're of course a strong team, but we're really fortunate to be within a much larger research organization that crosses multiple asset classes, right? So it's that willingness to me to share those insights across teams and divisions that really provides those good outcomes for our clients. We think about our connections with our investment grade team, about our connections with our equity franchise. It's just helped us so many times in those key sectors. Think about energy, electric vehicles, and particularly around market crisis events when there's a number of fallen angels coming out of our investment grade market. So there's a lot there, but I think the key is the collaboration across teams internally.
Stewart: That's really helpful. Thank you. So you talked about a couple of different segments, market segments in the high yield space, where are you and your team finding value in the current high yield market? Are there any dominant portfolio sector themes that you're focused on right now?
Paul: Yeah, there are a few. So I think on a maturity scale, we're focused on the early takeout based on some of these high yield bonds. As I mentioned, there's pretty low dollar prices in the mid to high 80’s at this point on an average dollar price basis. We've only been there twice before in the last decade, once during the energy issues in 2014, 2015 and once really for a cup of coffee during COVID. So there is a dollar price to be had, and we're of the belief that a lot of these bonds are going to come out at least one year early. There's a lot of reasons for a lot of these companies to extend out their maturities, take advantage of markets when they're there and not take the risk that the high yield market will be closed for them. So if you think about the maturity curve in that 2025 to 2027 range, we think there's a lot to do in that space with companies coming to refinance those bonds early and having that pulled apart will become accelerated for us.
We also think there's some opportunity in the secured new issue market. We're seeing BB names in that seven to eight and a half type range on new coupons that we think we're only getting given what the rates market is doing right now, and there's some opportunity in the secured new issue, high yield market. We do think there's a few more opportunities in high yield names being upgraded to investment grade. So we have a couple trades on there. And I think in terms of sectors and industries, we're getting more constructive on the energy space.
And I think the other two sectors I would mention would be back to that experiential spend theme of before around cruises, entertainment airlines. And the last sector theme I think we have been pretty consistent on the last couple of years has been insurance brokerage. That's a sector for us, I think has really shown stripes, particularly through COVID. The inflationary period over the last couple of years has really helped their business and we really like the high margins and the free cashflow potential of that sector. So there are a few things to do out there in high yield market.
Stewart: I love it. It's been a phenomenal masterclass on high yield and leveraged credit and I really appreciate you being on. We can't get out of here without asking our fun questions on the way out. Do you have two... We've introduced optionality since you were on last. You can take either or both. Lots of folks take both. No pressure. Here we go. What's the best piece of advice you've ever gotten and who would you most like to have lunch with, alive or dead?
Paul: All right, so on the advice I'd say, look, I grew up in this business. I worked for a gentleman named Mark Silvia for a number of years, and I think one of the things that we commonly refer to in a lot of our investment days was simple phrase around ‘good things happen to good companies’. And I think that's just meant to say that when we're looking at our names, there is a lot of names on the higher quality end of the space that you could really view as rich in terms of relative value, but they could easily be bought by better companies and more investment grade companies. And that just generates a lot of total return over time.
So if you think you've got a great credit, it's probably not lost on the other competitors in that space and they're probably a target to be bought over time. Look on the second one, I'd say a couple of things. I think just with what's been happening this summer, my daughter's a Swifty. At this point, I would say if you could have lunch with Taylor Swift and bring my daughter along, I think that would be phenomenal. And just given what she's done, that would be an amazing experience.
Stewart: My daughter would be right there with us. She just saw Taylor Swift, it is like she was beyond, so that's a great one. I can really relate to that one.
Paul: It's a cultural phenomenon at this point. It's just incredible.
Stewart: Totally agree. Yeah, absolutely. Good stuff. Well, thanks for being on. We've enjoyed the lessons and the education very much. I just wanted to say sincerely thank you, and thrilled to see that the fixed income side of the house at T. Rowe. I'm a fixed income guy and it runs in my blood, so it's always fun to talk fixed income. So thanks so much for being on today.
Paul: Thanks, Stewart.
Stewart: We've been joined today by Paul Massaro, head of global high yield franchise, and a member of the senior management asset allocation committee at T. Rowe Price. Thanks for joining us. If you like us, rate us, review us on Apple Podcast, Spotify, or wherever you get your favorite shows. My name's Stewart Foley and this is the InsuranceAUM.com podcast.
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