Emma Wall: Hello and welcome to the Morningstar series, "Why Should I Invest With You?" I'm Emma Wall and I'm joined today by Fraser Lundie, Manager of the Hermes Global High Yield Bond Fund.
Hi, Fraser.
Fraser Lundie: Hi, Emma.
Wall: So, I thought we'd start with oil. I seem to be inviting everybody who sits in that chair to start with oil at the moment because it is so prevalent on investors' minds. I know that you are light on oil across this fund and indeed, the two others that you run. There have been a lot of headlines about how oil is going to pull down the entire high-yield bond market. Is this true?
Lundie: Well, it's certainly been true over the last 12 to 18 months because the correlation between oil and high-yield returns have never been this high. There are some good reasons for that but like everything else it throws up some opportunities. We think there are some opportunities within the energy space, particularly along the pipeline side. But equally, it's throwing up opportunities as a second derivative to that in places like basic industries. So, actually, we think the real opportunity here is in the sort of Tier 1 players within the metals and mining space globally.
Wall: So, I suppose it's a bit like with the equities within this sector just because everything is being dragged down it doesn't mean you should throw the baby out with the bathwater?
Lundie: Yeah. There's definitely a relatively fat tail on the high-yield universe right now related to stressed and distressed oil plays and essentially they are option trades at this point. So, you know that certain companies are going to be okay if oil is at $50, or $60, or $70 or $80 [a barrel] and you can place your bets accordingly. We don't prefer to place bets in that way.
But as you say, in all of that malaise things like the pipeline space, things like the high end of E&P [exploration and production] where we've got some very low-cost producers, we think that they are not option plays but actually pretty sensible relative value investments at this point and that's where we're seeing the interest.
Wall: You're also seeing some opportunities in metals and mining, aren't you?
Lundie: Yeah. I think there you've got to the point where dividend yields essentially mean nothing and that is the equity market saying, to a certain extent, we don't care about taking near-term pain just to make sure that you're alive in two or three years' time when you have a turnaround in the commodity cycle.
And from that point of view, if you believe that, which we do, it's a great time to be investing from a credit story because all you are seeing is dividend cuts, capital raises, asset sales, very defensive behavior by a lot of the Tier 1 players and to a certain extent, now you're in a bit of a win-win situation because you know that they are strong enough from an asset quality and cost of production point of view to withstand further pain and equally, the longer that goes on, the Tier 2 and Tier 3 players are likely not to survive.
Therefore, they are going to be in a very strong position coming out of this cycle or commodities just go up and therefore they go up. And as a space, I still feel that it's a very under-owned space and in a relatively illiquid and sentiment-driven market I think that's important to recognize.
Wall: So, essentially, these are quite high-quality issuers who perhaps are rewarding you above the level that you perhaps suggest they should be just because there is so much negative sentiment around the sector?
Lundie: I think that's exactly right and I think part of this is about fund flow driven or sentiment driven or maybe just a need to manage volatility within certain sectors. But when I look at things like, for example, BHP hybrid bonds or Vale in Brazil, and I look at the relative value that they are offering as very likely survivors in that space, I think they look very favorable versus some areas like European financials, for example, right now where I think the type of sentiment and ownership levels are much stronger.
Wall: And on the contrary to quite a lot of your peers you're actually not that positive on Europe at the moment, are you? Why is that?
Lundie: I mean, there are a couple of main reasons. The first is related to the fact that globally we're entering a rising default rate environment today. There's no doubt about that. And I think people will probably be reminded that in Europe going bust is a mess. You can spend years in court in places like Portugal and Greece and France and they are different in each place.
You have a bankruptcy regime which non-homogeneous. So, from an IRR perspective as a distressed investor or as a credit hedge fund, I think the appetite to through four years of bankruptcy to then get what is likely to be much lower recovery rates this time around is going to be pretty low.
The recovery rate point I think people haven't really understood well yet. We've lived through six or seven years now of what I'll call cov-lite world. So either on the loan side or the bond side documentation has been getting looserr and looser in the search for yield and that's allowing companies to survive for longer, partly by being able to issue secured debt or issue security to revolvers to keep them alive. The net result of that is that in the longer term when they eventually do go bust, the recovery to unsecured holders is going to be close to zero and that matters a lot, especially in a place like Europe where you're going to be sitting around waiting for a few years.
Wall: So, you're chucking good money after bad really?
Lundie: I think it's just a pure risk/return trade-off compared to what is offered in the U.S. and in emerging markets today. Added on top of that you've got the liquidity-related premium which I definitely don't think is there. Obviously, on the U.S. stage you had a reinjection of liquidity premium in November-December time when you had some funds gating their funds and a real question mark over that asset/liability mismatch.
You didn't have that in Europe and I think if you had have done, you'd have seen a much bigger injection of liquidity premium. So, those two things together I think make me pretty conservative when thinking about that space.
Wall: Fraser, thank you very much.
Lundie: Thank you.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
