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9Questions is our Q&A series featuring key decision-makers in the corporate credit markets — get in touch if you know who we should be talking to!

In a period when some investors are wary of the "higher for longer" rate environment, Ben Santonelli, a portfolio manager on the credit team at Polen Capital, is bullish. He believes that the new rate regime means big potential payoffs, alongside higher risk.

We sat down with Ben to discuss his outlook for high yield and how he is finding opportunities in lower-rated credits.

1. What are the implications of a "higher for longer" rate cycle on high yield investing?

Since the end of 2021, the high yield bond markets adjusted to a new rate paradigm. With the initial price shock from rapidly rising rates likely behind us, attention has shifted to the fundamental well-being of high yield issuers under “higher for longer” conditions. 

We believe most U.S. high yield bond issuers are well positioned for the new environment. The overall quality of the market has improved, and the bulk of maturities have been extended. While higher coupons have begun to trickle into the high yield market, the transfer more broadly of higher rates to higher coupons for issuers will take more time. 

While a recession may not materialize in the near-term, the new rate environment has placed pressure on issuers. However, the effect varies. While some companies are challenged, we believe that broad strength among issuers should result in a more muted default environment. 

As of now, the high yield market is yielding high single-digits. The new rate regime provides considerable reward potential for the risks incurred. Although not without its challenges, the “higher for longer” rate environment presents a compelling opportunity set for yield starved investors.

2. How are you managing duration risk in this environment?

Polen Capital’s bottom-up investment process focuses on identifying attractive risk-reward opportunities. As a result, top-down considerations, such as duration risk management, are not an element of our portfolio construction process. Rather, duration is an output of the process.

That said, duration with respect to our portfolios under management tends to be shorter than that of the high yield market. This shorter duration is driven by a few factors. First, we buy floating rate debt, which resets higher with increasing base rates. In addition, we tend to buy debt that is rated B or lower, which generally carry higher coupons and have shorter maturity profiles. Lastly, we construct concentrated portfolios mainly through secondary market purchases, meaning most bonds and loans that we buy have been outstanding for some period, resulting in a shorter time to maturity.

3. Does the recent shift in sentiment from bullish to bearish in the secondary market affect how you assess and manage credit risk?

The goal of our underwriting process is to form a comprehensive, independent opinion of the credit risk profile of the individual issuers in which we invest. Importantly, we invest with a long- term focus, so our assessment of an issuer’s credit risk is rarely influenced by short-term shifts in market sentiment.

However, the recent shift in sentiment has pressured prices broadly, which itself has a direct impact on our assessment of relative value. Oftentimes, shifts in sentiment can result in attractive buying opportunities that can be accretive to performance over the longer-term. We believe that this time is no different, and we have taken advantage of recent price pressure to add to certain positions on the margin.

4. Polen touts a focus on “concentrated” investing in high yield, can you elaborate on what that means?

When we say “concentrated” investing, we mean investing in a select number of companies in our portfolio in which we have a high degree of conviction. The number of issuers held in a portfolio can vary depending on the strategy, but generally we are investing in fewer than 100 businesses. As a result, a smaller number of names account for a more meaningful portion of our portfolios relative to many of our peers. In our experience, it’s difficult to build concentrated portfolios if you don’t have high conviction.

Ultimately, it boils down to a “know-what-you-own” risk management philosophy. Instead of asking our analysts to each cover several hundred issuers across the high yield spectrum, our philosophy stresses fundamental analysis and a comprehensive understanding of each name in the portfolio.

Our analysts spend most of their time on the continuous monitoring of existing holdings. Through this active monitoring process, supplemented by regular conversations with the portfolio managers, conviction in a name grows, providing the confidence needed to take larger positions with respect to investments with a particularly attractive risk-reward profile.

5. Since you specialize in opportunistic investing, where are you seeing opportunities among lower-rated credits?

Broadly speaking, many businesses in the lower-rated segments of the credit market are challenged. However, that is not the case for all of them. As mentioned earlier, we construct concentrated portfolios, which allows us to be selective. Therefore, we do not have to buy broad swaths of the market to populate our portfolios, but rather target only those investments that our research shows are mispriced. Today, we continue to see attractive investment opportunities in lower-rated bonds and loans trading on the secondary market. On the bond side, higher base rates have translated into lower priced bonds offering attractive, mid-teens yields. Similarly, we have been adding to first lien loans that are offering low double-digit yields as a result of their higher coupons given the rise in base rates.

6. Are there any sectors you actively avoid?

While we evaluate investments in all sectors, there are certain sectors that we tend to underweight or avoid. A few sectors that fit that description are the financial services, energy and utility sectors. 

Through our bottom-up investment process, we try to identify investments that offer a yield premium to the high yield market. However, that yield premium needs to be supported by a cash generative business model. Further, we want to understand the value of the entire enterprise in an effort to ensure that there is an adequate margin of safety for our investment.

In the case of each of these sectors, investments often fail to meet one or more hurdles. For example, many high yield businesses in the energy sector do not generate free cash flow and are too reliant on the price of the underlying commodity. Many investments in the utility sector simply do not provide the yield advantage that we are seeking for our clients. Lastly, financial services companies can be difficult to value, and those values can be unstable.

7. For borrowers, what do you see as the value proposition for high yield versus private credit in the current rate environment?

In the current rate environment, the value proposition for high yield as compared with the private credit market is the ability for borrowers to potentially lower interest cost. With the rise in rates, interest expense for issuers of broadly syndicated loans has more than doubled since the end of 2021. The private credit market, although somewhat opaque, has likely seen a similar move higher in interest expense for issuers.

We also note that many private credit deals are “unitranche”. Because the investment is held in a single loan, an investor takes a combination of senior and junior risk. Issuers could potentially benefit by issuing secured and unsecured notes to attract high yield investors seeking different types of risk-reward. This approach could also result in a lower blended interest rate for the issuer, thereby lowering its overall interest expense.

8. What would the long-term impact for US high yield in the event of an economic slowdown in markets like China, Japan and Europe?

Although the long-term impact for US high yield in the face of an economic slowdown in other markets is uncertain, historically, the US high yield market has shown resiliency in the face of non-US recessions. The majority of issuers are US centric and derive most of their revenues domestically. However, supply chain disruptions related to slowdowns in other economies could have a negative effect on specific businesses, further illustrating the importance of conducting fundamental analysis with respect to each individual name held in a high yield portfolio.

9. What is your favorite place you’ve ever traveled, either for work or fun?

Although I love a good industrial manufacturing plant anywhere in the Midwest, I would have to say my favorite place to visit is Grand Cayman. The people are wonderful, the restaurants are great, and the beaches aren’t too bad either!

9Questions — Ben Santonelli, Polen Capital — Seeing the upside in high yield

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