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

Having been at Columbus-based Diamond Hill Capital since 2014, John McClain maintained his Ohio roots after his team was acquired by Philadelphia-based Brandywine Global last year. He has previously worked at Standard Life and Nationwide Mutual Insurance. 

Alongside his co-portfolio manager Bill Zox, McClain oversees two high-yield bond funds: BGHIX with AUM of around $1.1bn as of year-end 2021, and BCGIX with around $2.1bn of AUM as of year-end. In total Brandywine oversees $67bn in assets under management.

Alongside some astute sports analysis on how the Cleveland Cavaliers can become championship contenders, McClain gave 9fin his thoughts on what so far has been an especially volatile year in capital markets.

9fin: The stock market’s comeback last week after the initial selloff when Russia invaded Ukraine was pretty eye-opening. Was it just about rates, or do you think there were other factors?

McClain: Using the S&P 500 as a proxy for the market we saw oversold conditions leading up to February 24. Domestic equities had been moving lower with higher interest rates and inflationary pressures potentially hurting margins. 

However, the surface level selloff doesn’t accurately capture the monumental moves we saw in the most speculative areas of the market, including crypto assets and unprofitable biotech and technology. 

Investors need to buckle up—volatility will be persistent for some time as global central banks get out of the business of suppressing volatility, and now are pivoting to inducing volatility in risk assets.

Speaking of rate hikes, one of the main drivers is inflation, which seems less transitory by the day. How concerned are you about the impact of inflation on markets and your portfolio?

Inflation has spooked the market. Developed market central banks are behind the curve, and inflation is very broad-based. The ongoing conflict between Russia and Ukraine, combined with sanctions imposed by the rest of the world, will most likely keep inflation running hot in the intermediate time-frame. Inflation data is front and center for us and will be our north star for how we continue to position our portfolios going forward. 

High yield has become somewhat of an insulated asset class from inflationary pressures. Allocators should focus on the large commodity weighting the index has, and the fact that the majority of revenues and costs for the asset class are derived domestically. The index is also far shorter in duration than traditional high-quality fixed income asset classes, and reprices much faster towards attractive entry points. 

We continue to have a large overweight to financial services, with no supply chain disruptions there. We also have large overweights to reopening sectors. As the US consumer shifts from spending on goods to services, these companies have pricing power to combat inflation. Finally, we are very constructive on high yield technology, as companies spend heavily on improving labor productivity to combat wage inflation.

Where do you see the most value in the new issue market right now—is it in the big household-name LBOs, or do you prefer less mainstream situations? And why?

The new issue market has been essentially closed for the past few weeks but where we typically see value is in the underfollowed issuers, first-time issuers, smaller issuers—but skewed towards public companies and owner-operated private issuers. 

Private equity continues to take an aggressive posture with lenders. Covenant packages drafted by PE present lenders with unlimited downside and very few protections. We’d prefer to align ourselves with management teams that have the same objectives as we do. 

Further, many managers simply ignore smaller names in the index because they can’t build meaningful positions. Small debt issuers are not necessarily small companies, in fact, many infrequent issuers are very large companies in terms of market capitalization: CrowdStrike, Block (formerly Square), Roblox, and Twilio to name a few.

On the topic of primary issuance, volume has been weighted towards loans this year. As an investor focused on bonds, how does this trend impact you?

Loans have seen massive inflows and bonds have seen massive outflows year to date, but this is just a continuation of 2021. Supply and demand corrects itself quickly. We’ve seen a meaningful degradation of loan quality as investors chase rate protection. 

The loan market is dominated by private-equity-backed deals with aggressive covenants and EBITDA adjustments. Loans are priced for perfection and have started to underperform bonds since mid-February after their strong outperformance to start the year. The outperformance of loans relative to bonds to start the year is like what we saw in 2015 and 2018, and loans gave back that outperformance quickly. 

Meanwhile, bonds have weathered the outflows because the primary calendar has been so light, and they now present a liquidity-dislocation technical opportunity for investors who see the meaningful gap in relative value between high yield bonds and leveraged loans.

What about in the secondary market? Are there any sectors you have changed your view on recently? 

We’ve become more constructive on technology over the past 12-18 months, as the quality of issuers in the space has improved dramatically with many new first-time issuers. Companies are scrambling to mitigate wage inflation and labor scarcity, and should invest aggressively in businesses that improve their labor productivity. 

Conversely, we have no automotive exposure. Our market comprises auto suppliers who are beholden to the OEMs. We aren’t convinced seasonally adjusted annual sales will return to pre-COVID levels, as OEMs are making more money now not having to discount their product.

Covid seems to be becoming less of a focus these days. Do you think we’re over the hump in terms of its impact on the markets, or are you more cautious?

The US has emerged the clear winner of the developed world in terms of forward-looking economic output. We have the best access to quality vaccines and therapeutics. We’ve spent the past two years adapting to the challenges a global pandemic brings, and the global economy is more prepared for setbacks. 

We believe investors are compensated with excess spreads in sectors that were meaningfully impacted by COVID, and should be looking to capitalize on them—similar to owning bank debt following the global financial crisis.

Over the past few years, we’ve seen early-stage, cash-burning companies get a surprisingly positive reception in the high yield market. Do you think the past couple of years have reduced the market’s appetite for such deals?

With global central banks hiking aggressively for the foreseeable future, investors will be less willing to fund extreme cash-burn companies without a path to profitability. We continue to evaluate businesses that have not yet reached sustained free cash flow on a case-by-case basis. 

The key questions are: How does management fund their cash flow burn in terms of equity and debt? Is the business model proven? Does the company have a diverse set of funding sources? Can the company pivot its current model to generate cash if necessary? Are we receiving adequate compensation for the current state of the business? 

When we can answer these questions, and believe we are receiving adequate compensation for the business risk and bond structure, we will invest. We believe high yield investors struggle with valuing intangible assets and would remind investors that Amazon, Tesla and Netflix all started as low-rated high yield issuers.

What’s your pick for best picture at this year’s Oscars? We’ll accept movies that were not nominated.

I have two little girls, so I’d be biased towards something like Encanto as I haven’t seen any of the nominated films.

We’re both based in Ohio—do you want to see LeBron James back in a Cleveland Cavaliers jersey or can they make a deep run without him in the coming years?

The Cavs have a solid foundation with several cheap rookie contracts. They can make a run into the playoffs, but clearly need a top-tier player to be considered a championship contender. 

If Lebron were concerned about his legacy, it would make a lot of sense to go back to a team like Cleveland—but to do it on a veteran minimum contract or mid-level contract. Putting my convertible bond hat on, I’d like to see some creativity in structuring a contract with low base pay and meaningful upside in the event of a championship. 

Lebron the GM has an unimpressive track record. We’ve seen several superstars across sports (Tom Brady, Kevin Durant, and even Lebron) take discounts to put themselves in a position to win. It’s probably one of his best chances to grab another ring or two and put himself in the conversation with Michael Jordan.

9Questions — John McClain, portfolio manager at Brandywine Global

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