Most investors tell stories about being the odd man out, the contrarian, long after their bold and messy moves have paid off. Their retrospective tales often get taller once the market has recovered and the critics have been silenced.
But sometimes it’s true. William Eigen III, a veteran bond manager who is part owner of several auto repair shops and a restorer of classic American cars like Chevrolet Camaros, is currently scooping up high-yield bonds, even as investors race the other way and abandon the asset class in record numbers. Eigen, who runs $25 billion in opportunistic credit funds at J.P. Morgan Asset Management, says he is the most excited he has been about lower-rated corporate bonds since the beginning of 2009.
High-yield fund outflows are creating huge contrarian opportunities for intrepid investors like Eigen. For instance, State Street Global Advisors’ high-yield exchange-traded fund had lost about 9 percent of its assets, or $1 billion, by December 10, whereas junk bond funds overall saw outflows of $9.4 billion in November and December, according to the Investment Company Institute. As recently as October, flows into junk funds were near records. In September Frontier Communications Corp. issued the fifth-largest high-yield deal in history. Through December 14, high-yield was down 5.15 percent; two weeks prior, the category was down only 1.44 percent.
“If you’re going to slam a market with that much supply, it’s going to break down,” says Eigen. He adds that the high-yield market remains healthy, with an average dollar price for the JPMorgan High Yield index of 86, and interest coverage and net debt to earnings before interest, taxes, depreciation and amortization (ebitda) is much higher than in the past bear market. The average dollar price was in the low 80s before the Christmas holiday. Though defaults remain at 2 percent, the market is pricing in an 8 percent to 9 percent default rate, he says. “You could default the entire energy sector and metals and mining at 30 cents on the dollar, and you couldn’t get close to that,” he laughs. Eigen is on a roll: “A true bubble was ’07, ’08. Issuance was rotten to the core, you could put a dead squirrel carcass in a pizza box, and it would get oversubscribed. You don’t have that now.”
Eigen, who learned about cars from his father, an Army mechanic, is used to speeding around the track counterclockwise. After rising through the ranks at Fidelity Investments and growing the firm’s then-fledgling Strategic Income Fund and multisector institutional products to $10 billion, he quit in 2005. Eigen was using a still fairly rare strategy at the time: moving money between different fixed-income asset classes, depending on his views of the market. But he felt he couldn’t protect his investors anymore because risk premiums were tight, rates were low, and the fund’s mandate was to be fully invested at all times. Instead, he wanted to run an absolute-return fund, which would do well in any market environment, and get out of the business of relative returns, measuring himself merely against the fund manager up the street or a random benchmark.
Eigen wanted to preserve investors’ money using shorting and hedging techniques. He first moved to hedge fund firm Highbridge Capital Management and then in 2008 to J.P. Morgan, which owns a stake in Highbridge. His J.P. Morgan funds still move between different asset classes, but he can also do relative-value trades — both long and short — and hedge against big declines in prices.
Despite the huge opportunity in high-yield, Eigen is frustrated with investors. “As usual, investors are completely engaging in self-defeating behavior. They buy when returns are strong and you’re not getting paid for the risk, and they sell when it goes down, spreads are wide, and you’re getting compensated incredible amounts to own the asset class,” says the fast-talking Eigen. He spoke to us in an interview punctuated by lots of laughter, a little swearing, pointed criticism of financial reporting designed to “scare investors” and to-the-decimal-point statistics on gross domestic product and leverage ratios.
High-yield has had a tough year. Yields on U.S. junk bonds went from 7.43 percent in early November to 8.89 percent as of December 18, according to Credit Suisse. Third Avenue Management spooked the market when it took the rare step of preventing its investors from cashing out of its Focused Credit Fund in early December. Although the fund is not a high-yield bond fund — it is filled with highly illiquid distressed securities — investors took it as a sign of more problems to come.
Eigen says his market experience illustrates how investors maim themselves by buying and selling at the absolute worst times. In 2007 and ’08 the J.P. Morgan Income Opportunity Fund, which he now manages, didn’t own any high-yield, even though investors were racing to buy it. “Now here we sit with great valuations, but people would rather buy a ten-year Treasury at 2 percent,” he says, adding that he expects a 20 percent return on high-yield from just collecting interest payments and 150 basis points of spread tightening.
The J.P. Morgan Income Opportunity Fund has about 46 percent in lower-rated credit, including synthetics. Cash has come down from about 65 percent to 30 percent, and Eigen is still spending. He may ultimately bring the junk allocation to 55 percent or 60 percent. The fund also has hedges in place, including shorting investment-grade, some emerging markets debt.
“When I buy high-yield, I always feel like I’m the only one, because I’m typically buying when there is blood in the water,” he says. His moves do result in lumpy returns. In 2009 the fund was up almost 20 percent, because he had gotten great buys in 2008 and early 2009. He was up a little more than 8 percent in 2012 because of the setup he got in 2011 during the European debt crisis.
Though he’s perfectly happy buying what others are throwing out, he does suffer some criticism. “So much venom is being directed my way right now,” he says. “Last year, June 14, when we were at maximum cash, I was screamed at for not putting the cash to work in yieldy products. Now I’m getting yelled at for spending my cash.” Criticism makes many portfolio managers cower. It’s also the logic behind much of behavioral finance: that humans are captives of their minds’ wiring. We were once rewarded for following the crowd that was running from the predator. But it’s damaging behavior in the investment world.
Eigen says if he cared about career risk — the damage bold decisions can wreak on job prospects — he wouldn’t be able to add to an asset class that is going straight down. “I do it because I love it,” he says. Quitting Fidelity when he ran a star fund suggests he’s not always thinking about his career first.
But he’s also confident he’s doing the right thing. “I’m seeing IRRs [internal rates of return] of 15 to 25 percent all over the place in high-yield. In 2014, that was 5 to 8 [percent],” he says. Here’s a revelatory statistic: This week the yield on the Merrill Lynch U.S. High Yield Master II index, which is filled with highly liquid junk bonds, was 8.1 times the yield of the Merrill Lynch Global Government Bond Index II, which includes Europe, the U.S. and some emerging markets like Indonesia and Brazil. The record is a little more than 9 during the financial crisis. Investors are getting paid eight times as much to own U.S. high-yield in a growth environment with 2 percent defaults than they are to own a globally diversified basket of government bonds from all over the world. Every time the yield gets close to where it is now, high-yield subsequently outperforms. “But you gotta kick everyone out of the club before it’s going to get good,” he concludes.
