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Advisor select

Michael Kirkpatrick is a Senior Portfolio Manager with lead portfolio management responsibilities for the RidgeWorth Seix High Yield Fund and the RidgeWorth Seix High Income Fu +

RidgeWorth Seix High Income Fund
SAHIX (A Shares)
STHTX (I Shares)
STHIX (R Shares)
STHZX (IS Shares)
Fund Family
RidgeWorth Funds
Fund Advisor
RidgeWorth Investments
Sub Advisor
Seix Investment Advisors LLC

3333 Piedmont Road, NE, Suite 1500
Atlanta, GA 30305

T: 866-595-2470

Margin of Safety in High Yield Bonds
RidgeWorth Seix High Income Fund
Mar 8, 2017

Q: What is the history of the fund and the firm?

The RidgeWorth Seix High Income Fund was launched on October 3, 2001. It is a full high-yield fund which seeks potential opportunities across the full high yield market using an investment process that emphasizes a margin of safety concept. 

Historically, periods of dislocation have been more favorable to the fund, such as the financial crisis of 2008, or when the U.S. credit rating was downgraded in 2011, or when there were concerns about the European Union breakup. That the fund typically does well in these kinds of environments is a testament to our process.

Seix Investment Advisors, a subsidiary of RidgeWorth Capital Management, subadvises the fund. Founded in 1992, our firm initially focused on investment grade. In the late 1990s, we started investing in high yield bonds.  SunTrust Banks, Inc. acquired Seix Investment Advisors in April of 2004, and this past December, Virtus Investment Partners, Inc. agreed to acquire RidgeWorth Investments.

Q: How are you different from your peers?

One final potential advantage is that we take a longer timeframe, think about the valuation of the business and try to buy at a discount to our assessment of the company’s valuation.

With high yield assets under management (AUM) of $13.7 billion as of 1/31/17, we are small enough to be nimble but big enough to matter. Roughly two-thirds of our high yield assets are in bank loans and the remainder in high-yield bonds. 

Given the liquidity in the high yield bond market, having a smaller asset size gives us an advantage. Unlike some of our larger competitors who may not be able to be as selective in their purchases or quick in their sales, we can buy smaller issues and be more opportunistic. 

The long-term experience of our analysts is also beneficial to our process and ultimately gives us a competitive advantage. They are experts who have been within their industries a long time, know the management teams well, and understand how the business models perform through the cycle. 

We look for individuals who will bring expertise to the team, so the head of research actually has a degree in chemical engineering, worked for different chemical companies, and now follows the chemical sector and other industrial areas for us. Our energy analyst, before she joined the firm, was part of an Institutional Investor-ranked research team on the sell side. 

One final potential advantage is that we take a longer timeframe, think about the valuation of the business and try to buy at a discount to our assessment of the company’s valuation. 

Q: What is your investment process?

It focuses on five key investment tenets overlaid with a margin of safety. The margin of safety gives us the added confidence we need in periods of dislocation to continue to hold or add bonds that are trading lower when the rest of the market is panicking.

Our first investment tenet is to seek companies that are not only generating free cash flow, but also either reinvesting it back in the business at attractive rates of return or using it to reduce the absolute amount of outstanding debt. A combination of both is ideal, since it ultimately de-risks the company and requires a lower risk premium, meaning we get positive total return or spread tightening in that bond.

The second is asset coverage; we are looking for at least 1.5 times asset coverage through where we are investing in the capital structure, truncating the downside to free cash-flow generation and capturing the upside. A bond going from par to 80 is preferable to one going from par to the 30s.

For energy investments, we use the PV10 analysis, which estimates a cash flow stream from future oil and gas revenues minus expenses with a 10% yearly discount rate. That amount is added to any additional acreage an oil and gas company may own to give us a conservative valuation for the company. We compare that to the market value of the bonds where we are investing in the capital structure and would want at least 1.5 times asset coverage.

During the period of dislocation a year ago, energy companies did not have access to the capital or the high-yield bond markets. They needed either to tap the equity market which they did not want to do because they thought their equities were cheap, or they needed to sell noncore assets. Some combination of these allowed many of them to get through.

Our third investment tenet is management. We want management teams that are honest, capable, and bondholder friendly rather than ones just looking to put on excess leverage to increase equity returns. In this, our long-term relationships have proven to be critical.

The fourth investment tenet dictates we find companies with competitive differentiation – in other words, a “moat that protects the castle.”

Finally, our fifth key investment tenet revolves around access to liquidity. We are looking for companies that in difficult times have access to liquidity away from the bond and loan markets either through tapping the equity markets, accessing a revolving credit facility or by selling a non-core asset. 

  • Inception: October 3, 2001
  • AUM: $632 million

Knowing a company can pull one of these levers is key to our concept of having a margin of safety – and it not only gives us confidence, it often drives performance. For example, when the rest of the world was panicking in the energy space a year ago, we continued to make investments in companies with either the ability to sell equity or an asset to improve liquidity and fix their balance sheet. Ultimately, we got a lot of our 2016 performance gains because of the focus on the margin of safety.

This energy example highlights another crucial differentiator: In periods of dislocation many money managers become top-down experts, while we remain bottom up. Although we knew oil prices were unsustainable in the 20s, instead of trying to predict their short-term direction, we looked out several years and looked for companies with the liquidity and the levers to pull to survive a tumultuous multi-year timeframe. We believe it is easier to analyze a company than to figure out what is going on in China and how that might affect the global economy.

Q: Would you describe the type of companies that you find attractive?

An energy investment we added to in the first quarter of last year is Antero Resources Corp, an exploration and production (E&P) company. At one point, its bonds traded down into the mid-to-low 80s and were yielding around 10%. We focused on the first bond maturity in 2020 which was a manageable bond size, and thought Antero would likely to be able to handle that. The company had assets in the Appalachian Basin – the Marcellus and Utica Shales – the low-cost natural gas basin in the U.S.

Our long-term view was if natural gas prices stayed lower, a big reason would be because the companies in the Marcellus and Utica Shales are improving the economics. Though this may not be great for natural gas prices, it would be fine for the companies with assets in the low-cost basin. 

Not only did Antero have these assets, it was also one of the best operators in the industry. Management had a fantastic track record; the company had a multibillion-dollar market cap which they took advantage of to improve their balance sheet. Antero was fairly well hedged through 2020, and had significant assets that could be sold if necessary. We no longer own Antero because those bonds were called at a premium to par

Q: Can you give examples from other sectors?

Specialty finance companies like Ally Financial Inc. (first purchased on 8/7/14), an underwriter of car loans, also fit well with our process. During the financial crisis, many people would default on a mortgage before they would on a car loan. Their thinking was even if they missed mortgage payments, they could continue to live in their home for a while, but if they defaulted on a car loan, that car – which they desperately needed to get to work – would quickly disappear from their driveway.

Ally, which in 2008 was known as GMAC, realized it was not charging enough for car loans to account for the expected increase in losses. It stopped underwriting, threw off a lot of cash, and used it to reduce debt – illustrating our margin of safety concept. 

Nationstar Mortgage (first purchased on 12/6/13), a mortgage servicing company, is precisely the kind of investment we like to make. Not only is it a solid company that meets our five key investment tenets, but also it has an added margin of safety built in. 

Though it does some underwriting of its own, Nationstar purchases the mortgage servicing rights from much larger banks, then collects a fee for servicing them – billing homeowners, collecting payments, distributing payments back to the mortgage holder, and working with homeowners in default situations. 

Mortgage servicing is transitioning to a less capital-intensive business model in which the mortgage servicer is entering into a sub-servicing relationship.  Historically, Nationstar has used its cash to purchase mortgage servicing rights. The company now earns lower fees, but there is less risk involved, and these companies can throw off significant cash flow through this transition which can be used to pay down debt. 

Additionally, mortgage servicing rights can be traded and they can be sold. There is also an added layer of protection available through the sale of what is called an excess mortgage servicing right and entering into a subservicing relationship with a REIT. 

If it faces unseen liquidity pressure, Nationstar has several levers it can pull. First is the free cash-flow generation thrown off in its standard business model. Second, it can sell mortgage servicing rights, and third, it can sell the excess mortgage servicing rights. 

Nationstar is a great example of how we find potential opportunities in sectors our competitors avoid. Historically, the high-yield market is set up to analyze industrial-type companies, meaning the typical high-yield bond analyst focuses on debt-to-EBITDA and interest coverage ratios, metrics that do not work when looking at a company like Nationstar. 

As a result, many of our competitors shun investments like these. But we are willing to go into controversial areas, get to know companies and business models well, and make seemingly contrarian investments.

For instance, currently healthcare and retail are areas of concern in the market, so we are spending a lot of time looking for potential opportunities there. We are going through each of the companies that are not held in the portfolio, and have benefited on a relative basis as a lot of those bonds have traded lower, but we have not yet found many to invest in.

Q: How do you construct the portfolio?

Our portfolios tend to be more concentrated, focusing more on our best ideas and making those the larger positions in the portfolio. 

Generally, we have between 150 and 200 positions, though in periods of dislocation, we will likely be at the lower end of that range. In markets like today with little dislocation, we are at the upper end, because it makes sense to have more diversification. 

We are benchmark aware, not benchmark focused, but do follow diversification principles. Our maximum in any one issuer is 5%, but in practice we rarely will go above 3% unless it is for something opportunistic and short-term. The maximum industry weight is 25%.

Investment decisions are a function of the size of the bond, liquidity in the market, conviction of the idea, and how well it meets our investment tenets. We compare the liquidity of a bond and our conviction of the idea. If we see enough value or see a price disconnect, and it meets our investment criteria, we will continue to add to the bonds as the high-yield market is selling.

Q: What drives your sell discipline?

Three reasons drive sell decisions. One is if it hits our relative price target. Second is if something changes fundamentally. We also have a discipline when a bond is purchased that tracks its price relative to its peers. Should the bond underperform its peer group by 10% or more, it gets flagged and we must re-underwrite the investment. In a normal market more times than not, we make the decision and exit a position. But having this discipline is helpful.