Cover Page

High Yield Debt

An Insider’s Guide to the Marketplace


RAJAY BAGARIA











Wiley Logo

Preface

Today's U.S. corporate high yield market is worth over $2.5 trillion. That's more than the stock market capitalization of most countries including Germany, France, and Canada. Over 350 funds provide exposure to U.S. high yield including mutual funds, ETFs, and closed-end funds. In addition, a growing number of alternative funds such as distressed debt, mezzanine finance, and credit hedge funds also generate returns from high yield debt. High yield debt has never before been so accessible to both institutional and individual investors around the globe.

The attraction to high yield stems from its high risk-adjusted returns over time. High yield can be broken down into two market segments: high yield bonds and leveraged loans. Over the past 20 years, high yield bonds have produced high single-digit total returns comparable to the S&P 500 with less than half the annualized volatility.1 Leveraged loans have posted mid-single-digit returns with lower volatility than bonds and only one negative total return year in two decades.2 This performance is why pension funds, endowments, insurance companies, institutions, and retirees increasingly buy high yield as a source of current income and complement to dividend paying stocks.

Yet, despite its size and significance, high yield is an often misunderstood asset class. It's a market that is primarily traded over-the-counter and lacks transparency. It has also grown in complexity since its early “junk bond” days. What market professionals come to learn is that not all high yield exposure is the same: specific market segments and fund types can produce meaningfully different results over the same time period. Developing a more informed view of the market is what can lead to a performance advantage.

Working at leading investment firms has provided me with a front row seat to the latest developments in the high yield market during its most transformative period of growth. My first job out of college was in the investment banking program at J.P. Morgan & Co. I joined their high yield group at a time when the firm was pioneering the use of credit default swaps, a trillion dollar industry today. I later joined Goldman Sachs & Co., where I worked on a multi-billion dollar mezzanine fund that was a pioneer in making large-sized privately structured high yield debt investments. Following Goldman Sachs, I spent eight years at Apollo Investment Management where I was a Partner and Investment Committee member responsible for investments in all types of high yield debt through a business development company. More recently, I established a credit hedge fund with the backing of a prominent family office. This fund is engaged in both long and short investment strategies related to high yield bonds and loans and is a top performing high yield fund at the time of writing.3

In my career, which spans nearly two decades and two recessions, I have been fortunate to learn from some of the smartest people in the business. I have worked with teams to invest billions of dollars in high yield issuers. I've seen periods of economic growth and decline, high and low volatility, and have restructured companies that failed to perform. This experience has afforded me with numerous insights on the high yield market which I share in this book.

The decision to write High Yield Debt: An Insider's Guide to the Marketplace was made almost two years ago. While fundraising, I met with many individuals responsible for high yield investments who had surprisingly little understanding of the market. Rather than go through my pitch, I would take these groups through a primer I developed, addressing everything from the high yield market's evolution to tracking the health of issuers and value in spreads. Seeing the knowledge gaps even at the Chief Investment Officer level made me realize that there is a broad-based need for better information on the high yield market. Put another way, if the people managing large investment funds have difficulty understanding high yield, what does that mean for everyone else?

There is surprisingly little literature on the high yield market despite its market size and importance to the economy. In the early 1990s, several books on high yield were released that provided information on junk bonds but the market was very different then. It was one one-tenth its current size with less complexity and it did not include a large, traded leveraged loan market as it does today. Recent books on high yield are more specialized and written for the analyst seeking job skills or the fund manager contemplating more advanced topics related to risk management. What is missing is a book for everyone else – which actually encompasses most market participants.

Within the high yield industry, comparatively few people partake at the level of making buy-sell decisions on individual debt instruments. This is because high yield bonds and loans are difficult to transact in small quantities. Most wealth allocators are engaged at a level where they are deciding whether to buy into a high yield fund and, if so, which one? Other professionals, like market analysts and bankers, provide services related to the industry and are seeking a better understanding of the bigger picture. Participants like private equity firms, lawyers, and issuers need to know the financial and legal terms of high yield debt. Business school students and analysts in training programs can gain an advantage with interviews and a head start on the job with a more informed perspective of high yield capital markets and investment banking.

My goal in writing High Yield Debt: An Insider's Guide to the Marketplace is to explain the U.S. corporate high yield market in basic terms and as concisely as possible. This book will address how the market has evolved, who buys and issues high yield, high yield debt structures, asset class performance, and how to track and evaluate the market for investment opportunities in a variety of different funds. In writing this book, I make no assumptions about the audience's knowledge level; I assume that most industry jargon is confusing and requires explanation and I get into a fairly deep level of insight and analysis such that even experienced market professionals will find something new and interesting. I also seek to explain the most frequently asked questions I've received on high yield. Last, I include what I consider the most important historical market data so that this book can be referred back to over time on any areas of interest.

BEFORE YOU BEGIN

This book can be read either cover to cover, or consulted when topics of interest surface. The Contents outlines the book's progression. It lists key topics of common interest for easy reference. Many of these topics are questions I have been asked during investor meetings. Any potentially confusing terms are italicized and included in the Glossary. Each chapter contains an introduction and summary with key insights, which is relevant to subsequent chapters. While this can be kept as a reference book, I recommend at least skimming chapter summaries from start to finish to gain a better sense of the book's contents.

Chapter 1 starts with an introduction to high yield, beginning with a basic definition of high yield debt and progressing to how the high yield industry evolved from a market for fallen angles to a thriving $2.5 trillion industry. Chapter 2 delves into the issuers of high yield – explaining why they raise high yield debt, the decisions they face, and the capital-raising process with investment banks. Chapter 3 then addresses buying high yield, and provides insight on important differences in the buyer base and financing for high yield bonds and leveraged loans. I also address the implications of high yield being an over-the-counter market and trends with liquidity, a common concern. Chapter 4 addresses financial concepts and economic terms important to understanding high yield debt, which is vital to assessing and tracking the market.

Chapters 5 and 6 round out the foundational knowledge required to form a view on high investment opportunities. Chapter 5 addresses high yield debt structures and how these differ for high yield bonds and leveraged loans. Understanding what constitutes aggressive versus less aggressive debt structures also provides a means to track developing trends in the marketplace. Chapter 6 provides an overview of high yield credit agreements, a more technical topic, and also discusses other legal considerations such as recent regulatory developments, which are topics particularly important to credit investors, high yield issuers, and corporate lawyers. The purpose of Chapter 6 is to explain what protections exist in high yield credit agreements and clarify the meanings of certain industry jargon that is often used but frequently misunderstood.

After establishing a framework for understanding the high yield industry and the differences between its two key market segments – high yield bonds and leveraged loans – Chapter 7 gets into a topic of great interest: asset class performance. Chapter 7 addresses many frequently asked questions on high yield performance such as total returns, volatility, interest rate risk, defaults, and recovery. Building on this foundation, Chapter 8 provides a few tools and metrics that can be used to assess the market opportunity at a given time. This evaluation method includes incorporating a view of corporate spreads with industry fundamentals to provide a sense of the risk-reward for both leveraged loans and bonds. I also provide a list of the information sources used by high yield investors to make more informed decisions. Armed with this knowledge, the reader is better able to form and express a view on the various investment options, which for most investors are funds rather than individual debt instruments.

Chapter 9 describes the different “public” or 1940 Act funds that provide high yield exposure such as mutual funds, closed-end funds, ETFs, and BDCs. The different 1940 Act Funds have pros and cons which also vary depending on the type of exposure sought. I explain the primary considerations related to each of these fund options and discuss their performance over different periods of time. Chapter 10 addresses “private” or alternative funds that provide high yield exposure such as mezzanine funds, credit hedge funds, and distressed funds. Private funds are generally only available to larger investors that meet certain income and net worth requirements. These types of funds have higher fee structures but can outperform in certain market environments primarily through the use of fund leverage, active investment strategies, and greater portfolio concentration. Understanding the conditions under which these funds can thrive can be helpful when choosing which one to pursue.

CONTACT

I am grateful for your interest in this book and would welcome any questions or comments you have. Please feel to reach me at rajaybagaria@hydebt.com or visit the website www.hydebt.com for more information.

DISCLAIMER

The concepts and ideas in this book are my own and other professionals may disagree with my conclusions. There are risks involved with investing, including the possible loss of capital. Investors should consider the investment objectives, risks, charges, and expenses of the fund(s) carefully before investing. Please seek the counsel of your accountant for any tax-related matters as there is no tax guidance presented in this book.

NOTES

Acknowledgments

Although this book lists me as the author, it was shaped by the contributions of many friends and colleagues. First, I would like to thank Sean O'Keefe, my research assistant. Sean scrutinized every draft, created insightful charts and analyses, and tracked down permissions. I couldn't imagine finishing this book without his tremendous effort. I would also like to thank all my colleagues at Wasserstein & Co., who have been generous with their time. Ellis Jones, Chairman of Wasserstein & Co., is one of the kindest and most thoughtful investors I've met in my career. Ellis offered several insights based on his experience that helped improve the book's contents. My team at Wasserstein Debt Opportunities, especially Alex Kelsey and Beth Gardiner, also reviewed and helped improve drafts. I am grateful for their support.

Over the years, I've worked with some bright professionals who took an interest in my growth. At Goldman Sachs, Melina Higgins was a mentor and gave me numerous opportunities to learn about high yield. At Apollo Management, my friend and colleague Bruce Spector taught me about restructurings while working together on difficult situations. I feel lucky to have had such good teachers including my cousin Anup Bagaria and my friend and legal advisor Emil Buchman. Anup, a Co-Managing Partner of Wasserstein & Co., has been my biggest supporter and played a role in almost every step of my career. I could not have come this far without him. Emil, a corporate law partner at Fried Frank, taught me everything I know about high yield legal considerations. We have been working on deals together since 2000. Emil is a meaningful contributor to this book.

There are several people I would like to thank for their time. Barry Delman, a Managing Director from Bank of Nova Scotia, offered numerous insights on total return swaps, an obscure area of the market. Jessica Forbes, a corporate law partner from Fried Frank, reviewed and thoughtfully commented on Chapters 9 and 10. Marc Auerbach from S&P Capital IQ LCD helped provide much of the data used throughout this book to elucidate concepts. Ed Boll and Bill Visconto provided valuable insights on asset class performance. My writer friends, Peter Stevenson and Sarah Dunn, were also helpful advisors to this first-time author. I miss our days commuting and writing on the train together. My other friends, including Tracey Bernstein, Alex Tripp, Elliott Sumers, Scott Jarrell and Maria Stein-Marrison, have patiently listened to more about high yield than they ever cared to know. Although we decided against calling this book “Junkanomics,” I am nonetheless grateful for Radley Horton's creativity and friendship. I am also grateful for my brother, Sanjay, and my parents, Om and Chandra, for providing me with love and encouragement to pursue life to its fullest. Last, I want to thank my editor, Thomas Hyrkiel, and the team at Wiley, for their many contributions.

My deepest gratitude is to my wife, Rajni, and our children, Arjun and Amalie. My family encouraged me to pursue this idea despite its cost to them. I am forever grateful for their love and support. Rajni filled all the gaps in our household I created and patiently reviewed drafts of chapters, offering thoughtful feedback along the way. She is one of the smartest and most fun people I know. I could not imagine my life without her and our amazing kids, who in their natural way inspire me to be a better person. For that, I dedicate this book to my family.

About the Author

Rajay Bagaria has nearly two decades of experience in the high yield market. He currently serves as the President and Chief Investment Officer of Wasserstein Debt Opportunities Management, LP (“WDO”) a credit hedge fund he established in 2013 with backing from a prominent family office. From WDO's inception to June 2015, WDO was a top ranking high yield fund based on data from eVestment. 1

Prior to founding WDO, Mr. Bagaria was a Partner and Investment Committee member of Apollo Investment Management (“Apollo”), the investment manager of Apollo Investment Corporation (“AIC”), a publicly traded business development company with over $3 billion of assets under management (AUM). At Apollo, Mr. Bagaria invested in several asset classes including senior debt, high yield bonds, mezzanine debt, and equity. He also held responsibilities related to secondary trading, investment team development, portfolio company work-outs, and the development of Apollo's energy lending and aviation investment platforms. Mr. Bagaria has been a board member of several companies including LVI Services, Inc. Generation Brands, and Playpower, Inc.

Prior to joining Apollo, Mr. Bagaria worked as an investor for Goldman Sachs & Co.'s PIA Mezzanine Fund, the largest mezzanine debt fund globally, and as a high yield investment banker at J.P. Morgan & Co. Mr. Bagaria earned a BA degree at New York University with studies at the London School of Economics.

Mr. Bagaria is co-founder of The Manitou School, a private elementary school located in Cold Spring, New York. He lives in Garrison, New York with his wife and two children.

NOTES

Foreword

When, about a year ago, Rajay told me that he wanted to write a book about high yield investing, my reaction was two-fold. On the one hand, time commitment required to write a book, while managing a successful hedge fund, seemed to present a daunting challenge. On the other hand, after 20 years of practicing corporate law and handling a wide variety of leverage finance transactions, I understood that this book was long overdue. Having had to explain the very basics of high yield instruments over and over again in each transaction, I could understand how frustrating it could be to try and overcome common misconceptions, lack of knowledge, and suspicious attitudes.

As friends and colleagues who were involved in leverage finance for many years (Rajay, on the business side and me on the legal side), both of us knew well that the high yield market was largely misunderstood. The excesses of the late 1980s and early 1990s, which resulted in prominent criminal prosecutions, as well as a commonly-held notion of high volatility and high default rates of high yield instruments, gave the high yield market a bad reputation, the reputation that we knew was undeserved. Through a thorough overview of the fundamentals of high yield instruments, filled with facts and unbiased analysis, High Yield Debt: An Insider's Guide to the Marketplace debunks these myths of excessive volatility and the inherent danger of high yield market.

Indeed, who could have been better suited to demystify high yield investing than Rajay, who started his investment career at Goldman Sachs, continued it as one of the principals at Apollo Investment Corporation, a publicly traded business development company specializing in high and mezzanine investments, and finally ended up starting his own high yield investment fund that has been steadily generating returns far in excess of market average. And Rajay did it!

High Yield Debt: An Insider's Guide to the Marketplace unravels the mystery of the high yield market chapter by chapter. To put the topic in perspective, the book starts with a historical background (which to me was also a fun part to read as it brought back memories of the days past). It then describes market participants, explains the economics of high yield instruments, and touches upon prevalent debt structures and pertinent legal requirements. The book then moves to demonstrate high performance levels of high yield instruments making them attractive additions to an investment portfolio. The book concludes by addressing some of the more specialized concepts, such as mezzanine investments, distressed debt, and credit hedge funds. An extensive use of charts and statistics lends High Yield Debt: An Insider's Guide to the Marketplace a necessary credibility. Yet, the book is lively written, to keep the reader entertained, while educated.

To be sure, there have been books written about high yield investing before. However, those books addressed primarily the academia and were written in a much more scholarly fashion. I could not imagine any of those books being a desktop set or a day-to-day reference guide. High Yield Debt: An Insider's Guide to the Marketplace, on the other hand, is designed to address the needs of market participants, be it an investment manager in a family office, a young lawyer starting his or her career at a corporate law firm, or a rookie investment banker pitching a new instrument to a corporate client. This is a book that could be quickly referenced to conceptualize an investment thesis for a particular instrument or to understand a market lingo used by more seasoned professionals (for which the Glossary at the end of the book can hardly be praised enough). I would also recommend this book to CFOs of companies that are looking for efficient capital-raising techniques. Overall, the key attraction of this book is its versatility, clarity and scope, all of which could come in handy in many different situations.

Now, more than a year after the idea of the book was first conceived by Rajay, I am still awed by the sheer amount of effort that went into its writing. Yet, I am impressed even more by the quality, breadth and depth of the final product of this monumental effort, the product that deservedly occupies a prominent place on my desk. I am confident that readers will find High Yield Debt: An Insider's Guide to the Marketplace to be an invaluable treasure trove of information about high yield markets. I am very proud to take a small part in the exciting journey that the writing of this book turned out to be. It gives me a great pleasure to congratulate Rajay on the successful completion of his valiant efforts in writing this book and encourage him to embark on new, no less ambitious ventures.

Emil Buchman
Corporate Partner
Fried, Frank, Harris, Shriver & Jacobson LLP