Rob Almeida: Hello, this is Rob Almeida. Welcome to another edition of the Strategist's Corner Podcast.

Announcer: The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the advisor. No forecast can be guaranteed. Past performance is no guarantee of future results.

Rob Almeida: Today, I'm talking with MFS High Yield Manager, Mike Skatrud. Covering Mike's two-decade career looking at high yield companies, we learn about the experiences that formulated and how he thinks about high yield investing. And we lead into the current risk and reward presented in the high yield market today. We hope you enjoy this conversation with Mike. Mike, welcome. 

Mike Skatrud: Thank you.

Rob Almeida: So, before we get going, tell us how you got interested in the industry, how you got started, before you came to MFS. Take us back.

Mike Skatrud: Sure. Well, I'll take you way back. When I started in the buy side, I stumbled into a role as a quantitative fixed income research associate, which I really didn't know what that was at the time. I was at a different firm. It was a lot of math, a lot of spreadsheets. Great introduction to the buy side. Great introduction to fixed income and all the bond math and all that. But I said to myself, "Gosh, there has to be more to it than all these spreadsheets with just numbers. Does it relate to something in the real world that I could see or touch?" And so, I ended up going back to business school to pivot more toward analyzing companies and industries as a fundamental analyst.

Mike Skatrud: And so, I started doing that in high yield a couple decades ago. I can say that now. And it was really a good fit. It did have obviously a quantitative aspect to analyzing companies, but also that interaction with management teams, really understanding what goes on in the real world. How are businesses competitive? How do they fund themselves? And of course, in fixed income, what can go wrong when companies get over their skis in terms of financial leverage. And so that's how the journey began. And so I'm very interested in the quantitative aspect of investing, but I feel like the switch over to fundamental has been a good fit for me.

Rob Almeida: So maybe that's a great place to start. So, what were some of the maybe inflection points or big learnings from that era? What formulated your view on how to think about high yield investing?

Mike Skatrud: That's a great question. So, the first industry I had the pleasure of following was steel in the early 2000s.

Rob Almeida: Oh wow.

Mike Skatrud: And steel's not as big an industry today in the high yield index, of course. There have been a lot of casualties along the way, and I was living through that, where you're in a recessionary environment. The companies would go bankrupt faster than I could pick up coverage of them. And it was a real eyeopener for me in the sense that on the one hand, as a fixed income investor in high yield, you're "promised", maybe in air quotes, a coupon return. And yet if things go wrong in high yield, these companies have a lot of debt, and you might not get that coupon. And that was really an eye opener. It also, as you can imagine, was a crash course into how do you value enterprises, especially when there might be forced sales and that sort of thing?

Rob Almeida: So there's so much that goes on in fixed income, but particularly in high yield. Maybe the asset class that most translates across so many different risk spectrums. So, you covered some of them. So, you have not just the fixed income element, but obviously also the credit element and the bankruptcy element. Maybe bringing that all together, how does that translate to how you manage high yield strategies today?

Mike Skatrud: Right. So I think from a portfolio management point of view, it's really that intersection of the top down risk management, along with the bottom up research aspect of it. That's another piece I didn't mention, but it's understood that high yield is a very research-intensive asset class. And a lot of these companies, while they may be correlated to their industry like a steel company, a lot of them do have very company-specific idiosyncratic risks that we have to understand. And I think my formative years, if you will, in high yield, reminded me that if we're looking at the risk return profile at the portfolio level, we can't lose sight of the risk. We do have others in our industry who maybe have a tendency to put the foot on the accelerator a little bit more when it comes to through cycle risk.

Mike Skatrud: And I've always gone back to this idea where it's great when high yield's good. It's good, and you're clipping the coupon and things are working out great. But when it's bad, it's really bad. And so the way we approach it now is really thinking about, "Okay, let's acknowledge what the upside scenario is. What could the return in a positive way be for this investment?" But you know what? It's a batting average game. We're not perfect. If we get it wrong, how much could this cost us? It's not saying we won't take risk, but we want to make sure that the compensation is there and then we also want to make sure that if we're wrong, it's not going to disproportionately affect the performance stream.

Rob Almeida: So it's really what are the ranges of outcomes.

Mike Skatrud: Right.

Rob Almeida: What can go right fundamentally to get paid back, get your principle back, your coupon back. And then what you're referring to is what can go wrong.

Mike Skatrud: Right. That's right.

Rob Almeida: And as a lender, it can be everything?

Mike Skatrud: It can. One of the critiques of the asset classes is if you're buying a high yield bond at par, the best that can happen to you is you do. You get your coupon and then you get paid back at par. But the reality is the worst thing that can happen to you in some cases is the company hits the wall, files for bankruptcy, and your recovery can be next to nothing. And so it really in certain market conditions where investors have gotten complacent, it's really important to think about that asymmetry and be very cognizant of okay, we want to be positioned in a way where we can take advantage of good bottom up ideas that our analysts have, but we also need to manage the overall risk positioning in the portfolio, in the event that something unexpected plays out, or to be fair, a lot of what we're doing upfront is identifying the risks.

Mike Skatrud: And we assign some probability, even in a qualitative way to what's the likelihood that some of these downside risks could materialize. And we hope more often than not, even though we've identified them, they don't materialize and we're getting a good return above and beyond the inherent risk of the investment. But every once in a while, of course, we get surprised too. And that's where really the risk management aspect of managing the portfolio comes into play.

Rob Almeida: So two things you said that probably jumped out ... It jumped out to me, probably jumped out to our listeners: Complacency and asymmetry. So maybe let's triangulate that to the current market environment. So we had a recession in 2020.

Mike Skatrud: I guess you could call it that.

Rob Almeida: I guess you could call it ... Yeah. We financed; we bought our way out of it. So we really maybe didn't have one. I'll let you talk to us a little bit about how you think about high yield today in the context of everything that has happened and maybe everything that you think might happen.

Mike Skatrud: Okay, so I would say let's go back even a bit further than the most recent pandemic experience. I would make the claim that really since the global financial crisis in 2008, investors have been conditioned across all sorts of risky assets, including high yield to buy on the dips. When we've seen downturns over the last 10 plus years, they tend to be short-lived. They tend to be buying opportunities. And we really haven't seen a widespread true default cycle. And by that, we've seen certain pockets of trouble. So if you go back to 2015, you certainly see we had some energy and commodity related stresses in high yield. But it really wasn't in the US a recessionary environment. And so for investors who added risk on the dips that that worked out. And certainly, now bring it back into the pandemic experience, it was another episode that really reinforced that philosophy that some investors have where don't overthink it, just buy on the dips and you're going to get bailed out by fiscal stimulus or monetary intervention or fed facilities that can buy high yield bonds and so on and so forth.

Mike Skatrud: And I think that promotes the complacency. That really leads people to forget about, well, what if you do have a recession? A true recession across a lot of different industries where there is demand destruction? It's not just limited to commodities or one particular sector, but it's truly a widespread and sustained economic slowdown that lasts quite frankly more than the two months we saw in 2020. That's not normal. So we come to today, and your question about the market and where we are in the cycle, high yield valuations are not particularly compelling, we would argue. And really, I think it's because investors are assuming that this is more of the same.

Mike Skatrud: If you bought the most bombed-out stuff in 2020 pretty much across the board, good business, bad business, there really wasn't a lot of differentiation coming out of that initially, because everything went up in value in high yield. And the riskier it was, the better. So if you had bombed-out energy companies, we had a brief period in early 2020 where oil prices were negative and that's a quirk of the market. But we had energy companies that were at 50 cents on the dollar, and they've basically doubled in price. So the question is: Where do we go from here with so much good news, if you will? And it's weird to say good news, because obviously there's a lot of challenges in the world.

Mike Skatrud: We see the geopolitical, of course, comes to mind and the tragic war in Ukraine. But we also see in the US a central bank trying to unwind some of the stimulus in the face of what seems to be tenacious inflation. And that's going to have an effect. We really feel that the probability of a protracted slowdown and even a true recession is much higher than it has been. And if you look at high yield spreads in the US, they're still at the lower end of the range. And so when we put it all together from the top down, we say, "Gosh, we don't think we're getting compensated for the potential downside risk."

Mike Skatrud: And this goes to the second part of your question regarding asymmetry. We really think about how much better can things get in terms of fundamentals, understanding that there's some headwinds looking us in the face? Intersecting with evaluation, the upside downside return characteristics in high yield don't look particularly compelling. If the market were to become more concerned and valuations were to cheapen up, meaning spreads would go up because the market thinks, oh gosh, maybe we are headed into a recession, what we typically see then is the market overshoots and that can create opportunities. But we're not there yet.

Rob Almeida: Right. So you talked about complacency leading to asymmetry, something that you and your co-manager David Cole have talked about internally is, or at least maybe I nicknamed it fake spread.

Mike Skatrud: Right.

Rob Almeida: So where do you think ... So spread's at 300 plus over relative to treasuries, is below average. And in the context of fake spread, maybe first define that for the audience a little bit. And then where do you think spreads really are or maybe should be, given the risks that you and the team are observing today?

Mike Skatrud: Sure. That's a good question. So when we talk about fake spread, we really mean even though these companies have committed to pay us our coupon, our interest and our principal back, they don't always do that. And so we certainly see especially in the lower quality tiers of high yield, you may have a promised yield. Whether or not you actually earn it and receive that remains to be seen. To be fair, in the current environment, the distress ratio is relatively low. Companies coming out of the pandemic have done a good job of extending maturities. They've also put extra cash on their balance sheets. So I want to present a balanced view and say the folks who have bid up high yield, if you will, are not completely without their reasons, because coming out of the pandemic, companies did do what they could to shore up their balance sheets. And excuse me, be in a better spot, if we are going into a slower economic environment for sure.

Mike Skatrud: So the fake spread concept is one where at the moment would be limited toward the down in quality names where you say, "Gosh. Our analysts think this company is either in a difficult industry and or a difficult competitive position. It might have a 10% yield. We don't think we're going to get that." And obviously those are the kinds of names we want to avoid, especially if we think there's an elevated probability of going into a recession. To your question about the valuation, where should spreads be? That's a little bit of an art meets the science.

Rob Almeida: Sure, yeah.

Mike Skatrud: Maybe more art than science. You can think about why do we get a spread over treasuries anyway? It's really a combination of two things. One is, we need to get compensated for permanent capital losses in the form of default. As I said at the moment, it seems like you could maybe make an argument that those default losses are going to be subdued over the near term. I think the question is over a longer horizon, is the market sufficiently compensating high yield investors for permanent losses of capital? Meaning, the company goes bankrupt, you bought the bond at par and you get 30 cents back. That remains to be seen, but that's one of the components.

Mike Skatrud: I think the other component is just the risk premium and that can be a nebulous term. But by that we just mean how much should you get paid for the volatility and the uncertainty in the world? And we would argue today, given again the central bank reversal of accommodative monetary policy, the geopolitical risk we certainly see, and then the ongoing inflation, supply chain disruption, profit margins rolling over, we feel like that risk premium piece should be higher than it is. And that's a little bit tricky to measure, but you put it all together. And with high yield spreads in the 300s currently, and you look at long term average high yield spreads in the US, probably closer to the mid-500s, you could make an argument that we should probably be at least a hundred basis points wider, if I had to put a number on it. But what we also see is high yield spreads really pause at the average level. They tend to either be going much wider on the way into economic trouble and then much tighter when things recover.

Rob Almeida: Well, it's interesting. I wonder if ... And I love your perspective on this. If one of the reasons for the uniquely tight spreads, it's just the conditioning that investors have grown to, like you mentioned before in the post GFC era. When there was a blip, there was some sort of economic relapse. Central bankers would step in, liquify the market and provide a floor, if you will. And maybe this current investor base that hasn't lived through a full cycle or a real recession has been unintentionally or mistakenly programmed to think that markets don't price down or they price down moderately or slowly. But as we've lived through, as you've lived through, that's not the case when you have a full recession.

Mike Skatrud: I think that's right. And I think that I wonder to myself, if we had a recession that even lasted several quarters, I think that would feel like an excruciatingly long time to many investors. If the last recession was two months and it was over before you even really knew what was going on, and there was so much stimulus, asset prices certainly got ahead of that, and it was a quick draw down and then a very quick recovery. But again, a more typical multi-quarter recession I think, would lead to a very violent adjustment in high yield pricing.

Rob Almeida: So people listening are probably surprised that you're speaking relatively bearishly about your asset class. But I think what people should know is you're lending money to companies, not to the market.

Mike Skatrud: Right.

Rob Almeida: Right, so talk a little bit about from an opportunistic perspective or positive perspective, and maybe keep individual company names out of it from a compliance standpoint, but there are viable opportunities in high yield, and really what you're making the case for is security selection.

Mike Skatrud: Right. That's right. So we are fortunate at MFS to have a terrific research team. By now, you've all heard about the collaborative global nature of the research platform. And as we build the high yield portfolio bond by bond, we leverage that expertise every day. And we're so grateful for that. So you're right. At an any point in the cycle, even now when we're not as constructive on the overall high yield market from evaluation risk return point of view, there are opportunities. And so what we're really trying to do is take a look at the types of businesses that have performed well, say year to date, and assess through a critical lens with the help of our research team, are these businesses that have outperformed in 2022 likely to continue to outperform if we're going into a murkier, less constructive, macroeconomic environment?

Mike Skatrud: And so there's certain areas that we're a little bit more cautious on. So for example, it won't come as a surprise that energy has been a sector that's performed really well. And if we do see demand destruction, either because of high prices or slower economic growth, or the combination of the two, that could be an area at risk. But you're right. If we sell something in energy, we need to redeploy that capital somewhere else. And so what we've been looking at is really higher quality businesses. So by high yield standards, these are businesses that typically have a combination of a stronger balance sheet, so less leverage, and a competitive position and free cashflow profile that means they'll be fine, even if we do go into a recession.

Rob Almeida: Quantify the leverage for the listeners, or balance sheet. Range that for me?

Mike Skatrud: Yeah, so the typical metric we use in high yield for leverage is a debt-to-EBITDA. So you can think of debt as a measure of a cash flow proxy, if you will. And I would say if you're in a stable business where through cycle, you have two or three times debt-to-EBITDA, that's going to be a pretty good spot to be in. I think it also speaks to the variability around companies' balance sheets. Going back to my steel companies, you can imagine that at the peak of the cycle, they had practically no leverage when their EBITDA and earnings was very large. But of course at the trough of the cycle, when the EBITDA went negative, how do you even calculate leverage? It's very bad. On the other hand, we have businesses and industries that we've been thinking about more recently. You can imagine food and beverage would be one that we would expect to hold up pretty well. That should be a pretty stable leverage profile through the cycle.

Mike Skatrud: We look at other industries like wireless, to the extent that even in a recession, you're going to pay your cell phone bill. And so that should be a pretty steady type of business. And what's tricky in the near term, given the uncertainty around how will the economic backdrop develop over the rest of the year? How long will it take if things fall out of bed to actually happen? You can imagine for more stable businesses with less leverage, you're not getting paid as much in spread terms or yield terms today, but that speaks to another aspect of how we invest, which is really a longer term horizon. And it's going to take, call it one to two years for us to know, and we'll know in hindsight did we have a recession or not? Did the fed raise rates too fast? And all of that.

Mike Skatrud: But we know it will be obvious in hindsight. What we don't know is how long will it take to play out. But because we have a long term orientation and a long term time horizon here, and because we feel very good about investing in good businesses that our research process and our terrific colleagues all over the world have identified for us, we feel good about giving up a little bit of compensation today knowing that on a through cycle basis, these are businesses that no matter what happens in the broader world, are survivors and are going to be here for the long haul. And on a risk adjusted basis, that should lead to attractive risk adjusted returns over time.

Rob Almeida: So one of the unintended consequences of the massive amount of stimulus and central bank policies obviously been inflation, but really what you're highlighting is the growing risks inside the real economy and how that's manifested into complacency and asymmetric risk in fixed income. And I just think of the growing group of investors that have been maybe taught the wrong lesson over the last 10 or 11 years, that there's a fed put, if you will, or that there's a policy there that's going to protect you. And given where inflation is now, given the direction of monetary policy as a result, that security blanket or safety net isn't going to be there. And so if I'm hearing you right, or what you're describing is just the careful, thoughtful approach, but really just asking the question with the analysts, how good is this company? Are they going to be around? Are they going to be able to survive what may come down the pike over the next six months or two years or three years?

Mike Skatrud: I think that's right and I think things continue to evolve. And that's why our process is not static. It's constantly reassessing as new data points come in. For example, we had companies that even as inflation was proving to be more of an issue last year, many of the companies in the second half of the year that we follow said, "You know what? It's not a problem. We're able to pass through higher input costs. And yes, there's supply chain disruptions and yes, that's affected the volume. But from a pricing power point of view, it seems okay." I think as we moved into 2022, the question is how sustainable really is that? Especially when volume declines might not be simply due to, well, we can't get enough parts to make the car, so we're not selling as many cars.

Mike Skatrud: If we're moving to a place where I'm actually concerned that I don't have enough money to afford a car or other durable goods, I think that's another phase. And quite frankly, while it may be great, if companies still have pricing power, if you happen to be in a more economically sensitive part of the economy, demand for your product may just go down. And I think when you're looking at high yield companies that have balance sheets, and I'm not talking about the good businesses that we're more focused on now, I'm talking about more of the companies that really run a little bit hot-

Rob Almeida: Real high yield.

Mike Skatrud: Real high yield, exactly, or certainly real high risk-

Rob Almeida: Real high risk.

Mike Skatrud: We might say. Those companies do give us pause. It's not to say that we don't own any of those, but I think if we're honest about that riskier part of high yield, where there's the economic sensitivity, and then there's the financial leverage risk, the companies that'll outperform in the lower quality risk buckets will probably do so by going down less. I think we need to be honest that if we do go into an economic slowdown, the return profile of high yield is such that it will outperform equities if I had to guess, based on a beta point of view. That's often been the way. Although, the past does not guarantee future results. I want to make sure I say that.

Rob Almeida: Touche.

Mike Skatrud: Yes. But I think we need to balance looking for opportunities across the risk spectrum, but also as you say, be focused on investing and lending to good businesses because they will persist.

Rob Almeida: Yeah. I think what maybe gets lost in all the media coverage and excitement around financial markets, it's purpose. What is our purpose? I don't mean you and I or the MFS, but just the industry. What is the purpose of financial markets? And to me, we do two things. We price risk and we allocate society's scarce resources. And capitalism started doing that two, 300 years ago depending on when you start the clock. And you were talking about this, and I'll just say it a little bit differently, that purpose was disintermediated by central bank policy 10, 12 years ago. And it just accelerated to this point to where we are today. And it just seems that created some maybe complacency, that asymmetry of risk that you refer to. And I just think it's so important for investors and clients and everyone in between, just to remember what is the purpose of financial markets? You specifically, you are lending money to below investment grade companies and are they going to be around and do they have the ability and propensity to pay you back? And I think what you're saying is some of them won't.

Mike Skatrud: I think that's right. And one of the things I point it out and you bring up an excellent observation, the distortions that have been created in the incentives, the risk return profile across all risky assets, has been thrown a little bit out of whack, as you say, because of all this intervention. But that said, we still believe as part of our core philosophy that there will be defaults in high yield. And investors, shareholders will be well served to avoid those, especially if you have a market trading closer to par. I think the other piece of it that also resonates is even if the default environment remains relatively tame, we still will have periods of drawdown. And on the one hand, draw downs, not as big a deal because you can round trip it and ride it down and ride it back up. It's not necessarily a permanent loss of capital.

Mike Skatrud: But as you can imagine, we want to be smart about this. And if there's opportunities, even in fixed income, this may resonate with more equity investors in the audience, but buying low and selling high can still be a thing in high yield. And so even if draw down risk is temporary, it's excruciating at the time potentially. You look at the experience across all risky assets in March of 2020, and we were fortunate to be relatively defensively positioned. So we had capital to deploy, as you say, in ways that we thought were attractive after that draw down.

Mike Skatrud: On the other hand, the market snapped back so quickly, you could say, "Well, why not just ride it out?" Part of generating attractive risk adjusted returns is really being mindful, not only of the permanent capital losses, that almost should go without saying, but also how do we deploy that capital efficiently and really put it to work when we think we're getting compensated for the risks involved, when the market overshoots to the downside. And we think at this point, the market is vulnerable going forward to overshooting on the downside and we'll be ready to add risk and more attractive valuations.

Rob Almeida: And that's really the value proposition of active management. It's mistake avoidance and then being able to take advantage when somebody else is making those mistakes.

Mike Skatrud: Right. No, I think that's absolutely right.

Rob Almeida: Well, Mike, I've taken up a lot of your time. Thank you very much for this. I appreciate it. I enjoyed it quite a bit.

Mike Skatrud: It was my pleasure. Thanks.

Rob Almeida: Thank you very much to Mike Skatrud for joining my conversation today. We hope what you heard was the opportunity for active management and skilled security selection in the high yield universe, is probably more important than it's been in recent years, given the environment that we've been in. But more importantly, thank you all for listening and we'll talk to you next time.

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