An overlooked opportunity or undue risk?
We have been advocates of investing in small and mid cap credits since launching our high yield strategy more than seven years ago. In our decades following the high yield market, we have learned that this often-overlooked market segment can offer mispriced opportunities for bottom-up credit pickers willing to roll up their sleeves. Admittedly, however, we have been somewhat deficient in articulating exactly why we have such a penchant for this market segment. We look to mend this with our latest newsletter, which will focus on the composition, characteristics, and risks of small and mid cap high yield credits.
In preview, there are three primary reasons for our small/mid cap proclivity; each of these benefits will be explored in greater detail with Benefit #3 receiving disproportionate attention:
Benefit #1: Large opportunity set Benefit #2: Yield/spread advantage
Benefit #3: Upside potential overshadows manageable risks
Defining small and mid cap
Segmenting equity markets by company size is common practice. So much so, in fact, that even relatively novice investors are familiar with conventional size-based equity indices like the Russell 1000 (large), Russell Midcap (mid), and Russell 2000 (small). Analogous parsing of bond markets, however, is uncommon and fixed income research based on size is remarkably limited. To our knowledge, there is no universally-accepted method for defining large, mid, and small cap bonds. We will need to define the market ourselves as we wade into thinly-chartered waters. Table A summarizes our definitions, which will be used throughout the newsletter unless noted otherwise.
| Table A: Size Classifications | Issuer Size | |
| Large Cap | Over $1.2 billion | |
| Mid Cap | $600 million to $1.2 billion | |
| Small Cap | $200 million to $600 million | |
We are basing our size definition at the company level (i.e. issuer) rather than the bond level (i.e. individual issue). Performance of high yield bonds are typically dictated by positive or negative developments at the company level above all else. Defaults occur at the company level. Based on our definition, therefore, all bonds of the same company will be assigned the same classification. For example, HCA Inc., a hospital system, is one of the largest issuers in the high yield market with more than $22 billion in par value outstanding. The company has more than 20 individual bonds issued, 8 of which are less than $600 million in par value. We are classifying all of HCA’s bonds as large cap, even those with just $600 million in total par value, because the company is a large issuer. True small cap bonds, in our view, are bonds of small companies.
The breakpoints we chose ($200MM, $600MM, and $1.2B) are somewhat arbitrary and largely based on our experiences—we have to draw the line in the sand somewhere. We could alter the parameters slightly and our conclusions would remain intact. Importantly, we impose a $200 million minimum issuer size to be included in our small cap universe. It is exceedingly difficult to take meaningful positions in issuers below $200 million without incurring excessive costs and/or liquidity risks.
Market snapshot
Benefit #1: Large opportunity set
The BofA Merrill Lynch US High Yield Index—our proxy for the high yield market—is composed of about 1,000 companies with about 2,200 individual bonds. As shown in Chart 1, about 75% of the market is large cap and 25% is small/mid cap as measured by market value. Also shown in Chart 1, however, about 30% of the market is large cap and about 70% is small/mid cap as measured by the number of issuers. There are 660 small/mid issuers (442 + 218) compared to 279 large issuers. The failure to incorporate the small/mid cap segment of the market severely limits the opportunity set, thereby handicapping active managers’ ability to add value through credit research.
