David J. Breazzano wasn't even looking for a career in money management.
After receiving his MBA from the Johnson Graduate School of Management School at Cornell University in 1980, he decided to dabble in the investment field to get exposure to “a whole lot of different industries and companies,” said Mr. Breazzano — president and chief investment officer of DDJ Capital Management LLC, Waltham, Mass., which specializes in subinvestment-grade debt strategies, particularly in smid-cap companies. His thinking was, “Then when I found something I thought I would really like, I can get a real job.”
More than 30 years later, he still hasn't found anything he enjoys doing more. When Mr. Breazzano first entered the money management industry, he knew he didn't want to manage traditional equities investments because it seemed “a little too routine,” so he gravitated toward private placements and debt investing. “It seemed to allow one to be a little more creative,” Mr. Breazzano added. “High yield itself was going through the transformation of being some sort of a stepchild of the investment world into a mainstream asset class.”
Were there any particularly individuals who made a big difference in your early career? I really appreciated one of my first bosses, Peter Smith. He hired me to work in the investment department at New York Life. He was a very thorough and smart, and taught me the basics of how to analyze companies, read legal documents and other aspects such as negotiating investment transactions. Because of his thoroughness and patience, I was given a really good start in my career.
Then when I went to First Investors (Asset Management), I was hired by Mark Shenkman. He just gave me an incredible amount of responsibilities very quickly. Because of our lead role in a number of restructurings, I became a point person with pretty significant responsibilities. At a very young age, I was involved in potential takeover transactions involving Gulf Oil (Corp.), The Walt Disney Co., Union Carbide (Corp.) and RJR Nabisco (Inc.).
How does DDJ Capital differentiate itself? Our approach to (investment) analysis is a little different to the typical money manager in our space. We have quite a few people with backgrounds in investment banking and/or private equity, so our approach is to look at the value of the business. Then we look at the capital structure and identify where the best opportunities are within that capital structure. In comparison, a more traditional fixed-income approach typically ignores that aspect and tends to look at common ratios such as interest coverage ratios. We look at those, too, but we also look at what happens in the event that the company cannot pay us back, according to the original contract, and what is the equity cushion below us. If we had to own the company because it's unable to repay us, are we acquiring that company at a very attractive price? It gives us a more attuned focus on downside protection.
Where do you look for investment opportunities? We see a clear correlation between (bond) issue size and yield, so the smaller issue size, the higher the yield. In many cases, these companies are comparable in terms of credit risk. The only difference is the size, and there tends to be a bias toward bigger companies both by rating agencies and by investors. ... We pride ourselves by having sophisticated clients in large separate accounts willing to accept a little less liquidity for much higher yields. The yields can be significantly higher for smaller transactions. An investor would sacrifice a bit of liquidity but be able to pick up potentially several hundred basis points in yield.
If a significant part of your business is focused on smaller issues, are you concerned about capacity? In this past year, we've had two clients ask us to move up the credit spectrum in credit quality, so they wish to have more significant exposure to BB in their portfolio, which historically we did not do. But we have a good, long-term relationship with the client and we have the capability, so it allowed us to incept a new strategy, which we call our core strategy. We also brought in a new client to focus on core, so now we have over $1 billion in core, and that is a much broader market and has a lot of capacity. Where the constraints are for all our strategies is how rapidly the new money can come in. We wouldn't want to bring in too much money all at once, so we would want to schedule the inflows over a period of time.
How do you see the current environment in high yield, including concerns that we're entering a bubble? I'm a realist to know that high-yield bubbles occur every eight to 10 years, so we're going to have another one, but it's not (in 2013). We'll have little corrections, and we want to be prepared for that.
Right now, high-yield spreads over Treasuries average about 550 basis points. Historically, the average is just north of 500, so we're around the average for the spread over the long term for the high-yield market. The default rate today is very low by historical standards. The default rate is about 1.5%, which is almost non-existent. What's more important is the recovery rate. If a bond defaults, it doesn't necessarily go to zero. Today, it will probably go to about 50 cents on the dollar. To make the math simple, if the default rate is 1.5%, and the recovery rate is 50 cents on the dollar, you'd lose 75 basis points on average if you capture the market's default rate. The loss rate is half of the default rate of 1.5%, so it's 75 basis points. If you're getting paid over 500 basis points, you can easily absorb those losses. From a purely statistical standpoint, high yield is still attractive, and it's attractive by historical standards.
How do high-yield bonds compare to equities? There is a massive shift away from traditional equity. People are concerned about the performance of equities in a slow-growth environment. On the other hand, a slow-growth economic environment is ideal for high yield, because when we're investing in a company's bonds, we don't care if the company grows. We just don't want the company to shrink.
What signs might investors be on the lookout for in terms of high-yield bonds entering a bubble? If high-yield spreads get inside 400 basis points, we would start getting cautious. If they get to 300 basis points, look out. But there are things to do; it doesn't mean sell all your high-yield bonds. What we did last time around (in late 2008 and early 2009), which worked out, is that we moved up the capital structure. We went into senior secured paper. We made sure we got rid of unsecured holdings, or that we're inside of four times (earnings before interest, taxes, depreciation and amortization) to leverage, so that we have a cushion. We focused on short duration.
Another thing that can hit high yield is if interest rates start to go up. But I also worry about the panic in Treasuries and the high-grade market because once interest rates start to tick up, and you have a 1% or a 2% bond, you're going to get crushed. You're not going to have a chance to get out of it because everyone else is going to try to do the same thing.
This article originally appeared in the January 21, 2013 print issue as, "A dabbler turns pro".