Interview With J. Matthew PhiloSenior Managing Director, MacKay Shields

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HigH-yield corporate bonds Have had an impressive rally since early March. so is it time to get off the train? not yet, says J. Matthew philo, a veteran high-yield manager at MacKay shields, an asset manager based in new york with about $30 billion under management.

While philo, 49 years old, still sees value in this sector, he is focusing on the higher-quality end of the junk-bond spec-trum. He and his colleagues aren’t con-vinced a sustained economic recovery is at hand, based on their analysis of indi-vidual companies. philo’s duties include subadvising the MainStay High Yield Corporate Bond Fund (ticker: MHcaX). to learn more about what’s going on in the high-yield market, Barron’s caught up with philo last week.

Barron’s: Let’s start with your overview of high-yield investing.

Philo: the high-yield market got to its cheapest level ever in the middle of de-cember. at that time, the Merrill lynch High yield Master ii index, which is a reasonable representation of the broad high-yield bond market, was at an aver-age bond price of 55% of par. its spread over treasuries was a record 21.68 per-centage points. as of May 1, that same index was at 71% of par, and the spread had narrowed to 13.36 percentage points. so value is still attractive for high yield, but it is in the midst of a powerful rally that began March 9, along with the rally in equities. in terms of dollars, the high-yield index is up about 20% since the rally began. that is a powerful move that has accelerated somewhat recently.

By Lawrence C. Strauss

“Not only are we seeing soft operating results for companies with meaningful

cyclicality, but [there’s] not clear visibility on demand improvement.” —Matt Philo

High-yield investing isn’t for everyone, particularly not individual investors. Could you talk about the risks?it is important to understand that in high yield, any new issue at par has asymmet-ric risk reward. because we are invest-ing in bonds, not stocks, our upside is capped.

if you buy a bond at par, or 100, and it gets tendered for a small premium to treasuries, which is a high-yield home run, you can think about 20% or 25% of upside. conversely, if a high-yield bond defaults, it has historically traded down to

40% of par—although in the current envi-ronment, it’s much lower than that.

We think recoveries from defaults dur-ing this high-default cycle will be at re-cord lows. so you can think of about as much as 90% downside from par when you make a serious high-yield mistake. as a result, you quickly come to understand that high yield is all about risk control—and the primary enemies are defaults and the recovery level on defaults. We empha-size having a margin of safety, which we analyze by looking at asset coverage and free cash flow.

“Not only are we seeing soft operating results for companies with meaningful

cyclicality, but [there’s] not clear visibility on demand improvement.” —Matt Philo

Philo’s High-Yield Picks Year of CurrentCompany Maturity Yield

Hanger Orthopedic 2014 9.1%

Tyson Foods 2016 9.5

Harley Davidson 2018 10.4

Source: MacKay Shields

Explain those concepts, starting with asset coverage.it is the real-world value of a company’s assets in a less-than-ideal environment, relative to a company’s fully drawn debt, including credit facilities and various cov-enants. For a margin of safety we are comfortable with, we want a company’s asset coverage to be two times debt, fully drawn. the inverse of asset coverage is loan-to-value. We want to feel that the real-world value of our assets is worth twice the debt for most of the companies in our portfolio. sometimes, we’ll go to 1.5 times asset coverage, depending on the situation. the other metric that protects you against defaults is true free cash flow. that is cash from operations, minus what a company needs to reinvest in its business in order to keep that cash-flow stream intact.

How have cash flows been holding up?

there aren’t a lot of industries generating strong operating results. right now, peak free cash flow in health care and cable tv are the exceptions. but most companies exposed to any meaningful cyclicality are not generating peak levels of free cash flow.

We also favor strategic companies, meaning companies with big market shares and barriers to entry. they are the companies whose assets people will line up to bid on in a restructuring. all of this boils down to controlling defaults and striving to have recoveries better than the market average.

How else do you go about generating returns?We also look for bonds whose prices im-prove, as measured by tightening spreads, and we have three primary catalysts, one being whether a company has enough free cash flow to retire a significant amount of the debt over the next five years. sec-ond, if a company intends to raise money below you in the capital structure, com-monly through a public or private-equi-ty offering, that is always an improving credit. the third catalyst is an operational turnaround that a company has begun to implement successfully.

You divide your investing universe up into four groups, from least risky to most risky. Talk about that a little.

We don’t move from relative safety to relative risk unless we are being fully compensated or overcompensated for the additional default risk. and what defines safety or relative risk in high yield to us has nothing to do with the credit-rating agencies. it has to do with our measure of asset coverage and our judgment of the volatility of cash flow.

What is your overall take on the high-yield market in light of the recent rally?

We like the high-yield market, even after the recent rally, but it doesn’t make sense to have a full weighting in the riskier part of that market. so we are underweight credit risk.

Why is that?

it isn’t clear to us that there is high con-fidence that an identifiable economic re-bound is in the works. the jury is very much still out. What we ultimately care about is what we hear from the compa-nies we talk to. not only are we seeing soft operating results for companies with meaningful cyclicality—but we also aren’t hearing that they have any clear visibility on demand improvement in their markets.that makes us cautious on near-to-inter-mediate-term earnings prospects, and that isn’t the environment where you want to have a full weighting in the riskiest part of high yield.

and there are a couple of other fac-tors, one being that the environment for restructuring unsecured debt is the worst it has been in modern history, in our opinion. in other words, it is easier for unsecured debt to get wiped in court proceedings.

Are you avoiding unsecured credits?

no, we own lots of unsecured credits, which are the largest segment of the high-yield market. What we are avoid-ing, though, are unsecured credits with a meaningful probability of default.

Where do you see the default rate going?

default rates have picked up in the high-yield market, and we see that most likely heading to double-digit annualized rates for a year or two. the current trailing 12-month default rate is about 8%. so a spike in default rates is the bad news. the good news is that the market’s valuation re-flects that kind of default pain.

Besides the faltering economy and the lack of credit availability, why is the default rate going so high?

it is also the [leveraged buyouts] of the previous cycle, particularly the ones fi-nanced in 2006 and 2007. they will play a large role in future defaults, but they will be somewhat slow to default relative to historic norms, because the covenants were so lax on the financing. so a lot of those defaults may not occur until 2010.

Before we hear about a few individual companies, let’s talk about your portfolio in terms of sectors.

We are avoiding consumer exposure in a lot of ways. We don’t own any home build-ers. We are extremely underweight retail.

We have just begun to buy one credit in the restaurant industry, and we have been sellers of some consumer-discretionary bets over the last few weeks, including gaming. there, we made a significant bet on gaming companies focused on markets other than las vegas, which we think is overbuilt. We felt that secondary [gaming] markets all over the country will hold up much better, and the bonds of those com-panies have reflected that.

What is your biggest sector weighting?

For some time, it has been health care, both service providers and medical-prod-uct companies. that was a bottom-up analysis, which includes how earnings will look in the near to intermediate term. in health care, we actually see positive oper-ating momentum, which really separates this group from the average industry. and at the same time, valuation is attractive and remains attractive for a lot of those credits, relative to their default risk.

We have been modestly overweight in energy, with an emphasis on higher-quality credits within high yield—and, in general, we prefer natural gas over oil, although we do own both. We also have a modest overweighting in financials, main-ly in areas like insurance brokerage and property-and-casualty insurance.

Let’s move on and talk about a few com-panies that look interesting to you.

one is Hanger Orthopedic, which is the largest operator of orthotic and prosthetic patient-care centers in the U.s. it is a public company [ticker: Hgr]. they do manufacture and distribute, but they pri-marily service braces and artificial limbs. this business has very favorable demo-graphics, and they have a recurring reve-nue component, as there is a replacement cycle for these products. the regulatory environment looks pretty favorable, and they have gotten price increases. on a net-debt basis, which is debt minus cash, it is 3.6 times leveraged. its public enter-prise value trades at 7.75 times ebitda [earnings before interest, taxes, depre-ciation and amortization]. on an annual basis, the company generates 8% of its net debt in free cash.

Most important to us is that the 3.6 times leverage, in our judgment, repre-

sents two times asset coverage, and this company is a dependable free-cash-flow generator. When these bonds, which ma-ture in June 2014, were issued, they yield-ed 10.25%. now they are priced at 103 and yield 9.1%, which is 7.62 percentage points over [comparable] treasuries. We consider it to be a solid group ii credit—in our language, middle-of-the-road risk, at two times asset coverage—but it doesn’t have the lowest cash-flow volatility.

What is your next pick?

another area of opportunity in high yield is what we call the crossover market. these are investment-grade credits that are trading like high-yield bonds or have been downgraded recently to below in-vestment grade. that includes an issue by Tyson Foods [tsn] in arkansas.

Where is the upside?

tyson Foods is the world’s second larg-est food-production company, with annual revenues of roughly $27 billion. it has a [very strong] market share in beef, chick-en and pork. it also has a prepared-food business that is profitable and worth a lot. beef is its largest business, and they had a 22% share of the U.s. market at the end of last year.

tyson had weak years in 2007 and 2008, accounting for the downgrade of this particular issue to below investment grade. they faced a lot of pressure on

commodity prices. their chicken business was particularly weak, although that looks like it is turning the corner, and they have had some relief from corn prices.

their largest competitor in the chicken business, pilgrim’s pride—which actually has a slightly larger market share—was a recent high-yield bankruptcy, and is shuttering some of its chicken production. that should create a better environment for tyson. We are also encouraged that tyson has improved its liquidity, in part, with a $274 million equity offering last september.

What about the issue you mentioned that is now trading like a junk bond?

these bonds, which mature in april 2016, had a coupon of 6.6%. but because of the downgrade, the coupon is now 7.85%. they are trading at 92 cents on the dollar, which is yielding 9.5%—or 6.73 percentage points over treasuries. their net debt is about $2.8 billion and the market cap is roughly $4 billion. Under the worst-case scenario, this year’s ebitda could come in at $600 million, which would mean a very modest cash burn. but we think they are on the road to recovery, and normal-ized cash flow is $1-billion-plus. our view is that the asset coverage exceeds two times.

Let’s move on.

another so-called crossover credit was is-

sued by Harley Davidson [Hog], specifi-cally its bonds that mature in June 2018 with a coupon of 6.8%. the bonds are now trading at 79 on the dollar. the yield is 10.4%, roughly 735 basis points over trea-suries.

What’s to recommend this company?

Most people know Harley davidson as the world’s leading heavyweight motorcy-cle manufacturer. they have a 50% mar-ket share in the U.s. and they have an independent-dealer network that is 82% exclusive to Harley davidson, so it gives them a lot of control over the distribu-tion channel. and they have taken care of liquidity needs very recently, including a one-year, $625 million credit facility.

So it sounds like Harley has enough cash on hand?

yes, they do. We own bonds issued by the company’s finance subsidiary, which is called Harley davidson Financial ser-vices. Unencumbered financial-subsidiary assets, primarily accounts receivable, are 120% of its unsecured debt, which is very high for a finance company.

even if loan originations slow down a lot, a well-run finance company throws off a ton of free cash, and the credit perfor-mance has held up quite well. our analy-sis is that it will continue to do so.

Thanks, Matt. n

Before You Invest High yield securities (“junk bonds”) are generally considered speculative, because they present a greater risk of loss than higher-quality debt securities; these securities may also be subject to greater price volatility. Foreign securities may be subject to greater risks than U.S. investments, including currency fluctuations, less liquid trading markets, greater price volatility, political and economic instability, less publicly available information, and changes in tax or currency laws or monetary policy. These risks are likely to be greater for emerging markets than for developed markets. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise.

The information and opinions herein are for general information use only. New York Life Investments does not guarantee their accuracy or completeness, nor does New York Life Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice.

All holdings and sector weightings are as of March 31, 2009, and are not indicative of future holdings or weightings, and may change daily. MainStay High Yield Corporate Bond Fund holdings mentioned: Hanger Orthopedic (0.49% of Fund), Tyson Foods (0.50%), and Harley Davidson (0.50%). Inclusion of references to individual holdings is intended to illustrate contributors to recent performance or market trends and to provide examples of thematic or issuer-specific catalysts identified by MacKay Shields’ investment team as part of its investment process. References to specific securities should not be viewed as representative of an entire portfolio, nor should the performance of any particular security be viewed as representative of the performance experienced by any other security or portfolio. It should not be assumed that future recommendations will be profitable.

NYLIFE Distributors LLC and its affiliates do not own 1 percent or more of any class of equity securities of the research firm (the “firm”), if any; did not manage or co-manage a public offering of securities of the firm, if any; did not receive compensation for investment banking services from the firm in the past 12 months nor expect to receive or intend to seek compensation for such services in the next three months, if any; makes no market in the firm’s securities, if any; and does not have any other actual, material conflict of interest of the research analyst or member firm of which the research analyst knows or has reason to know at the time this research report is distributed or made available.

The Merrill Lynch High Yield Master II Index is an unmanaged index that tracks the performance of below-investment-grade, U.S.-dollar-denominated corporate bonds publicly issued in the U.S. domestic market. An investment cannot be made directly into an index.

For more information about MainStay Funds, call 800-MAINSTAY (624-6782) for a prospectus. Investors are asked to consider the investment objectives, risks, and charges and expenses carefully before investing. The prospectus contains this and other information about the investment company. Please read the prospectus carefully before investing.

mainstayinvestments.com

MacKay Shields is an affiliate of New York Investment Management LLC. “New York Life Investments” is a service mark used by New York Life Investment Management Holdings LLC and its subsidiary, New York Life Investment Management LLC. Securities distributed by NYLIFEDistributors LLC, 169 Lackawanna Avenue, Parsippany, New Jersey 07054.

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