Jem5: US High Yield Bond Funds
CATEGORIES: Investment Analysis
1. Alliance Bernstein High Income Adv AGDYX
2. Fidelity Capital & Income FAGIX
3. Lord Abbett High Yield LHYFX
4. Fidelity Advantage High Income FAHCX
5. Delaware High Yield Opportunity DHOIX
In the bond market there are two principal types of risk: interest rate risk and credit risk. Bonds are subject to interest rate risk by virtue of paying fixed coupons in a world where market rates change every day. If market rates go up bond prices go down – this is mathematically axiomatic. Interest rate risk is a major concern in the market today because, with benchmark rates having been at historic low levels for the past two and a half years, the prevailing view is that they have nowhere to go but up (notwithstanding periodic flights to quality when unforeseen events like the current tragedy in Japan arise). Many categories of bonds from US governments to agencies and investment grade corporates are very volatile as a result.
The other type of risk has to do with the credit quality of the bond issuer. Bond issuers promise to pay bondholders a fixed stream of interest and principal (hence the term “fixed income”) over a specified period of time. A bond’s credit quality is an assessment of its ability to pay its investors in full and on time. When a bond fails to honor its payment obligations it is considered to be in default, and that is the main adverse consequence that can happen from investing in a low quality bond – these go by the names “high yield”, “speculative” or, less ambiguously, “junk”.
But in some markets junk can be king, and we seem to be in one of those times. The fact is, a great many corporations are sitting on piles of cash and have ample capacity to take on additional debt without straining their balance sheets. Default rates among high yield issuers are around 2%, which is considerably better than average (as a rule of thumb high yield investors tend to price in a 4% default expectation to the speculative bond market). The high yield sector has been one of the strongest asset class performers since the 2008 crisis, with double digit returns each year since then. The sector has been more volatile than usual, but still considerably below the very high levels of intraday volatility seen in equity markets.
Pamela Lodge-Harrison
Meet this week’s Jem5 investor, Pamela Lodge-Harrison. Pamela hails from an old-money Boston Brahmin family and grew up listening to colorful stories of the financial and investment world . At Wellesley she majored in economics and was president of the school’s amateur investment club. Now 55, she is a partner in a small boutique investment firm where she advises clients, many of whom share her own background and pedigree. Pamela’s instincts are by nature conservative – back in her father’s day money was managed according to norms quite different from the modern portfolio theory axioms of diversification across less risky and more risky asset classes – closely held in government bonds and only the bluest of blue chip corporations.
Despite her involuntary tendency to turn her nose up at the mention of “high yield bonds” (she almost invariably applies the term “junk” in a most icy tone of voice – think Katherine Hepburn), Pamela is well aware of how financial markets have changed over the years and she is increasingly concerned about the high levels of interest rate risk she sees that could affect her clients’ fixed income portfolios, which are mostly concentrated in government bond and AA or higher-rated corporates. She knows it may be a tough sell, but Pamela decides the time has come do some restructuring of these bond portfolios and take advantage of the relatively favorable conditions in credit risk today versus interest rate risk. She sets up a profile for high yield bonds, and these are the results:
Comments on the results: There are two things Pamela notices right away about the Jem5 high yield funds – the returns over long time periods are quite robust relative to what equities have done over the same period, and the risk levels (as expressed by standard deviation) are higher than those for more conservative fixed income classes while still lower than equities risk over the same period.
High yield bonds in fact trade more like equities than they do like super-conservative bonds, and that is why traditionally their volatility levels are higher than those for other bonds. But Pamela is not so concerned about daily trading levels. She will probably employ a strategy of creating maturity ladders – putting bonds into a portfolio with different maturity or call dates, keeping clients invested through maturity (or call) for each issue and continually replacing maturing bonds with new issues so as to keep income streams reasonably predictable. The main risk this portfolio would face would be default, and given the strong balance sheets these companies possess this is a lower than average risk – while providing a way to earn her clients extra yield from the higher coupon levels of speculative bonds.
Pamela also likes the fact that high yield bonds tend to have relatively attractive fee structures – mostly below 80 basis points and sometimes as low as 50. She decides to go with Alliance Bernstein. She places the order, smiles wryly at the thought of putting her clients “in junk”, but feels confident about her decision.
*Note: Jem 5 is a regular feature on the Jemstep blog which represents our top mutual fund ratings for unique investor profiles. For more information, read our first post in the series.
