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Summary Franklin High Income has been the worst performing high yield bond fund over the last twelve months. The fund has suffered due to its heavy exposure to commodities via the debt of energy and materials companies. The fund sports a 7.14% yield, but investors should subtract 1% for the fallout that is to come to the coal debt the fund still holds. High yield debt will likely rebound in the short term, but I’d rather own small cap U.S. stocks instead. Introduction I select funds on behalf of my investment advisory clients in many different defined contribution plans, namely 401(k)s and 403(b)s. I have looked at a lot of different funds over the years. 401(k) Fund Spotlight is an article series that focuses on one particular fund at a time that is widely offered to Americans in their 401(k) plans. 401(k)s are now the foundational retirement savings vehicle for many Americans. They should be maximized to the fullest extent. A detailed understanding of fund options is a worthwhile endeavor. To get the most out of this article, it is helpful to understand my approach to investing in 401(k)s . I strive to write these articles for the benefit of the novice and professional. Please comment if you have a question. I always try to give substantive responses. Franklin High Income Fund The Franklin High Income Fund has the following share classes: If the fund is an option in your 401(k), it will likely come in the form of the R or R6 shares. The expense ratio for the R shares is 1.11% and for the R6 shares it is .47%. For the purposes of this article, I will assume the A shares are being discussed since that share class holds most of the fund’s assets. Some readers may also own the fund outside of a company retirement plan. The expense ratio of the A shares is .76%. The Franklin High Income Fund is a typical high yield bond fund investing in lower-rated, higher yielding corporate bonds. As of September 30, 2015, the fund’s holdings were most heavily weighted to the following six industries: Energy – 16% Health Care – 10% Finance – 8% Cable Satellite – 8% Metals & Mining – 7% Wireless – 7% Beaten Up By Energy Investors who have pay attention to the markets would be right to be concerned about the large exposure to Energy and Metals & Mining, which make up almost a quarter of the portfolio. Actually, 25% of the portfolio was in energy last November and this has clearly been a source of pain for the fund since. Here is a few places where some serious damage was done: Bond Principal Amount on November 30, 2014 Market Value as of November 30, 2014 Principal Amount on September 30, 2015 Market Value as of September 30, 2015 Alpha Natural Resources $25,000,000 $19,812,500 $25,000,000 $1,812,500 Chaparral Energy ( 3 different issues ) $31,700,000 $31,339,000 $31,700,000 $9,866,500 Peabody Energy ( 3 to 4 issues ) $64,400,000 $61,575,000 $58,445,000 $17,831,000 Quicksilver Resources $35,000,000 $27,925,000 $15,175,000 $5,690,625 Terrible Performance Recently, But Better Long-Term I suspect that this is the primary reason why the fund has been the worst performing high yield bond fund over the last year (at least it is using the Barron’s fund screener ). The following chart shows the vast underperformance of the fund over the last 12 months versus the iShares High Yield Corporate Bond ETF (NYSEARCA: HYG ), a good proxy for a high yield index. FHAIX Total Return Price data by YCharts However, to be fair, the fund’s longer term performance has been much better, as shown on the following chart: FHAIX Total Return Price data by YCharts Outlook It is likely that in the near term the worst is over for high yield bonds and the Franklin High Income fund. However, the fund’s 7.14% 30-day SEC yield is still not enough to tempt me. The fund continues to have a fair amount of exposure to the U.S. shale oil and gas industry. I am bullish on oil, but this may very well come at the expense of more bankruptcies in the U.S. shale industry. The fund continues to hold debt of coal companies Alpha Natural Resources ( OTCPK:ANRZQ ), CONSOL Energy (NYSE: CNX ), and Peabody Energy (NYSE: BTU ). I’ve done the research on coal and I remain bearish. As far as I’m concerned, you might as well subtract 1% off this fund’s yield to cover the fallout that is coming. I will give the fund an honorable mention though for holding a little over 1% of the portfolio in the 2022 debt of Fortescue Metals, a company whose debt I have touted several times on Seeking Alpha. The one advantage that this fund and the high yield universe, in general, currently has is that interest rates have yet to rise. There is less rollover risk for companies having to refinance their debt. Because of this, I would not be surprised to see high yield bonds stage a comeback in the short term. Strategic Positioning My view is that we are entering the latter stages of the economic cycle and high yield bonds have already felt the tremors of more trouble to come. At present, I prefer to hold U.S. equities-namely small caps where valuations have recently come down quite a bit-over high yield debt and also a lot of cash. Nevertheless, if the fund’s high yield is too much for you to pass up, given that short term rates are near zero, I would limit exposure to no more than 5% of your entire 401(k). Investing Disclosure 401(k) Spotlight articles focus on the specific attributes of mutual funds that are widely available to Americans within employer provided defined contribution plans. Fund recommendations are general in nature and not geared towards any specific reader. Fund positioning should be considered as part of a comprehensive asset allocation strategy, based upon the financial situation, investment objectives, and particular needs of the investor. Readers are encouraged to obtain experienced, professional advice. Important Regulatory Disclosures I am a Registered Investment Advisor in the State of Pennsylvania. I screen electronic communications from prospective clients in other states to ensure that I do not communicate directly with any prospect in another state where I have not met the registration requirements or do not have an applicable exemption. Positive comments made regarding this article should not be construed by readers to be an endorsement of my abilities to act as an investment adviser. Scalper1 News
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