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Summary Spread between yield on high yield debt and U.S. Treasuries is above average. Credit loss costs on speculative grade fixed income securities have been below average for the past few years. Among junk bond funds, Lord Abbett High Yield Fund has a strong track record and an attractive portfolio. The recent underperformance of speculative grade bonds has made the asset class attractive to investors focusing on fundamentals. The chart below shows that the spread between high yield fixed income securities and 5 year U.S. Treasuries is above average. Additionally, credit loss rates have been below average for the past four years. Combining these two trends suggest high yield investors are receiving a good premium for the risk in today’s environment. U.S. High Yield Spreads and Credit Loss Rates Sources: Federal Reserve Bank of St. Louis and Merrill Lynch Macroeconomic Conditions Since the latest data on high yield credit loss rates is for 2014, it is helpful to briefly assess the macroeconomic conditions in the U.S. and determine their implications on companies with high leverage, volatile cash flows or deteriorating profitability. The U.S. economy continues to recover gradually from the Great Recession. According to the Bureau of Labor and Statistics, the unemployment rate has declined to 5.1% from a crisis era peak of 10.0% in 2009. Last month’s non-farm payroll report was below most economists’ expectations, but the general trend in jobs has been good. The economy has added 13 million jobs since 2009 including 1.6 million in 2015. GDP and corporate earnings have been volatile in 2015, but expectations are for better growth in 2016. The International Monetary Fund expects U.S. real GDP growth to improve to 2.8% in 2016. Analysts surveyed by Thomson Reuters expect earnings for the S&P 500 to increase 9% next year. Some sectors of the economy definitely have blemishes particularly industries that produce energy or depend on sales abroad. Overall, macroeconomic conditions may not be great, but they are decent and improving which should limit corporate defaults. Fund Selection After determining high yield fixed income securities are an attractive asset class, the next step is selecting the appropriate security or securities. Most retail investment accounts do not allow investors to buy high yield bonds directly. Instead, they must use mutual funds or exchange traded funds (ETFs) to gain exposure to this asset class. Even if retail investors could buy individual high yield bonds, it would still be a good idea to use mutual funds and ETFs due to the diversification they provide. Below is the criteria used to select mutual funds and ETFs for more thorough analysis. At least 75% of holdings rated BB+ or lower Mutual funds with Morningstar rating of 4 or 5 stars No load or waived Top 20% in 5 year return vs benchmark Applying this criteria identifies the following mutual funds: Fidelity Capital & Income Fund (MUTF: FAGIX ) Oppenheimer Senior Floating Rate A (MUTF: OOSAX ) Lord Abbett High Yield A (MUTF: LHYAX ) Guggenheim Floating Rate Strats A (MUTF: GIFAX ) Selecting one fund for investment will involve more subjective judgment than the process used to identify a list of viable funds. Historical performance is obviously important. Since profiting on the above average spread for high yield debt and the below average loss costs is the investment thesis, the composition of the fund’s assets is important. Exposure to interest rate risk should be examined because rates are likely to increase which negatively impacts the value of bonds. Finally, it is appropriate to compare expense ratios. Fund Performance OOSAX’s performance compares unfavorably to the other funds selected by the screen. It also performed considerably worse than Morningstar’s high yield index over longer periods. FAGIX probably demonstrated the best performance over both short and long-term periods. LHYAX has the best five year total return, but its performance in the past year trails FAGIX and GIFAX by a wide margin. GIFAX has done well recently. However, it is a relatively new fund, and its three year total return is pedestrian. Return (%) YTD 1 Year 3 Year 5 Year FAGIX 2.04 1.26 6.84 6.78 LHYAX 1.99 0.18 5.88 7.01 GIFAX 2.39 2.21 4.45 — OOSAX 0.57 -0.28 2.84 4.06 Morningstar High Yield 0.09 -2.02 3.43 5.19 Source Morningstar Credit Risk LHYAX has the most attractive credit risk profile. It has the highest yield despite having similar interest rate risk and ratings distribution as other funds. FAGIX’s lower allocation to ‘B’ and ‘CCC’ fixed income securities is a negative because the investment thesis focuses on exposure to corporate default risk. Instead of dedicating its portfolio to high yield bonds, FAGIX has allocated about 20% of its assets to equities. Although this strategy has favorably impacted FAGIX’s total return in recent years, it is not consistent with the investment thesis. OOSAX’s greater proportion of ‘B’ and ‘CCC’ securities does not translate into a higher yield because OOSAX only invests in floating rate securities. Credit Risk and Yield (click to enlarge) The table below compares each fund’s actual SEC defined yield to the expected yield based on the credit ratings distribution of its holdings and the current yield for each rating category according to Merrill Lynch. A positive difference means the fund is generating a better yield than would be expected by the ratings distribution of its assets. Oddly, the difference is negative for all the funds. This issue would be more troubling if the funds have been underperforming Monrningstar’s high yield benchmark. Instead, it likely reflects a difference between the duration of the funds’ assets and duration of the securities used to create the benchmarks. Since LHYAX and FAGIX have approximately the same duration, it is reasonable to assert that LHYAX has done a better job of selecting securities that generate a yield consistent with their ratings. It is not surprising that OOSAX and GIFAX have a negative difference because they only invest in floating rate securities which tend to have lower yields. However, the magnitude of GIFAX’s negative difference is troubling. Return (%) SEC Yield Expected Yield Difference LHYAX 5.79% 7.59% -180 FAGIX 4.21% 6.34% -213 OOSAX 4.76% 7.19% -243 GIFAX 3.55% 6.92% -337 Source: Morningstar, Federal Reserve Bank of St. Louis and Merrill Lynch Ratings Distribution (click to enlarge) Source: Morningstar Energy companies are in the midst of very challenging environment due to the collapse in oil prices. Fortunately, none of the funds being reviewed have material exposure to this sector. According to Yahoo Finance, investments in fixed income securities represent 4% of LHYAX’s assets and 2% of FAGIX’s holdings. Neither OOSAX nor GIFAX has any exposure to the energy sector. Interest Rate Risk OOSAX and GIFAX have no material exposure to interest rate risk. LHYAX and FAGIX have a moderate amount of interest rate risk. If interest rates rose by 100 basis points in a parallel shift, investors should expect these funds to decrease by 4% to 5% as a result to the increase in interest rates. The actual impact of interest rate changes is extremely difficult to predict for the following reasons. Effective Duration Maturity > 5 (%) LHYAX 4.7 80 GIFAX 0.4 66 OOSAX 0.0 49 FAGIX 4.4 84 Fees and Expenses FAGIX has a moderate expense advantage. GIFAX has a modest expense disadvantage over the other funds under consideration. All of the funds’ expense ratios are below Morningstar’s average for high yield funds of 1.08%. Net Expense Ratio (%) FAGIX 0.72 LHYAX 0.94 OOSAX 0.97 GIFAX 1.04 Source: Morningstar Conclusion LHYAX is the best vehicle for executing on the investment thesis. However, a strong case can be made for long positions in either LHYAX or FAGIX. These two funds significantly outperformed OOSAX and GIFAX over the long term. LHYAX has the best comparison between actual yield and expected yield based on ratings distribution. Finally, LHYAX has the most exposure to high yield fixed income securities which is the heart of the investment thesis. FAGIX allocates a material portion of its assets to equities. Scalper1 News
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