Q: What is the history and mission of the fund?

In 1999, USAA launched the fund as the USAA High Yield Opportunities Fund. However, having “high yield” in its name meant the SEC required the fund have 80 percent of investments in below-investment grade debt. Because we often find attractive high-yield investments in investment-grade credits, the fund was later renamed and now better reflects our primary objective of providing high current income. 

Today, the USAA High Income Fund is a total return fund with primarily high yield investments; about 75 percent of assets are in non-investment grade corporate bonds. The remaining 25 percent is what makes it different from its peers. There we find fixed-income opportunities in areas like high-yielding investment-grade bonds, hybrids, equities, bank loans, commercial mortgage-backed securities (CMBS), and even municipal bonds. 

Q: What core principles guide your investment philosophy and process?

We believe yield-focused portfolios generate attractive total return and will outperform peers in the long term. 

There is nothing top-down about our portfolio. It does not have interest rate or economic calls in it, but instead is built bond-by-bond through fundamental bottom-up analysis. What we are looking for are strong stories which will pay us with yield – meaning individual securities having an attractive total return over their holding period.

Ideas can be brought forward by portfolio management, traders, or analysts, and are then sent to our credit research team for vetting. While that takes place, the rest of us examine relative value with each role taking a different perspective.

Our portfolio managers view relative value by comparing different investments. For example, should we buy a BB-rated energy company at six percent or a CCC packaging company at five percent? Traders seek relative value among the different bonds in the market for a certain company. Our analysts then look for value within that company’s balance sheet and determine if it is preferable to buy loans, equity, or preferred stock. 

Q: Can you cite an example that illustrates your investment process?

One outcome of our philosophy is that we typically end up buying the best companies in weak industries and the riskiest companies in strong industries. 

For example, an analyst came to us last year with a large, investment-grade copper company that had fallen in value. It was beaten down by low copper prices, and mid last year, the spread widened, followed by a market selloff. 

At that point, it was yielding as much as high-yield securities, but the story behind its fundamentals was still positive. The company had world-class assets rarely seen in the high-yield universe. It had free cash flow and its management team was doing everything possible to improve the balance sheet, including taking bondholder-friendly actions like selling assets and equity to pay down debt. 

As a result, we bought a position. When spreads continued to widen and the bonds traded off even more, we stayed in because our original thesis remained intact. Our fundamental outlook suggested copper prices would improve and that number keeps getting pushed out. We believe over the next several years that copper will be a commodity with good supply and demand characteristics.

As the market started to recover, these bonds recovered as well. Because we were willing to buy an out-of-favor industry and wait until it improved, we earned roughly a 15-point price change and continued to earn interest along the way resulting in a nice total return.

Another example comes from the healthcare sector, which is seeing volatility due to the Affordable Care Act. Certain hospitals have traded off even though they will not feel a meaningful impact if it is repealed and replaced, so we find them attractive.

Q: How do you construct your portfolio and when do you decide to sell?

The portfolio is truly built bond by bond, story by story. Every day, analysts look for individual securities that have an attractive total return during their holding period. They frequently bring ideas to us when they see value in their industries, but only portfolio managers can make decisions concerning what we include in the portfolio. 

At any time, the fund has around 300 obligors, sometimes more. Because it is a ‘40 Act fund – as defined in the Investment Companies Act of 1940 – there are limits on how much we can hold in a certain obligor or industry. We voluntarily limit position sizes.

Even with these limits, and given the general decrease in fixed-income opportunities, we still find attractive bonds across many industries, in new bonds that come to market or in sectors that are out of favor.

We remain index aware of the fund’s benchmark, the Barclays US High Yield 2% Issuer Capped Bond Index. Part of our diversification process is to form an opinion on every large name in the benchmark. If something is outside the index, typically asset allocation is kept at five percent or less though there is no fixed rule that requires us to do so.

Many bonds are held until maturity. Compared to other in-house funds, the high income portfolio does more trading, but its turnover rate is still quite low – typically under 50 percent.

One of the reasons we sell is when the thesis or story changes like, for example, if the management changes drastically or something happens in the industry. On the high-yield side, sell decisions can be driven if yield becomes unattractive for the risk.

Q: How do you view risk and manage it?

We focus on credit risk and manage that through our bottom-up process. The credits held in the portfolio are constantly reviewed. We also limit risk in certain ways by having restrictions on what we invest in any given industry or how much we will do in something that is not high-yield bonds.

In this fund, we are not managing volatility. We are managing to ensure it outperforms other high-yield bond funds over the long term.