Q:  What are your core beliefs in money management? What are the major benefits and pitfalls of high yield investing? A : We have the same investment philosophy across all our products and, for us, high yield is just a subset of the equity world. We believe that the long-term trend of the economy and the markets is upward, despite the volatility. We expect the markets to be very dynamic, with high degrees of volatility and business success or failure. That volatility, however, presents opportunities for us. Sometimes it may look like chaos, but that’s just part of the capitalist system. So, the flip side of the volatility is opportunity, which we aim to take advantage of. Second, we believe that you cannot manage returns; you can only manage risk. That’s why we focus on risk management and protection against loss of principal. We don’t try to time the markets and we believe that you need to be fully invested at all times. As the environment changes, we just adjust the risk/reward of the products. In terms of our high yield investments, we believe that the real value added often comes from avoiding the disasters, and you need to be defensive. An important differentiator is that we focus on the higher quality part of the high yield market. We don’t invest in distressed paper and we avoid triple C rated bonds. We participate in all the levels of the capital structure and we tend to prefer the higher quality. Q:  What is the unique proposition of high yield investing? What do the other market segments fail to deliver? A : It is the ability to participate in the emerging growth companies with less volatility. If you buy the equity, potentially you can lose all the principal, while many high yield names provide additional seniority and payoff potential. Along the way, you are getting paid. Even if a situation doesn’t work out over 10 years, it may work out successfully over five years. In general, the high yield market provides a way to play the growth side of the economy with less risk than the equity. Q:  Would you explain what you mean by lower risks? How do you define risk? A : I define the risk in high yield relative to the alternative which, in many cases, is the equity. If you invest in a company, you can choose between its debt or its equity. Often the high yield issuers only have below investment grade paper or equity to purchase. Compared to the issuer’s equity, the high yield can provide much lower risk, less volatility, and higher consistency of returns because of the yield component. You are a senior holder relative to an equity holder, and that makes the position a lower-risk position. Of course, in comparison with government bonds, high yield is a more volatile and risky segment. Q:  How has the high yield market changed in the last two years? What has been the effect of the turbulence in the credit markets? A : Obviously, the high yield market has changed quite a bit as the credit markets are in turmoil. Among the major changes, the spreads have widened out. I don’t think that we have hit a bottom yet, although we are getting paid more than a couple of years ago. When the spreads were tighter, we didn’t feel that we were getting paid for the risks, and we utilized more convertibles, more synthetics and structured products. Now there is much better opportunity and we are definitely increasing our exposure to high yield. Also, the market has a bimodal distribution of yield. Many securities yield between 7% and 9%, typically those of companies in good shape. On the other hand, if there is any hint of a problem, the yields go to 12% to 16%, and there isn’t much in between those two types of companies. That’s quite an unusual distribution. Another major change is that liquidity has definitely deteriorated, and that’s a function of several factors. There are capital constraints on many large firms and the trading desks have reduced their commitment to this marketplace. So, liquidity is harder to come by than it was two years ago. The issuance cycle isn’t what it was, and the access to capital has definitely gotten more difficult and costly. Q:  Could you describe your research process? A : There are two different ways we evaluate securities. First, we do an analysis of the new issues or the new candidates. That analysis is similar to the analysis we do for equities or convertibles. It is about understanding the business valuation, and a reversion to the median return on capital that the company can generate. In that process, we look at the cash flow of the company, the sustainability of that cash flow projected over twenty years, and then discounted back. The cash flow analysis drives our business valuation. We also assess the quality, the flexibility, and the sustainability of the balance sheet to come up with an intrinsic value for the business. In that process, we evaluate the attractiveness of the capital structure. We actually look at all the debt in the capital structure and the equity. At any point in time, we may own the senior paper, the subordinate paper, or the equity in the same company. For example, several years ago, we owned Nextel through the entire capital structure—the senior paper, the subordinate paper, the convertible, and the equity. We wanted everything. On the other hand, in ADF Corp. We were concerned about the equity, but we found the senior paper attractive. So, we do business valuation and assessment of the cash flows because, ultimately, that’s how the company will pay off its debt, and also because the generated cash flow is the value of the business. As a result, our databases are filled with companies that we have evaluated and updated for years. To build a high yield portfolio, we filter our database according to certain criteria. We filter out all the distressed credits and any situations with a high probability of bankruptcy. The models also score for liquidity and quality of the balance sheet. In other words, we filter out the companies for which credit momentum is weakening. Then we look very closely at which sector or industry we want to participate in and we may filter out a few industries or sectors. The next step is applying additional credit models on the likelihood of credit rating improvement or downgrade. Then we rank these opportunities on a relative basis in terms of yields and potential total return. Finally, we analyze the selection from a portfolio construction standpoint. The important considerations are how well the individual name fits the portfolio and how much inherent risk is there relative to the positioning of the portfolio. Q:  Regarding portfolio construction, what are your views on diversification, exposure limits, and risk control? A : Risk management is crucial in this space and it is our major focus. As I noted earlier, we believe that you can’t manage the returns; you can only manage the risks. That’s especially true in the high yield space because here you are dealing with balance sheets that are often questionable, or at least vulnerable. To manage the risks, we maintain at least 100 different positions. Our maximum exposure to one credit is no more than 5% but, typically, it is much lower than that. We keep our industry exposure to less 15%, so we maintain significant diversification. We are aware of the high correlation among many industries and sectors, and being diversified is especially important when the economy weakens. Another strategy is to minimize the presence of distressed credits in the portfolio. We focus on the changes that occur and the access to capital of the companies. That’s a call both on the economy and the individual companies. We monitor the changes in their balance sheets and we also apply liquidity models. From a total construction standpoint, we establish a perspective on where the good opportunities may be over the next 12 to 24 months. We tend to overweight the industries and sectors that we like the most as we maintain a focus on the opportunities and the risks out there. However, the high yield space is not that straightforward under a top-down approach. We can spot a certain industry or sector, but we won’t invest if the opportunities aren’t there or if the risks are too high. Unlike other market segments, the high yield market has too many special situations that have to be evaluated separately. You may want to overweight consumer discretionary, but when you analyze the individual names, you may conclude that you don’t want to own any of them. Even if it is the right space to be, it may not be the right space in the high yield sector. So, it is really a special situation market. Q:  Does the faltering economy put additional pressure on research of special situations? A : Yes, the economy is an important factor that you have to account for. Regardless of what people say, when you determine the sustainability of the cash flow of a business, the economy has a big impact. Our approach is to build a margin of safety, or to make sure that the company doesn’t need to access capital over the next three years. Regarding the research, many of the names that we own are names that we also own in our equity or convertible products. We are very familiar with the companies and the industries, and we have 50 people in the research department to cover everything. The key is to make a distinction between a fundamental change and noise. From a macro perspective, we have avoided the home building, the mortgage, and most of the financial companies. We have been very defensive and that has helped to avoid many problems, but we still have exposure to the auto sector, for example. The major question is whether a downturn in those sectors would drag the rest of the economy down, and which companies will falter. Overall, it may sound as if following 50, 75, or 100 companies is a lot, but we know the portfolio and the names well; we have followed them for many years; and we are comfortable adjusting to the changes. Q:  Do you use any benchmarks? Would you describe your product as an absolute return fund or as a relative return fund? A : The proper benchmark is the Credit Suisse High Yield Index. However, we also use convertibles and synthetics, so we don’t strictly adhere to an index. If clients select us to manage separate accounts, we’ll adjust to what they’re trying to accomplish. I think that the product should be viewed as a relative return fund because high yield is not an absolute return field. It’s awfully hard to generate absolute return there. But we manage the fund looking for total return, which means that we may give up 100 basis points in yield because we believe that the upside potential is additional 300 basis points. The convertibles would be a great example of that strategy. I would make the tradeoff of giving up yield for the same downside risk and three times the upside potential. Q:  What are the major difficulties for generating alpha in the high yield space? A : It is difficult to consistently deliver alpha in any area, but the high yield is a very competitive space where you need to play a lot of defense. Moreover, there are many smart people evaluating the same situations. We look for the ability to deliver alpha in a couple different ways. First, the security selection is important. Then, we add alpha through our sector and industry rotation. We sometimes use other fixed income securities, such as convertibles, emerging market debt, or bank loans to give us an edge over the competition. One of the benefits of the high yield market is that there’s a lot of indexing going on. And if you’re not indexing, you can find individual opportunities that are overlooked, or issues that are bought just because they’re big in the index and the pricing doesn’t make any sense. In our fund, we are not forced to follow an index, so we are more opportunistic.