Q: What is the history and objective of the fund?
Prudential Investments launched the Prudential High Yield Fund in 1979, more than 30 years ago, and it currently has about $2.5 billion in assets (as of 8/31/2012). The Fund seeks to maximize current income by investing primarily in high-yield bonds rated below investment grade. Capital growth is a secondary goal. While the Fund invests in a diversified portfolio of high yield securities in a wide range of sectors and maturities, we do not actively invest in stocks, preferred stocks, or convertibles.
Q: What core beliefs drive your investment philosophy?
The main tenet of our philosophy is research-based security selection. We believe that actively managed high yield bond portfolios, built from the bottom up using research-based subsector and security selection, can lead to solid returns over the long run. Our focus is on identifying strong, improving credits with attractive yields, and on minimizing downside risk.
Q: Would you describe your investment strategy?
We follow a relatively pure high yield approach that emphasizes fundamental research, diversification, and relative-value based security selection, the Fund’s key source of alpha. We do not take extremely large positions in a single issuer or industry, and we do not hold a significant portion of the Fund in securities other than US high yield bonds, such as common stocks, government bonds, or emerging markets. Although we have some non-U.S. companies in the Fund, all of the bonds are denominated in U.S. dollars. At times, we may invest a small portion of the Fund in bank loans when we believe they offer superior relative value. Generally, any non-high yield exposure in the Fund would be less than 10% of assets. From a quality perspective, the Fund looks for opportunities across the high yield spectrum on a name-by-name basis – from ‘crossover bonds’ that may be candidates for a rating upgrade to investment grade to the lowest-rated issues. Given our focus on downside protection, the Fund tends to have an up-in-quality bias. During periods when we do not believe CCC-rated bonds offer sufficient yield given their risk, we often hold an underweight relative to the market indices.
Q: How is your research team organized?
We have a large Global Leveraged Finance Research Team that is organized to cover the full capital structure of each company’s debt. Our portfolio managers and analysts are closely aligned by industry/sector and together make joint recommendations. In total, 12 portfolio managers and 28 credit analysts are dedicated to the global leveraged finance platform.
Q: What is your credit research process?
We have a proprietary research process that continually evaluates the value proposition of securities in the marketplace. Our analysts begin by screening the entire universe of high yield issuers and eliminating those with poor asset quality, financial measures, liquidity, and management teams, among other factors. They also review each layer of an issuer's capital structure to identify bonds with strong covenant protection and trading liquidity. The outcome is a smaller universe of about 400 high yield bond issuers that receive intense coverage. Our analysts cover both industries and issuers and rank each by fundamental quality based on their present financial strength and future prospects. At the industry level, they evaluate key drivers such as capacity, competitive dynamics, regulatory issues, political issues, and secular changes. At the issuer level, analysts assign a proprietary credit rating and fundamentally rank each issue by analyzing revenue trends, profitability, market position, tenure and quality of management, capital commitments relative to leverage, and debt service requirements. We spend a lot of time understanding each issuer’s business strategy and model, looking at each bond’s asset quality and protection, and importantly, at liquidity. We focus on companies that can generate liquidity in times of stress to fund interest payments, maturing bonds, and required cash outflows. As part of our research efforts, we frequently meet one-on-one with management teams and host new issue roadshows in our offices Portfolio managers also participate in the research process. They analyze the same industries and issuers from a portfolio management perspective, contributing information on trading patterns and liquidity. Together, the portfolio manager and analyst rank each issuer by relative value. The ranking process highlights bonds that we believe offer the best risk-adjusted returns. It also helps guide how we size positions in the portfolio.
Q: Could you cite an example to better illustrate your research process?
Back in 2008/2009, during the last recession, we had a position in MGM Resorts International, the largest casino operator on the Las Vegas Strip. The bond was scheduled to mature in June 2009, but early in the year it was trading at a 40% discount to its maturity value because the market was concerned it might not be able to repay its principal. We felt MGM was a good company with high quality asset value whose business was suffering due to the recession. More importantly, MGM had the ability to use different levers to generate liquidity in a difficult market environment. To fund the 2009 maturity, the company issued a 13% coupon bond in early 2009 that was secured by one of its Las Vegas properties. The bond that was trading at a discount quickly rebounded and paid par when it matured in June.
Q: How do you look at the capital structure of the company?
We do a lot of capital structure and term structure analysis, which goes beyond just selecting the right company. We put a lot of emphasis on the right part of the capital structure and on the right maturity. In particular, we look at a company’s secured bank loans relative to its bonds, to assess which has the more attractive value at a particular time. In 2008, for instance, many bank loans were more attractively priced than the companies’ bonds, and also offered better structural and credit protections during a volatile market. During this period, we raised the Fund’s exposure to bank loans to more than 10%.
Q: Do you have any sector preferences?
Sector weightings are influenced by the firm’s view on the global economy and our analysts’ outlook for each industry. We tend to steer toward those with longer histories and are defensive in nature. For instance, we generally have a smaller exposure to airlines because historically the industry can be volatile and cyclical. Retail is another challenging sector in the high yield market because retailers tend to have limited assets to protect bond holders in times of stress. We have also traditionally underweighted the financial sector, where low funding costs and ready access to financial markets is critical, and therefore not a sustainable, long-term business model as a below investment grade credit. Airlines, retailers, financial companies, and restaurant operators are sectors that we tend to be wary of for structural reasons. Generally, we have a bias toward companies in more defensive sectors such as gaming, cable, healthcare, and defense.
Q: What do you like most about the tech sector?
The Fund currently has an overweight in technology companies. We are not overweighting the sector, per se; we have simply found a number of technology issues with attractive fundamentals and longer-term value. As a sector, technology is a bit more volatile because risks to the business tend to be high, with products and services changing quickly. We prefer companies more entrenched in the sector, businesses that are more stable due to a competitive advantage, sizeable market share, and/or have low levels of leverage. Many of the technology companies we like are benefiting from good secular trends.
Q: Do your internal ratings differ from credit agency ratings?
Yes. The fact that we rate our own bonds independently is a big driver for us. Our view from a credit fundamental standpoint is often different than the rating agencies, and that’s how we try to add value. Our internal ratings help us to anticipate both positive and negative credit events before others do.
Q: How do you build portfolio positions?
Our largest positions tend to be those that have high internal rankings. These may each represent about 3% of assets, on average. If a bond has a low internal ranking, we either do not buy it or we underweight it. Positions are sized based on their relative value, market liquidity, and internal risk thresholds. All portfolios, including the Fund, have a risk budget with guidelines for sector, industry, quality, and issuer diversification. At any given time, the Fund holds roughly 200 to 300 issuers.
Q: What is your sell discipline?
Our sell discipline is based on fundamental and relative value analysis. If a bond’s internal relative value ranking starts to fall, either because its fundamentals have begun to deteriorate or its valuation becomes less compelling, we reduce exposure. Unless we identify a serious credit issue, we do not necessarily sell an entire position at once, but reduce exposure gradually.
Q: What kinds of risk do you focus on and how do you manage them?
We believe by far the biggest risk in a high yield bond fund is credit risk. Monitoring credit quality and avoiding credit losses is a key focus of the team. We forecast the trajectory of each business for a couple of years out. As our analysts’ projections of future cash flows and credit statistics change, our portfolio positions can change, as well. Credit meetings are held daily with our US and European teams where we review credit trends, market news, and, importantly, news on multi-national companies that do business in both regions. We also place a heavy emphasis on managing overall portfolio risk and tracking error. The portfolio managers and a separate risk manager receive daily online risk reports for the Fund, indicating where active risk is taken relative to its risk budget. Our systems provide dozens of different views that allow us to evaluate risk in the Fund and across different portfolios. The system is fully integrated with credit research, allowing both portfolio managers and analysts to share internal ratings, issuer rankings, and credit information on the same platform. Our reports also include scenario analyses to manage actual – and gauge potential – portfolio reaction to external stress events. Moreover, we look at the total positioning of the portfolio versus the market. We may have overweights in several industries, but we make sure they are not all exposed to deep cyclical or macroeconomic trends.
