Q: What is the history of the fund?
The Wells Fargo High Yield Bond Fund was originally launched by Wachovia in 1998, but when Wachovia was acquired by Wells Fargo in 2008, Wells Fargo took it over. I began managing the fund five years ago, and in mid-2015, it was merged with another legacy fund and doubled in size.
Our holdings are primarily in below-investment grade corporate and convertible bonds, though the fund has a 10% sleeve for equities, which can provide capital appreciation in a market with limited opportunities. Also, because the fund can own both the bonds and the stock of a company, the sleeve effectively allows us to create a quasi-convertible without using derivatives or options.
Q: How have opportunities in high yield bonds evolved?
We are quite top-down and focused on applying our macro view to identify the most attractive industries; within these, we look for leading companies using fundamental analysis of their full capital structures.
For many years, high yield offered investors an outsized opportunity far beyond the risks they were taking – they basically got a 20-year free lunch. Though the high-yield market was liquid and volatile, over time returns would average out.
Now this universe has more investors and underwriters. The good news is that high yield has become an acceptable asset class, but the bad news is that those outsized opportunities due to illiquidity and volatility have diminished significantly.
Today, the main opportunity is simply being in companies that pay an above-average yield because they are below-investment grade, while avoiding capital impairments or losses through permanent erosion of value or through bankruptcies.
Q: How would you define your investment philosophy?
After 30 years of falling interest rates, high-yield bonds generally trade around their face value. The opportunities for underpriced or overpriced securities have decreased and nearly all the names are well researched and more or less priced appropriately for the risk.
In our view, the main opportunity in high yield is through establishing a risk budget for today’s market as well as for tomorrow’s – determining how much risk can be taken, on average, without capital impairment or loss.
Our philosophy has a strong industry focus. Historically, the majority of return, whether in bonds or stocks, comes from industry selection. The more highly levered a company is, the more important it is that the industry fundamentals are good; what could be a small downturn for a well-capitalized company could be fatal for a levered second-tier company.
Q: What is your investment strategy and process?
Our approach begins top-down, looking at factors like where we are in the economic cycle, whether the economy is expanding or contracting, and whether we are in a period of stable spreads versus U.S. Treasuries.
We anticipate positive conditions in the high-yield market. The Federal Reserve is committed to providing liquidity and not doing anything unexpected, and we see at least modest economic growth with signs that under the new administration there may actually be acceleration – so growth of 2.0% to 2.5% instead of 1.5% to 2.0%. I believe this will be favorable for medium quality bonds, meaning single B-rated, and expect bankruptcies to stay at a fairly low rate.
In the light of these macro factors, we next determine which industries have good fundamentals – or if they are cyclical, with fundamentals on the upswing – and we concentrate investments there, using bottom-up fundamental research to identify attractive companies with leadership positions.
A distinguishing part of our strategy is having a 10% sleeve for equities. This allows us to add value, giving exposure to industries where there may not be good high-yield alternatives or where the risk/reward may not be as favorable.
Not only does the sleeve provide an important avenue for capital appreciation, being able to own both the bonds and the stock of a company in effect creates a quasi-convertible without derivatives or options.
Finally, the equity sleeve also provides a source of liquidity. Having 10% of the portfolio in highly liquid common equities that can be sold for a low commission rate – a few cents a share – is our first line of defense should there be a financial crisis.
Q: What is your research process and how do you look for opportunities?
The analysis performed for a high-yield bond candidate is no different than what is done for equities. We look at the company’s positioning in the industry. Does it have a reason to exist? Does it have unique distinguishing points? Is it stable to improving? Is the industry cycle stable to improving?
In high-yield investing, good operating results are the only real safeguard. If a company does well, it may be upgraded or acquired by another company, so our fundamental research on it and its position in the industry is crucial.
Looking at a company’s capital structure, particularly at the spreads between its senior and subordinated debt, shows us whether it is on a path for improving financial results. If we feel the company is likely to have a substantial improvement, we consider the subordinated. Generally, though, more senior securities provide a better risk/reward profile, especially if we expect only stable results from a company rather than improving results.
Q: Could you cite examples that illustrate your research process?
Tenneco Inc is a leading supplier of auto components. The company is a high-quality issuer, and because of our positive outlook on the sector, we bought it about six months ago. Though it is below-investment grade, we think it has a reasonable chance to be upgraded to investment grade, giving us an opportunity for capital appreciation.
Another example is Jarden Corp – now known as Newell Brands Inc – a diversified consumer products company with widely affordable and recession-resistant brands that include Coleman campers, Wilson baseball equipment, and Mr. Coffee. In addition to its diverse product range, the company had done a good job making relatively modest-size acquisitions which were virtually always cash-flow positive and contributed to growth.
We owned Jarden bonds and stock; it was one of our quasi-convertible holdings. About six months ago it had a takeover bid from Newell Brands (formerly Newell Rubbermaid) and the bonds went from below-investment grade to investment grade. We ended up benefiting in three ways: from the higher price on both the bonds and the stock, and from the upgrade of the bonds.
Q: How do you construct the portfolio?
In constructing an equity portfolio, it would be reasonable to view the top 10 holdings of an index as companies that in some way represent their place in the economy. Doing this in high yield gives a different picture, however.
The top high-yield companies may not actually be leaders or have cash flow – they may simply be taking advantage of the markets being wide open, and issuing a lot of paper. For instance, Sprint Communications Inc and Valeant Pharmaceuticals Intl Inc are two of the largest issuers in the high-yield market, which is quite different from the equity ranking of either company.
So, we do not hug a benchmark, though we seek to outperform the BofA Merrill Lynch U.S. High Yield Master II Index, a standard high-yield bond index.
Instead, we identify attractive industries and use a more absolute weighting for our bond investments, letting industry weightings on the equity side be our guide. We believe equity indexes are better indicators of economic activity than high-yield markets, and look to the S&P 500 Index or Russell 1000 Index to remain diversified through the economy. Generally, the portfolio is limited to 18% in any broad sector or 15% in a narrow slice of that sector, and no more than 5% in any issuer.
Also, the high-yield market can have a harmful pro-cyclical bias which overweights the most recently admitted sectors, distorting risk. When credit conditions are easy, in particular, these high-yield entrants include marginal issuers or sectors, meaning weightings increase precisely at the time that reducing exposure to a sector should be considered.
For example, when a large number of shale companies came into the high-yield market, they virtually doubled the energy weighting of the portfolio from 8% to 17%. An indexer would feel this was a safe strategy. However, these were negative cash-flow businesses selling a commodity product, and none had a long operating history – so, not a good way to reduce risk in our opinion.
Our portfolio is more concentrated than many high-yield funds, with about 120 line items and approximately 85 issuers. This focus allows us to fully research names and have a high level of confidence in their industries. Also, being over-diversified would make it difficult to respond to changing market conditions, as trying to buy or sell hundreds of securities is extremely costly.
Q: What drives your sell discipline?
Two things drive sell decisions. It is an easy decision to sell when we lose confidence in a management team and are disappointed in how they conduct operations. That happened with Valeant, which was our largest holding until 2012. It went from being a modest serial acquirer of smaller-sized companies to becoming an acquisition machine and we had questions about the company’s accounting, pricing, and research investment. We began to scale out of it and sold our last bond at premium to par in January 2015, well ahead of all the bad news.
Secondly, we sell when the macro factors of an industry are changing, as they did in energy several years ago. At the time, we had a good commitment to a lot companies in the shale energy and oil service sectors. When the crack in oil from $100 began to appear more permanent, we started to sell out toward the end of 2014 into 2015. Things were down, but it turns out it was not too late to sell. When that sector collapsed we had basically zero exposures.
Q: How do you define and manage risk?
We rely on our risk management team which provides monthly analysis of exposure and where the risk budget is.
More generally, we do not think the high-yield market favors those who take high risks, so the best strategy is to avoid risk in the first place and look at companies that have a good position, positive cash flow, and enough equity to get out of trouble should they need it. We stay away from deteriorating names especially now that liquidity in the high-yield market is much more limited than before.
By taking a modest risk, we can achieve a modest return that exceeds the risk-free rate, and we supplement that with our 10% equity sleeve by using our industry focus.
