Ivy Beats Blackrock-Pimco Revealing Flaw: Riskless Return

Bryan Krug, a 35-year-old junk-bond fund manager at Ivy Investment Management Co., is beating peers at Pacific Investment Management Co. and BlackRock Inc. (BLK) with higher returns and less volatility by ignoring ratings companies.

Krug’s $5.7 billion Ivy High Income Fund (WHIAX) rose 9.8 percent in the past five years after adjusting for price swings, the best among 27 junk bond funds holding more than $2 billion in assets, according to the BLOOMBERG RISKLESS RETURN RANKING. Krug beat rivals including those from the world’s two biggest bond firms, Pimco and BlackRock.

Krug won by favoring the education and technology industries and holding 28 percent of his fund in bank loans, which can reduce volatility and risk. He benefited from holding lower-rated bonds when he disagreed with the views of ratings companies such as Standard & Poor’s and Moody’s Investors Service. Debt with S&P’s CCC rating, deemed “currently vulnerable to nonpayment” by the rating company, beat all other non-investment grade bonds in the portfolio this year, according to data compiled by Bloomberg.

“In our view the credit-rating agencies do a poor job,” Krug, who has run the fund since 2006, said in an interview. “I think their methodology is flawed.”

Debt Ratings

Ivy High Income holds more low-rated debt than its peers, according to data compiled by Bloomberg. The fund had 27 percent of its assets in debt with a CCC rating from S&P, almost triple that of the SPDR Barclays Capital High Yield Bond ETF (JNK), which tracks an index of liquid high-yield bond securities.

The fund holds more than half of its assets in debt rated B, or five levels below investment grade, compared with about 46 percent for the SPDR ETF, the data show. Of BB rated debt, which is two levels below investment grade, the Ivy fund holds only 9.2 percent, compared with 38 percent for the SPDR fund, according to data compiled by Bloomberg.

High-yield, high-risk bonds are rated below BBB- by S&P and lower than Baa3 by Moody’s. Krug says the lower credit ratings don’t mean that his fund is riskier.

“You are assuming that credit rating agencies are good at measuring risk,” he wrote in an e-mail.

U.S. speculative-grade companies are in the best position ever to meet debt obligations as Moody’s said Aug. 1 that its Speculative-Grade Liquidity-Stress index, which falls as corporations’ ability to manage cash improves, dropped to a record low in July. That index fell to 3.1 percent in July, beating the previous record low of 3.3 percent in May.

CCC Outperforms

Debt rated CCC in Krug’s fund has advanced 10.8 percent this year, compared with the 10.6 percent return for B rated debt in the portfolio and the 9.7 percent gain for debt with a BB rating, according to data compiled by Bloomberg.

Junk bonds have been buoyed by rising corporate earnings and record low interest rates since the 2008 financial crisis, which have made it possible for even lower-quality borrowers to refinance their debt, said Jack Ablin, chief investment officer at Harris Private Bank in Chicago, where he helps oversee $60 billion. High-yield bonds returned 9.2 percent a year in the five years ended Aug. 13, outstripping the gains on other corporate bonds and Treasuries, according to Bank of America Merrill Lynch indexes.

The risk-adjusted return, which isn’t annualized, is calculated by dividing total return by volatility, or the degree of daily price variation, giving a measure of income per unit of risk. A higher volatility means the price of an asset can swing dramatically in a short period, increasing the potential for unexpected losses.

Pimco, BlackRock

Ivy High Income returned 60 percent in the five years ended Aug. 13 before adjusting for volatility. It ranked 13th out of 27 funds in volatility over that period. Over the past year, the fund had the best risk-adjusted return with the third-lowest swings.

The $2.5 billion Columbia Income Opportunities Fund (AIOAX) produced a total return of 54 percent over the period with below-average volatility, for a risk adjusted gain of 9.5 percent, the second-best in the ranking. The $2.4 billion Prudential High Yield Fund, ranked third with a risk-adjusted gain of 9.4 percent.

The $18.5 billion Pimco High Yield Fund (PHDAX) advanced 45 percent over the past five years, according to data compiled by Bloomberg. The fund has a risk-adjusted return over that period of 6.2 percent, ranking 21st in the ranking. The fund’s volatility is the third-highest in the group.

The $8.4 billion BlackRock High Yield Portfolio (BHYIX) has climbed 52 percent over the past five years. On a risk-adjusted basis, the fund ranks 10th, with a volatility that is ninth-highest in the group.

Down Markets

Krug beat a majority of his peers in six of the last seven calendar years. In 2008, he lost 20 percent compared with 26 percent for the average high-yield fund, by avoiding cyclical industries, including autos, Krug wrote in a regulatory filing in 2009.

“The manager has done well in down markets,” Ronald Sugameli, chief investment officer of Wellesley, Massachusetts- based Weston Financial Group Inc. said in a telephone interview. Sugameli, who has a stake in Krug’s fund, helps oversee $1.7 billion for wealthy clients.

Krug has been pessimistic about the U.S. economy because he anticipates it will take time to work off the debt burden weighing on households and the government. That outlook has influenced his choice of investments.

Slower Growth

“It’s hard to get too excited about cyclical industries when you expect 1.5 percent GDP growth,” he said. Economists surveyed by Bloomberg predict the U.S. will expand 2.1 percent this year.

Industries favored by Krug such as telecom and technology outperformed all high-yield bonds this year, according to Bank of America Merrill Lynch indexes. High-yield bonds issued by technology companies rose 11 percent this year, compared with a 9.8 percent increase for junk bonds through Aug. 13, according to the data.

Krug has boosted leveraged loans to 28 percent of the fund, up from 17 percent two years ago, regulatory filings show. Leveraged loans or bank loans, typically five- to seven-year loans made to companies with below investment grade debt, provide a fixed spread over a benchmark, usually the London interbank offered rate.

Bank loans tend to be less volatile than bonds, Michael Weilheimer, director of high-yield investment at Boston-based Eaton Vance Corp. (EV) said in a telephone interview, because they are higher up in the capital structure. In the event of a default, loan investors typically suffer smaller losses than their high-yield bond counterparts, he said.

Laureate Stake

Bonds issued by education companies are another favorite for Krug. Two of his top 10 holdings as of June 30 were bonds issued by Laureate Education Inc., a Baltimore, Maryland-based provider of college education. The two bonds represented 4.8 percent of Ivy High Income, according to the fund’s website.

The company, which is privately-held, hired Morgan Stanley and Barclays Plc to manage an initial public offering, a person familiar with the plans said in April. Most of Laureate’s students are outside the U.S., where for-profit colleges face less competition, Krug said.

Because Laureate isn’t a public company, he said, relatively few people pay attention to it, creating opportunities for investors like himself to exploit.

“When Apple reports earnings, 50 people have a take on the numbers,” said Krug. “With these under-followed holdings, you don’t have that.”

Laureate’s bonds are rated B by S&P, which has a stable outlook on the bonds, according to data compiled by Bloomberg.

Mispriced Securities

Krug avoids making predictions on the overall direction of the high-yield market, preferring instead to focus on individual securities he regards as mispriced.

In 2007, he began buying debt issued by Dollar General Corp., a Goodlettsville, Tennessee-based discount retailer. Moody’s had rated the company’s senior subordinated notes Caa2 at the time, the fourth-lowest step on its risk scale.

The rating, said Krug, didn’t accurately reflect the company’s strength. Dollar General, he said, was already improving its operations and stood to benefit in a weakening economy in which consumers would gravitate toward sellers of low-priced goods.

Events supported Krug’s confidence. The company’s bonds rallied in September 2008 after Dollar General reported a profitable second quarter on a 10 percent jump in same-store sales. Moody’s raised its rating on the company’s senior subordinated notes twice in 2009, once in March and again in December, data compiled by Bloomberg show.

‘Fantastic’ Result

“The trade was over by the time of the upgrade,” Krug said. “If you had waited for the rating agency you would have missed a fantastic result.”

One of the securities Krug owned, the 11.875 percent senior subordinated note due in July 2017, returned more than 50 percent between April 1, 2008, the first time it appeared in Ivy’s portfolio, and Dec. 17, 2009, the date of the second upgrade, according to data compiled by Bloomberg.

Krug has been scouting for opportunities in Europe. Over time, he said, regulatory pressure will force loans and debts off bank balance sheets into the capital markets.

“Europe could be interesting to watch,” he said. “They just haven’t felt enough pain yet.”

To contact the reporter on this story: Charles Stein in Boston at cstein@bloomberg.net

To contact the editor responsible for this story: Christian Baumgaertel at cbaumgaertel@bloomberg.net

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