Being Picky about Junk
With the junk-bond market reeling from blowups in the telecommunications and cable sectors, it's no wonder that Kent Gasaway, manager of Buffalo High Yield Fund (BUFHX ) is picky about his portfolio holdings. Instead of buying higher-yielding distressed bonds, Gasaway sticks to issues with higher-credit ratings. The fund's average credit quality is B+, although Gasaway says it's getting closer to BB.
Gasaway says the fund has avoided many of the defaults in the telecommunications area. He currently favors debt of travel, gaming, cyclical, and small-pharmaceutical companies. The problem now, though, is finding enough quality bonds, he says. Plus, many of the better-quality securities have already moved higher. But he figures that as the economy recovers, there should be more opportunities among the higher-rated junk bonds.
One of Gasaway's remedies is convertible-bond holdings, which now make up about 20% of the fund. On top of a 6% to 7% gain from his core positions, Gasaway believes he can get an additional 2% rise from convertibles.
Gasaway's focus on quality has helped his fund earn a 5-STARS rank from Standard & Poor's. But his performance has recently taken a hit, primarily from his holding in Kmart (KM ). For the three-year period through May, the Buffalo fund was one of the top-performing high-yield offerings, gaining an annualized 5.0%, vs. a 0.8% loss for its peers. More recently, the fund was up 1.3% for the one-year period through May, vs. a 0.4% decline for its peers.
Bill Gerdes of Standard & Poor's Fund Advisor recently spoke with Gasaway about his investing strategy, top holdings, and portfolio moves. Edited excerpts from their conversation follow:
Q: What's your approach to high-yield bonds? A:
Q: What's your approach to high-yield bonds?
A:We follow a two-pronged strategy of core holdings with strong long-term trends and additional holdings in more cyclical industries. We would like to fill the portfolio with bonds with good prospects, but many industries are healthy and don't have a lot of debt. About 60% of the portfolio is in core long-term holdings, and the rest is in cyclical areas we aren't necessarily married to after they reach their peaks.
Q: Is your approach primarily top down? A:
Q: Is your approach primarily top down?
A:That's where it starts. Our top-down approach is a little different, since we focus on trends in industries rather than the direction of interest rates. Right now, we're following 18 trends for the next three to five years in a number of industries.
Q: What are some of those trends? A:
Q: What are some of those trends?
A:One is demographics, where we're focusing on the sweet spot of the growing population -- the 45-to-65 age group. That segment will grow three times as fast as the overall population, and since they have more discretionary income, they'll boost the travel, gaming, and hotel sectors. In "debt land," we own a lot of hotels, casinos, and cruise lines.
Q: Those areas have been growing for some time. A:
Q: Those areas have been growing for some time.
A:The gaming industry is traditionally a debt-financed industry, but it has been deleveraging and paying down debt as it matures. Gaming is getting to the point where it's self-funding, but it's in the early stages, so there has been a lot of debt financing. Some gaming subsectors are new, like riverboat gaming, so there are opportunities.
Q: What other trends are you following? A:
Q: What other trends are you following?
A:The pharmaceutical area is also benefiting from demographic trends, but the larger players don't issue much debt. We own some smaller, specialty pharmaceutical players, but not a lot since there aren't very many.
Q: What are some of your cyclical plays? A:
Q: What are some of your cyclical plays?
A:Our cyclical holdings have underlying trends causing the industries to grow faster than the GDP. In this area, we've been selling energy bonds since oil prices are high, and buying homebuilders, automakers, and auto suppliers, like Cummins Inc. (CUM ).
Q: What kinds of returns do you aim for? A:
Q: What kinds of returns do you aim for?
A:We're in the middle of the pack, probably with above-average yield. We don't look for the highest yield, since that can come back to bite you if you're always on the edge. We typically have above-average yield, solid cash flow, and a little of an equity kicker from convertibles.
Q: Would you call your approach conservative? A:
Q: Would you call your approach conservative?
A:It's more conservative in that we've been moving toward higher quality instead of only looking for yield. We've taken the higher road. Ultimately, people will judge you by total return. In the end, if you have a lower default rate, you have a better credit history.
Q: Have you had problems with defaults? A:
Q: Have you had problems with defaults?
A:Do you know a high-yield bond fund that hasn't had a default? We've been fortunate in that we largely avoided the telecom debacle.
Q: What is your average credit quality? A:
Q: What is your average credit quality?
A:It's still B+, although it's getting close to BB. Our credit quality has been getting higher as the high-yield market has moved toward a two-tier structure. The recession has divided the high-yield market into bonds returning around 8% or lower, and distressed bonds, with not much middle ground in between. You can make a lot of money with some distressed issues, but others will go bankrupt.
When the economy gets better and interest rates go up, there will be more issues of traditional higher yielding bonds, so we may get more opportunities.
Q: Will you sacrifice some gains as a result of focusing on higher quality issues? A:
Q: Will you sacrifice some gains as a result of focusing on higher quality issues?
A:If I put all our money into industries we like long term, I'm going to have a lot of investment-grade bonds. That's a dilemma. We've been able to find a number of high-yield issues in industries we like for the long term, such as hotels and gaming.
Q: As a bond investor, what's your view of the recent accounting scandals? A:
Q: As a bond investor, what's your view of the recent accounting scandals?
A:It certainly makes you step back and try to understand companies better. Everyone has learned a lot from this. For example, if a healthy CEO resigns for no reason, you try to figure out what really happened. Companies will find ways to commit fraud, and you'll never know until after the fact. We watch the stock market closely because it can sometimes tell you things sooner about companies.
Q: Sometimes, the stock market is slow about realizing things, though. A:
Q: Sometimes, the stock market is slow about realizing things, though.
A:You're right. It goes both ways. Sometimes, the bond market finds out quicker. Often, higher quality companies in growing industries are less likely to misrepresent themselves.
Q: Your fund is less volatile than many other high-yield funds. A:
Q: Your fund is less volatile than many other high-yield funds.
A:Our convertible holdings -- currently about 20% of the fund -- help keep volatility down. Convertibles tend to have a higher correlation with the equity market than the rest of the high-yield market does.
Q: Why do you hold convertible bonds? A:
Q: Why do you hold convertible bonds?
A:Convertibles help us to offset defaults. For every default we've had, we've had a convertible bond that has gone up 50% or more.
Q: Is that why you did well last year? A:
Q: Is that why you did well last year?
A:We had relatively few defaults, and some good convertibles offset the few defaults we did have. It was pretty much an income year, where we earned 8%, and made 3% on top of that from good convertibles. Also interest rates didn't fall last year, so our higher quality bonds did better.
Q: Your returns this year have been good, but not great. A:
Q: Your returns this year have been good, but not great.
A:It has been so-so this year. Our reasonably large position in Kmart -- about 1.5% of the fund -- has hurt us, but we think it's ultimately going to recover.
Q: How do you think the fund will do this year? A:
Q: How do you think the fund will do this year?
A:I expect we'll outperform, but we won't be one of the biggest beneficiaries of the improvement in distressed bonds, because we don't think they justify the risks. I'm not sure about the whole market, but assuming no defaults, we'll get 6% to 7% from income and an additional 2% gain from our convertible holdings. Convertible bonds should move up nicely with a better stock market in the second half of the year.
Q: It's often said that the high-yield market does better in an economic recovery. A:
Q: It's often said that the high-yield market does better in an economic recovery.
A:I think it will be different this time because of high yield's move toward a two-tier market. A lot of the good credit bonds have already moved up, and as credit quality improves, spreads in the high-yield market will probably tighten.