Online Extra: This High-Yield Fund Skirts Risk
Alex Lock isn't afraid to be different. The 45-year-old co-manager of the $125 million Westcore Flexible Income Fund owns an eclectic portfolio of junk bonds, preferred stocks, convertible bonds, and even real estate investment trusts. By scouring the entire investment universe for securities with high yields, he has been able to deliver an above-average 10.7% five-year annualized return with less downside risk than his peers in the high-yield bond fund group.
As a result, his fund has received an A category rating on BusinessWeek's Mutual Fund Scoreboard. As President of Denver Investment Advisors, the 20-year money management veteran oversees some $2.7 billion in bond assets and $7 billion overall. Lock recently chatted by phone from his Denver office with BusinessWeek personal finance writer Lewis Braham. Edited excerpts of their conversation follow:
Q: Tell me about Westcore's investment strategy. A:
Q: Tell me about Westcore's investment strategy.
A:Many funds in the high-yield universe focus on short-term trading in risky credits rather than looking for solid, stable companies that offer attractive yields over the long term. We tend to look at each investment over the projected life of that security, whether it be 3, 5, 10, or 30 years, and only invest if we are comfortable holding to maturity.
Our strategy allows us to look at many areas of the market that produce income. This means we look not only at the high-yield debt market but also investment-grade debt, preferred stock, and even income-generating equities.
Q: Where are you finding the best opportunities today? A:
Q: Where are you finding the best opportunities today?
A:Right now the best opportunity may be in the auto makers. The bonds of GM (GM ) and Ford (F ) are both rated investment-grade yet are currently yielding more than most high-yield credits and offer significant opportunity for capital appreciation in an improving economy.
We like GM's floating-rate notes maturing in December of 2014. This bond pays a coupon that floats off of three-month LIBOR [London Interbank Offered Rate] + 2.20%, virtually eliminating interest rate risk and paying more in interest now (4.56%) than the 10-year U.S. Treasury note. We also own several other GM issues and preferred stocks.
We also like hospital management company Tenet Healthcare's (THC ) bonds maturing in July of 2014. We have owned Tenet on and off for the past 10 years, buying it when the credit is having difficulties and selling when it gets overvalued. Tenet has had a spate of problems lately, but the debt offers an attractive yield right now of 8.40% and strong asset coverage if the company's turnaround is not successful.
Q: How do you control risk? A:
Q: How do you control risk?
A:Due to our long-term emphasis, we don't worry too much about quarterly or even yearly volatility. We firmly believe that a lumpy 15% return is better than a smooth 10%. We think any investment -- whether it's in bonds or equities -- should be made with a long time horizon and should focus on the underlying fundamentals of the business.
In bonds especially, the downside risk is loss due to default and poor asset coverage. We spend the vast majority of our time evaluating each credit's business, assets, and management to attempt to mitigate any losses in the event of credit deterioration.
Q: What's your outlook for 2005? A:
Q: What's your outlook for 2005?
A:We believe that this recovery will continue to drag on slowly over the next few years and that interest rates will rise, but not in a quick, 1994-type correction. We think rates will stay within a tight range but will trend higher overall.
That said, it doesn't make sense to invest heavily in short-term bonds because you're still giving up too much in yield. Yield is by far the largest driver of fixed-income total returns over long periods of time. Our exposure to interest rates is modest, the portfolio's duration is around 4.25 years, and we would expect to remain there for the foreseeable future.
On the credit side, defaults ended 2004 at 2.2% of bonds issued, and we expect that level to continue in the near term. There will always be another bout of euphoria like we saw in the high yield market of the late 1990s, early 2000s where companies that shouldn't be accessing the capital markets will. Until that happens, we think many companies have significantly improved their balance sheets and taken advantage of low nominal borrowing rates and should be able to avoid defaulting over the near term.