We already own quite a bit of preferred shares issued by Annaly Capital Management (NLY), but I'm re...
The “Sleep at Night” High-Yield Strategy
03/13/2012 7:00 am EST
A high-yield bond portfolio doesn’t have to keep you awake at night worrying, says advisor and fund manager Eric Scholl of Caywood-Scholl Capital Management. He discusses a couple of US-based companies whose short-term debt issues he likes.
Eric, the name of the fund pretty much spells out the investment philosophy, but maybe you can give us some more detail about the objectives.
Eric Scholl: Sure. I’ll first start with the strategy, and the strategy is pretty simple. It’s for us to invest in a portfolio of high-quality, high-yield bonds, and bank loans, with maturities typically five years or shorter. Our target portfolio duration is between one-and-a-half and two years, and weighted-average life of between two-and-a-half and three years.
So, what we look to do is reduce the risk of longer-tail credit events, as well as rising interest rates. So, we’re investing in the front portion of the high-yield bond marketplace on the credit curve. The objective is to achieve superior risk-adjusted returns with primarily emphasis and capital preservation, followed by focus on generating current income.
Kate Stalter: A lot of individual investors get kind of nervous when they hear the term “high yield,” but what type of investors would this kind of portfolio be appropriate for?
Eric Scholl: Well, if you’re an investor in equities, you’re an investor in a lower portion of the capitalization of companies than high-yield bonds, typically, because your cap structure obviously starts with the bank loan—secured paper up top, and then soon you’re entrenched in debt below, of which high-yield bonds are a part of, and then your equities.
So, high-yield bonds, from a risk perspective, kind of fall in between an equity investment and a high-grade bond investment. Over time, a portfolio of high-yield bonds, when you look at the risk metrics versus these other asset classes, display pretty good risk-reward ratios, if you will.
Kate Stalter: Say a little something about the holdings. I was looking at the Morningstar data for the fund, and you seem to be invested internationally as well as domestically. Is that still the case?
Eric Scholl: Well, there are a few holdings that are international, but I would say that the majority are domestic holdings, and some of them are household names.
One of our larger holdings right now is MGM (MGM). Of course, MGM has properties around the globe, but particularly a large portion in Las Vegas.
Las Vegas, as we know, went through a pretty bad slump during the recession of 2008 and 2009. But they’ve been working their way back. It’s really a play on the convention business, which has really been improving in that sector of the economy.
We’ve seen MGM post numbers that have actually been pretty strong here recently, and they have a very short paper that makes a lot of sense.
Also, one of the bigger holdings in the fund is Ford Motor (F) credit, and we all know Ford Motor credit, and the autos, went through some pretty tough times. Here again, we’re capitalizing on the rebound in the auto industry, the restructuring that took place there, costs that were taken out of the business, and the increase in the ARPU [average revenue per unit], which is the number of vehicles that are being sold.
And we are on the credit side, which is the captive finance vehicle for Ford. Frankly, they are very high BB-rated credits, and we believe they are going to be upgraded to investment grade sometime in the near future.
Kate Stalter: If that occurs, would you have sell that holding?
Eric Scholl: No, because our guidelines allow us to own some investment-grade. We want to own 80% in what we’ll call low-investment grade, high-yield bonds, on the front end of the curve.
We are also allowed to own up to 20% in bank loans, cash, and investment-grade securities in that 20% bucket. So, if we still think there’s some value there, we’d hold on, but chances are, if we get the type of appreciation that we expect in those securities, we’ll be swapping them into better opportunities.
Kate Stalter: I just want to wrap up today, Eric, by asking: How do you believe that an investor should incorporate a fund such as yours within their overall equity and income portfolio?
Eric Scholl: Well, we think of the short-duration strategy as being more or less the “sleep at night” high-yield investment for those that want to gather a little bit more yield in the high-yield bond market. We have an institutional client that we’ve been managing this strategy for 13 years, and we’ve been able to capture 75% of the return of the high-yield bond market over that period of time. However, we’ve only captured 25% of the volatility or the risk.
So, this strategy is not going to give you the full return of the high-yield bond market, but actually quite a bit less risk. Again, it’s more of the “sleep at night” way to invest in high-yield securities.
I think everybody has a different profile in regard to their asset classes that they’re relying on for some income. Certainly, that’s up to their individual profile, but we see this as a nice complement to some other, more aggressive high-yield strategies, for a way to invest and gather some income with a less risky profile than the broad-based, high-yield bond market.
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