(PUB) Investing 2016

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High Yield Faces Challenges but Isn’t in Third Avenue’s Shoes Income Strategist | Sarah Bush

What are the signs of outsized credit or liquidity risk?

There are several telltale signs, such as large stakes in the lowest-quality bonds, especially if they’re concen- trated in individual names or sectors. Nonrated bonds make up only a tiny part of the market, while bonds rated CCC or below account for 13% of the Bank of America Merrill US High Yield Master II Index. Those issues can be difficult to sell in stressed mar- kets and are more susceptible to permanent capital losses. Another sign of risk is a yield that well exceeds market norms, as it can denote outsized credit or liquidity risk. Finally, shareholder concentration or volatile flows can leave a fund vulnerable to a large redemption request at a highly inopportune time, raising the risk that a manager will have to sell quickly, driving down prices in the process. What should a high-yield investor do? It is important to take a long-term perspective when investing in junk bonds. Given the sector’s higher correlation to stocks, investors should view high-yield bonds as long-term tools for income generation but not as safe-haven assets. For those uncomfortable with the sector’s risk profile, it is probably best to steer clear. Morningstar’s Christine Benz points out that many institutional asset-allocation experts skip high-yield bonds altogether and argue they don’t add anything to a portfolio that one can’t get from standard stock and bond allocations. For those who do invest in high yield, what are the key considerations? Look for well-resourced managers with proven track records who don’t reach for yield. When Morningstar analysts evaluate high-yield funds, we favor managers who have demonstrated bond-picking skills through a variety of different market environ- ments. Because success in high yield is driven in large part by security selection and avoiding permanent capital losses following defaults, the size and experi- ence of a firm’s analyst staff is also important. K Contact Sarah Bush at sarah.bush@morningstar.com

Third Avenue Management shuttered its Third Avenue Focused Credit fund in early December 2015 . That fund was atypical in that it employed a high-risk strategy focused on distressed debt, but the story definitely spooked the market. Losses across the broad- er high-yield bond Morningstar Category, however, were not severe. The average fund in the category fell 2 . 4% during December. That said, it was still a rough year overall for the junk market, with the most pain coming from energy and commodity-related sectors, which have been hit hard by a slide in oil and an economic slowdown in China. The average loss for the category was 4 . 1% for the year, while some funds suffered much more. How likely is it that other high-yield funds will follow in Third Avenue Focused Credit’s footsteps? Not likely. Most high-yield funds have far less risky portfolios thanThird Avenue Focused Credit. That fund’s large cadre of distressed names made it one of the riskiest high-yield funds around. The portfolio held a big allocation to the lowest-quality tiers of the junk market and a sizable stake in issues without ratings, and it was concentrated. As of July 2015 , close to half of the fund was in bonds rated below B and another 40% in nonrated fare. By contrast, the median allocation to below-B rated debt in the high-yield cate- gory is just 12% , and most funds hold little non- rated debt. (Firms often classify equities as nonrated, explaining the large nonrated stake reported by funds such as Silver-rated Fidelity Capital & Income FAGIX .) The Third Avenue fund was also unusually concentrated, with a 5% position in its largest name, the troubled Clear Channel Communications (now iHeartMedia IHRT ), and only around 60 positions over- all. Most high-yield funds are more diversified and focus on less risky credits.