For income-starved fund investors, an alternative source of returns -- at least for a portion of their fixed-income holdings -- is the High Yield Fixed Income category. Though these funds may hold investment-grade issues, they must invest more than 25% of their portfolios in high-yield securities in order to belong to the category.
Since high-yield funds hold securities with lower credit ratings, or that are unrated, they are subject to higher default risk. Nor are there any assurances that investors, over any given time period, will be rewarded for assuming these risks. For example, in the three years ended May 31, the median annualized return in the High Yield Fixed Income category was 2.4%, compared with 3% and 4.2% respectively for Canadian Fixed Income and Global Fixed Income.
However, for investors who are willing to tolerate higher risk in return for potentially higher returns, high-yield funds can play a role. Here are three funds that Morningstar's manager research team have analysed, including the only two that have received better than Neutral ratings.
Manulife Strategic Income Advisor
Expense ratio: 2.00%
Morningstar analyst rating: Silver
This fund, which has a global mandate, invests primarily in U.S. high-yield and investment-grade corporate bonds, domestic government securities and foreign government bonds. Lead manager Dan Janis and his team at Manulife Asset Management (U.S.) LLC also invest in residential and commercial mortgage-backed securities, bank loans and convertible bonds. The team looks for sectors it finds attractive and selects individual securities by employing a relative value analysis.
The fund's allocation to high-yield securities is usually in the 30% to 50% range, held mostly in U.S. bonds. To reduce credit risk, the managers try to limit individual holdings to less than 1.5%. The weighted average credit rating of the fund's holdings is single A, one of the highest in the category.
Though the managers invest in emerging markets, they tend to avoid the riskiest and most illiquid markets, such as Russia, Ukraine and the Middle East. The team has a currency-management strategy in place to lessen the impact of currency fluctuations.
The managers made a good call in the first half of 2014 when they sold energy and mining bonds and shifted into more defensive sectors like pharma and health care. When commodity prices dropped, they avoided some losses as bonds in cyclical industries declined.
"This fund is a good choice for those comfortable with its risks and sometimes bold positioning for a core holding," says Morningstar analyst Achilleas Taxildaris. Although the fees aren't a bargain, he says the fund has an experienced team and a proven process.
PH&N High Yield Bond D
Expense ratio: 0.87%
Morningstar analyst rating: Silver
The management team, led by Hanif Mamdani, takes a contrarian approach and seeks to invest in bonds trading below their historical valuations. The team evaluates credit metrics to measure the current period of the credit cycle. It allocates more of the portfolio to high-yield bonds when the market sentiment is negative, and more to investment-grade bonds and cash when sentiment is bullish. The team also examines different industries to find securities that appear to be inexpensive.
Mamdani, who is the head of alternative investments for RBC Global Asset Management Inc., likes to allocate the largest weightings to bonds he believes are the best combination of quality and low valuations. He also has a portion dedicated to securities that the market dislikes, in expectation that there will be an eventual reversion to the mean.
The fund invests in Canadian and U.S. bonds, with the vast majority of them being domestic. As of May 31, its top 10 holdings were all Canadian, and eight of them were issued by energy producers. Mamdani believes the selloff in the energy sector is overdone.
To offset some of the industry and issuer-concentration risk it has taken on, the fund recently held 15.5% in investment-grade bonds and 12.7% in cash. There has also been a preference for shorter maturities, with 13.4% of the holdings maturing in less than one year and 48.6% between one and five years.
Morningstar analyst Jeffrey Bunce notes that due to the fund's large size (it's currently closed to new investors), there are some additional risks. He says the fund relies heavily on Mamdani's skills and adds that he "could have a tough time repositioning the portfolio quickly and getting in and/or out of some smaller names, particularly its Canadian holdings."
CI Signature Corporate Bond
Expense ratio: 2.11%
Morningstar analyst rating: Neutral
Co-managers John Shaw and Geof Marshall of Signature Global Asset Management, a division of CI Investments Inc., seek to find the right balance between investment-grade and high-yield bonds. They're both members of Signature's asset-allocation committee, and use the committee's guidance to decide on their weighting in high-yield bonds. Although they're allowed to invest all of the assets in non-investment-grade debt, their exposure is often between 30% and 60%.
While the fund's weightings in investment-grade and high-yield bonds have varied between 30% and 70%, the high-yield exposure has stayed below 60% for the past four years because Shaw and Marshall haven't been able to find appealing opportunities. Investment-grade corporate bonds make up about 40% of the holdings, and there's a small allocation to government bonds and cash.
More than half of the fund is allocated to foreign securities, mostly U.S. corporate bonds. The team hedges between 60% and 100% of its currency exposure. Canadian bonds recently made up 46% of the portfolio, and there are smaller allocations to countries in Europe and the Caribbean.
The managers choose securities by looking at a company's financial strength and its ability to carry out its operational strategy and repay debt. They prefer market-leading companies that can increase prices while also reducing production costs.
Morningstar analyst Achilleas Taxildaris says the defensive approach taken by the fund may be attractive to some investors. But he adds that the fund's fees will "make it difficult to consistently outperform its peers."
