Spreads on high-yield bonds, also known as “junk” or “below investment-grade” bonds, are substantial right now as the vast majority of issues are trading at sizable discounts to their pre-market-meltdown prices. The good news is that these depressed price levels mean a market rebound could provide lots of upside.

Risk-tolerant investors interested in playing in the high-yield space will find that not all high-yield fixed-income funds are created equal. The high-yield fixed-income category contains a hodgepodge of funds with widely different characteristics, as funds need only 25% of assets under management in high-yield bonds to be eligible for inclusion. Consequently, many high-yield bond funds hold a significant amount of higher-quality (usually government or investment-grade corporate) issues.

We chose two high-yield funds for comparison. Both are Morningstar Canada fund analyst picks, but the reasons that place them among our favourites are very different. TD High-Yield Income Fund, sponsored by Toronto-based TD Asset Management Inc., is a pure play on this asset class and is aggressive by nature, while PH&N High-Yield Bond Fund, sponsored by Phillips Hager & North Investment Management Ltd. of Vancouver, has a more conservative stance that has allowed it to best its peers.

Hanif Mamdani, lead manager of the PH&N fund, begins the investment process by forming a macroeconomic view of the relative attractiveness of various industries. Mamdani and his team then look for promising companies within those industries, examining free cash flow, interest coverage and credit scenarios to gauge a bond’s risk and reward potential. They look for cheap bonds (as defined by the yield spread offered above government bonds) and will also consider other components of an issuer’s capital structures, such as preferred shares.

Similarly, Gregory Kocik and Nicholas Leach manage the TD fund by examining the industry outlook and conducting detailed issue-specific analysis. Kocik and Leach focus on industries that are either stable or improving, or ones that are in a slow decline but represent a good risk-adjusted opportunity.

The difference in geographical exposure between the two funds is pronounced: the PH&N fund has 70% of AUM invested in Canada, whereas the TD fund has more than 75% invested in the U.S. In Canada, there are relatively few high-yield issues and liquidity is limited compared with the U.S., making the U.S. a more natural place to make high-yield investments.

The hedging policies of both funds limit their foreign-currency exposure.

In the PH&N fund, all currency risk is hedged, and in the TD fund the strategic policy is to hedge about 80%, although tactical moves are permitted. This gives the TD fund some U.S. currency exposure at times; recently, it has been fully hedged.

An offshoot of these funds’ geographical exposure is their credit ratings. Because there are fewer high-yield issues in Canada than in the U.S., the Canada-focused PH&N fund typically maintains a higher average credit rating than the TD fund.

PH&N’s approach has been to focus on the highest-rated issues within the “junk” portion of the credit spectrum. In his report on the PH&N fund, Morningstar fund analyst Al Kellett points out that the fund isn’t exactly what its name implies; it’s actually a hybrid in that it invests mainly in securities rated BB and BBB. (High-yield bonds are generally considered those rated below BBB- by Standard & Poor’s Corp. or Baa3 by Moody’s Corp.) That approach should keep the fund’s volatility lower than that of its peers. Indeed, for the past five years, its standard deviation was second-lowest among 28 funds in the category.

Conversely, the TD fund is positioned more aggressively as its benchmark — 75% Merrill Lynch U.S. high-yield master II index (in US$) and 25% Merrill Lynch global high yield Canadian issuers index (C$) — is a true high-yield measure. The majority of the fund’s holdings are typically rated B or BB. The fund can also participate in distressed issues, but these comprise a small portion of the portfolio.

Credit quality plays a role in the concentration levels of the two funds. The TD fund’s holdings are more susceptible to bankruptcy, according to their credit ratings. To reduce the company-specific risk, the fund holds a greater number of issuers — it has 172 positions, vs 56 for the PH&N fund. Also important, the TD fund is broadly diversified across 30 industries, as a problem with one company tends to taint other companies in the same industry. In the case of PH&N, the fund’s portfolio can afford to be more concentrated because it maintains a higher credit rating.

@page_break@Category limitations aside, the PH&N fund has stood out against its peers. In 65 rolling three-year periods since its inception, it has outperformed the category median every time. Kellett notes that Mamdani and his team have shown an ability to limit volatility without sacrificing performance: the fund’s five-year Sharpe ratio is highest in the category by a wide margin. And recently, the fund is near the top of its category with a 1.3% gain in 2008. A bias toward shorter maturities and the decision to keep the portfolio’s credit quality at higher than average levels until opportunities emerge in mid-2009 helped relative performance.

The TD fund underperformed its category peers with a loss of 39.1% in 2008. Even when compared with a more relevant peer group of bond funds that have similar U.S. exposure and high-yield credit ratings, the TD fund’s return is still in the bottom quartile. Here, the more aggressive stance and premature optimism really hurt the TD fund. In late 2007 and early 2008, its managers thought that valuations were attractive and decreased the portfolio’s credit quality to B (highly speculative). At first this helped the fund, but when spreads really widened this past September, the fund suffered.

The PH&N fund’s relative performance is boosted by its modest expense ratio, which at 89 basis points is a full percentage point lower than the category median. This provides a marked advantage over its peers, including the TD fund, which is priced at par with the median.

High-yield bonds are riskier than most bonds, having a risk-return profile more akin to equities; they are also less influenced by interest rates. Given current yields, the market is pricing in Great Depression levels of defaults, suggesting conditions are expected to get worse. As of Dec. 31, the NASD/Bloomberg high-yield U.S. corporate bond index had an average redemption yield of more than 17%, which is extremely high.

Each of these two funds is suitable for investors, depending ontheir profiles. Risk-tolerant investors may benefit from the TD fund and more conservative investors may prefer the PH&N fund. Nevertheless, the diversification provided by high-yield bonds can complement a typical investment portfolio. So, a small degree of exposure to this asset class warrants consideration. IE



Esko Mickels is a mutual fund analyst with Morningstar Canada in Toronto.