WHY WE LOVE HIGH YIELD CORPORATE BOND FUNDS

Well-managed High Yield Corporate Bond funds have historically provided excellent long-term returns and low volatility.  As a result, Sierra often uses this asset class as a core component across all of our programs.  But because there are some popular misconceptions about this asset class, we feel it’s important that clients and prospective clients get a clear overview of High Yield Corporate Bonds.  This reprint from Sierra’s Update newsletter reviews how HYCB funds behave, the strategic benefits to you, and why Defensive Timing^SM makes these bond funds even less volatile.

HYCB Funds Have Long-Term Returns Disproportionately Higher Than Their Risk:

High-Yield Corporate Bonds (HYCB’s) are IOU’s of companies who are too new or too debt-heavy to qualify for “investment grade” ratings (AAA, AA, A or BBB from Standard and Poor’s, for example).  In effect, investment-grade bonds are judged to have a low risk of default (inability to pay each installment of interest when due), whereas HYCB’s are judged to be more risky as to the potential for future default – hence the term “junk bonds.”

As a result of this characterization, HYCB issuers must pay a higher interest rate (thus, “high yield”), to compensate bondholders for the higher perceived risk of default.  The difference in yield (interest rate) paid on HYCB’s compared to Treasury bonds with the same due date is called the HYCB “yield spread”.

Over the past ten years the yield on HYCB’s has averaged about 10%, while the yield on comparable Treasuries (which have zero default risk) has averaged about 6%.  So HYCB bondholders are being paid about 4% per year, on average, in extra interest to compensate them for the perceived risk of default.

Over the past 50 years, however, HYCB’s have always substantially over-compensated for the actual impact of defaults.  And by diversifying a HYCB portfolio among 60-100 different bond issuers, a large portfolio manager can assure that the portfolio as a whole will not suffer significantly if one company defaults without warning.

HYCB funds pay very generous dividend yields for every month you are “in” these funds.  Because these high yields overcompensate for default impact, HYCB funds have a long-term history of providing much better returns than CD’s, Treasuries or money-markets funds (see table comparing average annual returns on final page).

Some HYCB Fund Managers Add Extra Value:

The HYCB arena is one where a “skillful” portfolio manager can really add value, in two ways:  First, finding the gold among the dross — bonds of companies whose fundamentals are likely to improve, resulting in an upgrade in rating and an increase in bond value.  Second, after buying each high yield corporate bond, a skillful manager keeps close track of the issuing company, dumping the bond quickly from the fund if any sign of deterioration occurs.

Out of over 100 HYCB mutual funds, Sierra selects those managers whose quarterly results provide evidence of skill — the ability to deliver better returns than the average manager most of the time, without extra volatility.

The HYCB fund managers we use for Sierra clients have experienced an actual default impact of less than 1% per year on average — while collecting a “yield spread” averaging over 4% per year to compensate for defaults.  This is a good deal!

WHY HYCB FunDS LOOK ATTRACTIVE FOR 2002 AND BEYOND

The High Yield Corporate Bond market is very good at anticipating changes in the economy – sort of an early-warning barometer.  The HYCB market tends to turn down months in advance of a recession, and to bottom out and turn up well before the economy shows tangible signs of recovery.  And the HYCB sector tends to trend very well, both in up markets and down markets.

As shown in the chart below, in the three years overlapping and following the 1990-1991 recession, the HYCB sector (illustrated here by Northeast Investors Trust) actually performed better than the S&P 500 stock index each year for three years!  And with much less volatility.  (It is also worth remarking that 1991 constituted the worst year in 40 years for corporate bond defaults – but the best year in 40 years for Total Return in the HYCB sector!)

In the current cycle, as the U.S. economy levels out and begins to recover from recession, we expect a similar or even longer period of excellent recovery and very satisfying returns in the best-managed HYCB funds.

Why Timing “Works”, AND LIMITS DOWNSIDE RISK, for HYCB Funds:

HYCB mutual funds are notoriously easy to “time.”  Not only are they less volatile than stock funds, they are actually less volatile than Treasury bond funds.

Over the past fifty years, there have been about twenty significant declining episodes in the HYCB sector.  But because the HYCB sector always changes direction rather slowly (see Northeast Investors Trust graph below), each significant decline starts out as a mild decline – giving a professional timer plenty of opportunity to react (to “duck” temporarily into money-market) before the HYCB decline becomes painful.

Down arrows indicate when Sierra implements a "sell" signal, and up arrows indicate where a fund had risen enough to give the next "buy" signal.

This “Queen Mary” turning radius which characterizes the HYCB sector is why Sierra’s HYCB timing technique has always allowed us to move 100% into money-market before the fund is off its high by more than 3% — and sometimes we are “out” less than 1.5% off the high day.

For the HYCB portion of your Sierra account, your downside risk is never greater than 3% — true even during the 1987 global crash.  In other words, because of Sierra’s daily monitoring and Defensive Timing^sm, 97% of your HYCB fund assets are unaffected by “market risk” – downward swings due to global crisis, economic problems, etc.

Not every Sierra “sell” signal is productive – some turn out to be false alarms – but every single one protects your account from any adverse impact should the initial mild decline continue or worsen.  Thus, our “sell” discipline serves as a rather close safety net, limiting your downside risk at all times, and delivering peace of mind so that you will remain comfortable having a portion of your investment assets participate in this productive asset class for many years. 

As a recent example, in 1998 most HYCB funds ended the year with a loss, whereas Sierra’s Defensive Timing side-stepped most of the 14% decline (see graph above) and resulted in a profit of about 8% for the year. 

Look at the HYCB table and compare other unproductive “buy-and-hold” years for Kemper High Yield with the “timed” result for those years.  Then study the average annual return for the different columns to see how Defensive Timing can enhance returns over the long term.

On those occasions when a decline in the HYCB market persists for several months (as in 1998, see the above graph), we buy back in at prices significantly lower than we sold, so that you end up owning more fund shares than the buy-and-hold investor.  Although these opportunities to enhance return through timing do not occur every year, over the longer term they result in higher returns than the buy-and-hold approach.