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Bryan Krug
Portfolio Manager
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Ivy High Income Fund - June 2010
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The uncertainties surrounding sovereign debt and the European banking system have escalated perceptibly in recent weeks, impacting markets. How has this affected your management of the Fund?
Like all risk-based assets, the non investment-grade market has seen pressure due to the sovereign debt crisis in Europe. Going into the downturn we were defensively positioned and there was still demand, albeit at lower prices, for our bonds and loans that were higher quality. With the selloff we have started to dip down and have opportunistically found very good value in assets other investors were forced to sell because they did not maintain adequate liquidity. As we’ve discussed in the past, we like to be providers of liquidity, rather than being forced to demand liquidity from markets during volatile periods. It is our goal to be opportunistic and take advantage of volatile markets.
The other Fund characteristic that is important to note is its flexibility. Ivy High Income Fund’s mandate allows it to own all types of debt and to modify percentage weightings within the portfolio at our discretion and based on market events. The Fund can own any fixed-income security, from cash to floating rate bank loans to high-yield bonds, depending on which we feel is most advantageous at a given time. That can be a tremendous advantage, particularly in periods of heightened volatility.
How is the Fund positioned?
In late 2008 and early 2009 we moved more aggressively into relatively riskier assets. For the past six to nine months, we were actively participating in a new-issue environment, one in which we were able move up in quality in the capital structure. During that time period we sought to own better-quality names, and in many cases also made the choice to move up in the capital structure and into bank debt. The lower-quality part of the market rallied aggressively in the last few quarters of 2009 and into 2010 but we did not chase performance because we felt valuations were stressed. With the correction in May this decision was validated.
How could a financial crisis, such as the one facing Europe, affect the Fund?
Although we have a flexible mandate, the Fund does not own any sovereign debt. The Fund holds primarily non investment-grade assets, which includes Senior Secured bank debt as well as high-yield bonds. Fundamentally, we continue to believe we have will have a benign default rate in the non investment-grade market for the balance of 2010 and at least the first half of 2011. Within the portfolio, we stress-test the financial models of all our issuers and we believe they will remain cash-flow positive and that financial covenants are not an issue. Immediate refinancing need for most of our issuers is minimal, so if the credit markets do shut down for an extended period of time, we do not anticipate default risk. That is the fundamental risk to the Fund.
In the worst-case scenario, if another major financial institution were to declare bankruptcy, we could see parts of revolving credit lines not honored like they were with Lehman. Companies in the market have revolvers for liquidity and broadly syndicate the risk.
From a near-term trading perspective, all risk assets have varying degrees of correlation and valuations are negatively affected by a financial crisis such as the one facing Europe. In this environment, the selloff has been fairly logical, with spreads for both investment-grade and non investment-grade assets widening and equities selling off. The magnitude we have seen also makes sense because the riskiest assets—equities—have sold off more compared with more conservative assets such as credit. Risk-free assets—treasury bonds—have surged in price.
Are you increasing exposure to bank debt/floating rate?
When we make investment decisions we have no preconceived notions about where we will go within the capital structure of a company. We are not box driven. We look across the cap structure to find what we think are the most attractive opportunities available from each issuer and we are totally agnostic if it’s bonds, bank debt/floating rate or convertible securities. It’s really a deal-by-deal decision.
We have increased the Fund’s exposure to bank/floating rate; it’s now 20 percent of the Fund because we think we have found very good value there. That market has very interesting dynamics because its buyer base is primarily structured-product driven and the market is very ratings sensitive, and that creates technical factors that we believe create opportunities.
If we were to characterize our approach in general, it would be that we probably take a little more risk on the bank side where we are higher in the capital structure with strong collateral packages, which reduces our loss potential in an unforeseen scenario. On the unsecured bond side we tend to be a little more conservative.
There are some who see the “high yield & bank debt trade” getting a little long in the tooth. Do you think they are materially underestimating how much risk still exists in the equity market?
Like any other investment, you can’t look at it in isolation. Investment grade bonds, equities and commodities have all had robust recoveries. There is not one risk based asset that has not participated in the recovery of the capital markets.
The outlook really depends on how bullish or bearish you are about economic growth, the amount of liquidity in the system and investor sentiment. If you think we have a robust recovery with abundant liquidity, I would expect see multiple expansion and better relative performance in equities than we would in a credit product. If you expect growth to be slow, credit products will provide very competitive performance with a much lower degree of volatility. The successes of our investments in our portfolio are not predicated on top-line growth and/or margin expansion to satisfy debt obligations. If you are more pessimistic on the outlook and you see a double dip, historically you have seen materially greater volatility and deeper losses in equities than in credit products.
There’s a perception that you really have to have the timing right in below-investment-grade credit, but that’s inaccurate according to Zephyr StyleADVISOR. In the last 27 years, there have been four negative years for high yield, and one negative year in the past 10 years when the loan market has been an institutional product. The worst draw down, looking at just the indexes, was in 2008 for both high yield and loans, and prior to that the worst draw down on the Merrill Lynch U.S. High Yield Masters Index was 5 percent. High yield spreads currently are 725, with the average historical spread at 525, so valuations are not stretched.
What about defaults?
Since we started talking about the opportunity in the non investment-grade space more than a year ago, it has been one of the best-performing asset classes despite the fact that 10 percent of the market restructured. With respect to the Fund, less than 1 percent has defaulted. Total losses from defaults were around $1 million. We ended the year at $1.1 billion in assets under management.
As a function of the restructuring, the Merrill Lynch U.S. High Yield Masters Index naturally evolves to higher quality. In the cycle, the weakest companies have been eliminated and “Fallen Angels” (bonds that were once investment grade but have since been reduced to junk bond status) have been added to the index. At this point in the cycle, expectations are for 2 percent default rates in both 2010 and 2011. Those estimates are consistent across Wall Street strategists. Spreads compensate investors for default risk. If the default rate is 2 percent as projected and losses from defaults are 60 percent on average (40 percent recover rate), mathematically a pure high yield fund would have a 1.2 percent loss due to credit losses. Ivy High Income Fund is not a pure high-yield fund.
So who’s buying your fund?
It’s been an interesting evolution. Eighteen months ago the marginal buyer was a tactical investor. Those investors played a trade and now they are gone. Right now it’s really two distinct camps. One group is using the product as a substitute for equities because their clients don’t want the volatility, and/or they believe the equity market is overvalued but they need to take some risk to achieve returns for their clients. A second group is using the Fund to enhance their income because the market is currently yield starved. The income substitute is a bigger portion. The view is traditional Treasury investments and investment-grade assets have had massive tailwinds for the last 20plus years as interest rates have come down. With a 10-year Treasury at 3.25 percent, it’s likely there will be headwinds with rates going higher and with a low coupon it’s very possible to have negative returns going forward in these types of fixed-income investments.
The investment grade index is also very tight and the correlation of Treasuries is extremely high, so investors are also getting concerned about losses in investment-grade assets due to treasury sensitivity. The coupon may not provide positive returns for investors if the value of principal goes down.
There is a lot of discussion about how $450 billion poured into bond funds last year. Only $30 billion of that went into high yield, which is not that much. Loans were under $10 billion. The bulk of the money went into investment-grade products and Treasury products. We believe we will see the allocation to non investment grade increase over time.
What about the buyer base of the market now?
Collectively, the high-yield and loan market are over $2 trillion. These markets are very large and the retail buyer base is only 20 percent of the high-yield market and less than 10 percent of the bank debt market. Insurance companies and pension plans are both more than 20 percent each of the buyer base of the high-yield market. Those investors are increasing allocations because they are having funding problems due to low yields in other fixed-income alternatives and funding requirements due to demographic needs. With demographics what they are and the need for yield and returns, it’s hard to see demand waning. The bank debt market is a bigger wild card because of the structured product market being impaired. It’s less clear what the demand picture will look like for that market.
The opinions expressed are those of the Fund managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through June 1, 2010, and are subject to change due to market conditions or other factors. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise. Investing in high-income securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Holdings information is not intended to represent any past or future investment recommendations. Holdings and allocations can and do change frequently. Past performance is not a guarantee of future results.
The Merrill Lynch High Yield Master is an unmanaged index used as a general measure of market performance consisting of fixed-rate, coupon-bearing bonds with an outstanding par which is greater than or equal to $50 million, a maturity range greater than or equal to one year and must be less than BBB/Baa3 rated but not in default. Investing in an index is not possible.