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Avoiding Mistakes in High Yields

Oct 24, 2011

Wells Fargo Advantage High Yield Bond Fund

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Q:  Can you briefly explain the advantages of investing in a high yield bond fund? A : High yield bond market is about $1 trillion in size and there are over 2,000 bonds from over 1,000 issuers. Historically, investors have been compensated quite well, especially on a risk-adjusted basis in high yield and have gotten equity-like returns with about half the volatility of equity. The asset class has been very effective in compensating investors for what could be deemed as less liquid issues or dealing with securities that have a higher probability of going default. Moreover, the risk-reward is attractive. So, we think for investors who are looking for a relatively stable income, especially in periods of low default rates, this is very attractive relative to alternatives. Q:  What core beliefs drive your investment philosophy? A : Our approach is that managing risk, first and foremost is the way we want to achieve the promised yield as possible. Our focus is on understanding the intrinsic value of a company and then buying the debt of that company at a price where we feel we have downside protection even in the event of something going wrong with that company. We look to avoid mistakes, minimize volatility and losses from price depreciation and capture the attractive coupon payments. To us, it really doesn’t matter whether or not a company goes bankrupt but what the recovery in a bankruptcy is. Q:  What is your investment strategy? A : We have a very diligent bottom-up process. We grind through the balance sheets, understand the cash flow of each company and model that in good times and bad times to ensure that we get current pay. But, basically, what we are doing is attempting to understand and create an intrinsic valuation of the company. For us, as bondholders it is important to understand where we are in the capital structure and in the priority of payments in the event of bankruptcy. It is all focused on minimizing risk and making sure we are invested in companies that pay us back. But on the flip side, the mistakes we can make in high yield are really to become too concerned with macro forces and trying to time liquidity. We operate under the assumption that liquidity in the market can dry up at any time and don’t want to be beholden to positive macro forces in order for us to continue to be paid back. We want to be invested in companies that are going to be fine through the entire cycle and still get paid back. Q:  How does high yield perform through different cycles? A : High yield has gone through periods of stress. In the 2001/2002 period, there were issuers borrowing money specifically to build out their infrastructure, a very risky type of borrowing because from an investor’s standpoint, it is not necessarily investing in current cash flow generating projects but essentially doing venture lending to companies. We recall many of those telecoms and utility companies that borrowed significantly to build out their infrastructure. They simply were not able to grow into their capital structure and many of them went through restructuring or bankruptcy. So investors were hit quite hard by investing in those types of securities. In the 2008 downturn, high yield was a victim of outside forces and also overleveraging at the private equity level, too many aggressive deals were structured and high yield experienced significant volatility, much of it driven by forced selling of investors who had margin calls as prices fell. Q:  What analytical steps involve your research process? A : Our research process is bottom-up driven where our research analysts are segmented by sector. At least at a cursory level, our analysts are familiar with virtually every issuer within their sector. We expect the analysts to identify on a relative value basis what they feel is the most attractive risk-adjusted opportunity within their sector. Here, they are trying to develop a continual list of companies that we scrub through our research process to identify the risks. We are less concerned about identifying a perfect company. We are more concerned about understanding what the risk is and then making sure we are getting compensated for that risk. Our process is designed to put a company through the process and identify the risk. We have a 23 point checklist that we use early on in the process that is designed to identify the most likely reason or reasons why something will go wrong with this company, maybe it has too much debt or has a convoluted capital structure, maybe it doesn’t generate free cash flow in a downside scenario, whatever the case may be, what we want to do is identify the potential problem upfront, dig into it deeper and make sure that we are going to be compensated appropriately for that risk before we invested in it. The various steps in our process is number one, we go through the 23-point checklist. After we have identified those potential issues early on, we dig in deeper to understand if there is the appropriate compensation for it. The second step is our due diligence process. At this point, the analyst will tap into their industry contacts. They will call customers and suppliers of the company. We like to verify what management tells us and what we hear from management. We like to understand what the company does and the competitive nature of the market that the company is involved in. The third step is to go through our committee process. The analyst will bring to us their idea and I, the other portfolio manager, Philip Susser and Sean Lynch, the Head of Research sit down in a committee format with the analyst. We tend to just challenge the thesis or work that has been done, more often than not, the analyst has to come back with answers to questions we have raised in the process. The final step in the process is if we feel that at that point we really understand the risk associated with the issuer it then becomes an investable name for us. It is a comprehensive approach to get into the portfolio. All designed to weed out unnecessary risk upfront. The idea is that we then have a portfolio of names where we have eliminated much of the uncompensated risk early on. An important ongoing step in the investment process is the monitoring process designed to make sure we are managing the risk as we go forward. Q:  Would you expand a few key points in the 23-point checklist? A : One of the points in the checklist is, is the company growing twice as much as its industry. We don’t necessarily think it is a terrible thing if a company is growing fast but it does raise a couple of questions that we need to dig in deeper to understand. Why are they growing that much faster? Is there some sort of accounting irregularity that is going on here? Are they growing that fast because they continue borrowing money to acquire other companies or are they a type of company that needs to continue to borrow money to finance growing ventures. That is not necessarily a reason why we don’t want to be involved in it. But in fast growing companies, the value of growth goes to equity holders. We, as bondholders, don’t get any benefit from fast growing companies. Since we are being exposed to risks that we are not being compensated for we need to understand better what we are being exposed to with a fast growing company like that. The first thing we need to do is check on off-balance sheet accounting. The other point on the checklist is no significant off-balance sheet liabilities. It is just a key reminder to dig deeper when we look at the balance sheet. Another point on our checklist is if free cash flow is positive. We believe that the most effective way to pay back debt is to generate free cash flow rather than rely on market liquidity to continually refinance and roll over existing debt. We model a company’s ability to generate cash in both good and bad times to understand what the company’s ability looks like to pay us bondholders back; even in downside scenarios. The other thing that is unique from our checklist standpoint is, is a company independent and not managed or controlled or influenced by a financial sponsor or investment banker or management consultant. Many deals in high yield are from leveraged buyouts where the original management has been replaced by a management team. We tend to be very skeptical of those situations. We like to be invested in companies where the operators have been there for a long time and feel that they do a better job of understanding the marketplace or the business. Understanding asset coverage, especially in a downside scenario is another point in the checklist. We assess if there is a secondary source of protection such as hard-asset coverage. We do a full valuation of the hard assets. What that means is that we tend to be biased against retail and service companies and other companies in general that do not have hard assets. Historically, we have been heavily invested in companies that are issuers that have real estate or plant and equipment that are a basis of asset protection in an event of a bankruptcy. Q:  Can you share examples that illustrate your research process? A : In the 2001-2002 periods, when high yield went through an extremely difficult scenario, we avoided those companies that were borrowing excessively and were focused more on issuers where the operations were stable and there was real estate backing up the value of that. A classic example of that would be the Las Vegas gaming companies. They did not have too much debt, were stable companies and the real estate more than covered the market value of debt in our opinion at that time. However, we were not the only ones to recognize that. Over the next few years much of that real estate was stripped out through leveraged buyout transactions and issuers were left with highly leveraged operating businesses with little to not assets. That has created a very different risk/reward proposition for us bond investors. That is an industry that’s changed dramatically and because it changed, one of our favorite sectors that had served us extremely well in a downturn became one of our least favored sectors. The telecom or utility companies that we had avoided in the 2001/2002 period look very different now. They have gone through their restructuring, don’t have nearly as much debt as they used to have and are very stable. Our allocation as a result has flipped from heavily real estate backed type of companies to more stable revenue and intrinsic value type of companies like the telecoms and healthcare and utilities nowadays. Q:  How do you build your portfolio? A : Our core holdings will be 125 to 150 issuers and our historical turnover is usually between 40% and 50%. The reasons we keep the turnover low is first, we set up a very high hurdle before we get involved in any company, and second, we believe strongly that transaction costs are quite significant in high yield. So, minimizing unnecessary turnover is a good way to protect the investors from transaction costs. Otherwise, the portfolio construction process is very much bottom-up driven. We don’t care about the benchmark or the index. We think managing risks to the benchmark is going to expose us to risk that we don’t want to get exposed to. We look to the benchmark or index as a valuable source of information for relative value and investment opportunities. We build the portfolio on a bottom-up basis. Each security should be attractive on its own. We then set guidelines to ensure that we manage risk from a diversification standpoint. We monitor the exposure across the different quality spectrums and sector exposures to ensure that the bottom-up process doesn’t become myopic and over concentrated in any one area. We do not take interest rate or duration bets. We select where we want to be in the capital structure of a company on a one-by-one basis when building the portfolio. But we make sure of a cap exposure of 3% for a single issuer and not exceed 15% in a given industry. Our average maturity is between 5 years and 7 years and average bond quality is B+ or B or higher. We have largely avoided airline bonds. Historically they have been a very bad place for investors with an extremely low return on invested capital, are exposed to very competitive forces and cyclicality in terms of the cost that they are exposed to. Similarly, we tend to be biased against service and retail companies. There is not much intrinsic value in retailers as they can easily be replaced by somebody else should they go under. Q:  What risks do you focus on? How do you measure and manage risks? A : We measure risk at multiple levels. We avoid getting involved in issues where we are exposed to risks that we didn’t anticipate. That is the first level. The second level of measuring risk is our monitoring process. We have a systematic approach to monitoring wherein each analyst writes a quarterly write-up for each credit that we are involved in that gets filed. We have our own internal rating. We don’t necessarily care what they are rated by the ratings agencies. In addition to our bankruptcy rating, we also have a recovery rating. We analyze what we think the recovery would be like in the event of a bankruptcy. We are very focused on making sure we get compensated for that downside risk and the probability of it occurring. That is all on a bottom-up basis. When we do the top-down risk management, we make sure the portfolio is diversified across sectors and the sector, maturity and the quality allocation matches our macro views. Philip Susser, the co-portfolio manager, and I discuss on a regular basis what is going on on a macro basis and ensure the portfolio matches those views. . As far as quantifying risk, we don’t measure it on a tracking error basis or relative to the benchmark. We do track it by assessing the volatility in the issue. Understanding the price level is very important in understanding risk, so we tend to be very contrarian. When things look really good and the yields get very low, the inclination for most investors is to stretch for yield because that tends to be the way to outperform in the near term. We go the opposite direction. The higher yields get and lower prices get, we feel that actually reduces our downside risk exposure. In good times and yields get lower, we tend to move up in quality and down in yield because we don’t know when the economy is going to turn the other way and liquidity will dry up. High prices, even though times may be good, increases downside risk and when markets turn, that risk can be quite significant. In terms of managing risk, we are much more focused on absolute risk and being compensated on an absolute or individual basis.

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