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Small Steps

….And Many of Them, Please. IFA Magazine talks to Tom Price, Senior Portfolio Manager of the Wells Fargo US Short-Term High Yield Bond Fund

 

It might seem a little counter-intuitive to be thinking about buying into a bond fund during a year when all the signs are pointing toward rising yields and falling prices. Surely, you might suppose, the combination of the QE taper and the prospect of rising interest rates ought to have finished off what little remains of the market’s enthusiasm for debt?

But that would be to misunderstand what this particular bond fund actually does. It would also be to miss the fact that its appeal continues to grow among risk-averse investors seeking refuge from the pitifully low returns that are available from deposit accounts. That goes not just for the United States but for a large part of the continental European market too. And here’s why.

The Short-Term Strategy

Wells Fargo Asset Management has been investing in short and very short term corporate paper, ever since 1997 – offering one of the first Short-term High Yield strategies on the market. Tom Price, senior portfolio manager at the corporation’s Wisconsin offices, has been the lead manager of the strategy at the firm since 2002 – and an awful lot of turbulent water has passed under the bridge during those 11 years.

The US Short-Term High Yield Bond Fund, the UCITS version of the strategy available to UK investors, typically carries around 100 and 150 US corporate bonds, with a typical effective maturity of three years or less. Its particular interest is in BB and B rated corporate debt securities – at the end of 2013, 60% of its 110 holdings were rated BB/Ba by Standard & Poor’s, Fitch or Moody’s, with another 33% rated B and the remaining 6% rated Baa.

Please Don’t Call Them Junk

That, of course, is mainly below-investment grade, making it unsuitable for some investors – but the counterbalancing and stabilising factor is the short effective maturity of the paper in question – just 2.31 years at the end of 2013. With 23% of its holdings expected to be refinanced within a year, 40% within 1-3 years and the remaining 37% within 3-5 years, prices for these securities are getting closer to face value and their vulnerability to unexpected shocks is diminishing all the time.

As Tom Price told us, the QE taper is unlikely to impact significantly on paper this short-dated, so the resulting yield is pretty secure and resistant to volatility. The fund manager’s art is to actively manage the securities held, and to maintain a constant bottom-up scan for companies which can satisfy his team of their ability to fulfil their debt obligations while still offering attractive returns.

How can the fund managers pull off the trick of getting higher yields with lower volatility? It’s because the main rating agencies are making a generalisation, he says. “If a company has two senior bonds, and one’s a two year bond and one’s a ten year bond, they’re both getting the same rating, But [with the two year horizon] we can look with much greater certainty as to what’s going to happen, and because of that we are able to hit higher yields than the agencies’ ratings might have suggested.”

The largest part of the fund’s portfolio allocation is currently invested in consumer cyclical and non-cyclicals, communications, capital goods, basic industry and technology. Constellation Brands, Hertz, Ford, CIT and Dell are all among the fund’s top holdings, although none accounts for as much as 2% of the portfolio. “Since I became lead manager,” says Price, “not a single bond purchased has subsequently defaulted in our Short-Term High Yield strategy.”

The Returns

And so to the returns themselves. As the chart below confirms, the fund’s Class Z USD retail clean shares returned 4.16% during the year to 31st December 2013 – significantly ahead of most bank rates and almost double the 10-year Treasury yield.

 

1 month

3   months

6 months

1 year

WFAM US Short-Term High Yield Bond Fund Z USD Share Class (clean share)

0.37%

1.99%

4.17%

4.16%

BofAML 3-Month LIBOR Constant Maturity Index (GBP) +200

0.19%

0.57%

1.16%

2.33%

Source: Wells Fargo Asset Management. Total return performance as of 31 December 2013

The Clients

Why would an investor want to settle for a puny 4.16% when they could make much more in high-yielding equities? That’s the wrong question, Tom Price replied. Short-Term High-Yield isn’t just a better earner than a bank deposit – it’s also ideally suited as one side of a “yield barbell, where the other side delivers a higher return by taking more risk.

“Our guiding principle has been to say, we need to offer a differentiated product here. Let’s not worry about what the benchmarks force you into – let’s develop a lower-volatility product with higher-yield”

Who buys the funds? Primarily private investors using the adviser channel, he says, but there have also been institutions over the last couple of years. “The challenge here was to get the institution people comfortable with the lack of a good benchmark to judge our funds against. And that in turn made it hard for them to evaluate their own managers’ performances.”

The lack of a suitable benchmark can also be a problem sometimes for private investors. “We get lumped into the general high yield category by Morningstar and Lipper, and in most good credit markets that means we’re going to lag significantly and we’ll end up with low ratings. But once a financial adviser sits his client down and explains what we’re doing, it all becomes clearer. And the important thing is that we’ve performed as we indicated we would perform. That’s great for our fund, and we’re proud of what we’ve achieved.”

 

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