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Ivy High Income Continues to Face Challenges

Instability in the management team and an overly voracious risk appetite result in a Negative Analyst Rating for this high-yield fund.

Sumit Desai, CFA, 08/21/2016

Ivy High Income's Negative Morningstar Analyst Rating reflects the challenges this team has had since management changes in 2014. Though the team has shown some signs of stability since then, it still needs to show it can control the portfolio's voracious appetite for risk through a full credit cycle.

Portfolio manager Chad Gunther took over here in July 2014 after parent company Waddell & Reed fired previous manager William Nelson for reasons unrelated to his portfolio management responsibilities. Nelson's departure marked the fund's second management change in less than a year. Nelson had run the fund since November 2013 after Bryan Krug left for a similar role at Artisan Partners. Krug had managed this fund since early 2006 with much success. Gunther has been an analyst with Waddell & Reed since 2003 and was named an assistant portfolio manager in 2008, so his appointment provides some continuity to the fund's process.

This fund has historically courted significant credit risk, but Gunther appears to have turned the dial up even further since taking over. Bonds rated CCC or lower made up an already-high 30% of fund assets in March 2014, before Gunther took over, but skyrocketed to 44% as of June 30, 2016, compared with only 13% for the fund's BofAML US High Yield Master II benchmark. Gunther argues that many of his CCC positions yield less than the average CCC bond in the fund's benchmark. That said, the fund's overall 12-month yield still ranked as one of the highest in the high-yield bond Morningstar Category as of June 30, suggesting the fund does take considerable credit risk compared with its peers.

These bets have yet to pay off. Since Gunther took over through July 2016, the fund's 0.4% annualized decline ranked in the bottom 30% of the category, which returned a positive 0.3% during that time frame, on average. The fund's approach can also create challenges around liquidity management. This was evident over the past few years as this fund faced large outflows and appears to have had difficulty in managing those flows without impacting portfolio composition.

Process Pillar: Negative | Sumit Desai, CFA 08/09/2016 
The team's approach tends to take significant credit risk, even compared with most high-yield bond funds. The fund's Negative Process Pillar rating reflects the team's struggles to manage this risk.

Lead manager Chad Gunther and team steer the portfolio to take on significant credit risk while minimizing interest-rate exposure. The team invests across the capital structure, including sizable bank-loan stakes, which also helps to reduce the portfolio's interest-rate sensitivity. The team is benchmark-agnostic and will often deviate significantly from the market by typically underweighting the top 30 issuers in the benchmark (the BofAML High Yield Master II index) while seeking opportunity in smaller and lower-rated issuers. Gunther believes that ratings agencies can be slow to reflect changes in underlying businesses, which leads this portfolio to often carry oversize stakes in lower-quality B and CCC rated holdings. The team will occasionally make concentrated bets (2% to 3%) on high-conviction names but aims to keep the portfolio's top-10 issuer concentration between 15% and 20% of total assets.

The focus on lower-quality and smaller issuers can create challenges with liquidity management. This was especially evident over the past few years as this fund faced large outflows and appears to have had some difficulty in managing those flows without impacting portfolio composition.

The portfolio stands out for its outsize stake in CCC bonds, which stood at 44% as of June 30, 2016, compared with just over 13% for the fund’s BofAML US High Yield Master II benchmark. The exposure to CCC bonds skyrocketed from just under 30% in early 2014 to 48% by mid-2015. Manager Chad Gunther argues that many of his CCC positions yield less than the average CCC bond in the fund's benchmark. That said, the fund's overall 12-month yield still ranks as one of the highest in the high-yield bond category as of June 30, suggesting the fund does have considerable credit risk compared with peers. Gunther and team offset this CCC stake with a large underweighting to BB names, at 15% compared with 49% for the index.

Sumit Desai, CFA is a senior stock analyst with Morningstar.

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