Fund Spy

A 5-Star Fund With a Negative Analyst Rating

Brian Moriarty

The following is our latest Fund Analyst Report for Ivy High Income (IVHIX). Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days. 

Ivy High Income remains a work in progress. Stability in the management ranks and a growing team are notable given historical concerns about turnover and staffing. However, the fund hasn't done enough to rein in its riskiest exposures. It continues to earn a Morningstar Analyst Rating of Negative.

Manager Chad Gunther took the helm here in July 2014, following the firing of one manager that same month and the departure of another in November 2013. Gunther, who joined Waddell & Reed, the fund's advisor, as an analyst in 2003 and became an assistant portfolio manager in 2008, leads a team of eight dedicated high-yield analysts. This is up from six analysts last year, and the growing team is an improvement, given the risks prevalent in this strategy.

Indeed, this remains one of the riskiest funds in the high-yield bond Morningstar Category. Gunther and his team believe that the rating agencies can be slow to reflect changes in underlying businesses and often unfairly penalize certain types of companies, which leads the portfolio to carry outsize stakes in lower-quality B and CCC rated holdings. The fund used to be almost entirely agnostic to the ratings of its holdings, and its CCC exposure climbed to almost 50% in the past. Gunther has since reduced that stake, and the team recently instituted two new portfolio guidelines: There is now a 30% limit on CCC holdings (based on S&P credit ratings), and the fund can't own more than 10% of a company's total debt.

These are sensible steps, but they don't go far enough. The fund's yield remains higher than all but a handful of peers, and its top holdings have continued to grow more concentrated, adding idiosyncratic risk. Meanwhile, a not-insignificant 7% of assets are in securities that the team deems illiquid. To be sure, the team has made an effort to shift into larger, more liquid deals, and the analysts have had some successes. But there have also been a few notable misses in recent years. Even with recent changes, concerns about risk and liquidity controls remain. For now, investors should steer clear.

Process Pillar: Negative | Brian Moriarty 06/08/2018
Lead manager Chad Gunther and his team steer the fund to take on significant credit risk. They invest across the capital structure, including a sizable bank-loan stake, which reduces the portfolio's interest-rate sensitivity. The team is benchmark-agnostic and will often deviate significantly from the ICE Bank of America-Merrill Lynch U.S. High Yield Index. The strategy is premised on a belief that rating agencies can be slow to reflect changes in underlying businesses and often unfairly penalize certain types of businesses, which leads the portfolio to carry outsize stakes in lower-quality B and CCC rated holdings.

The team recently instituted two new portfolio construction rules: There is now a 30% limit on CCC holdings (based on S&P credit ratings), and the fund can't own more than 10% of a company's total debt. These are both sensible, but they don't go far enough to curtail the risks inherent to the portfolio. Its yield is higher than all but a handful of peers, which is one indication of an elevated level of risk. Its top holdings have continued to grow more concentrated against the backdrop of outflows, and a not-insignificant 7% of assets are in securities that the team deems illiquid. The lack of robust risk and liquidity controls has long been a concern here.

Despite modest improvements in recent years, the fund retains a Negative Process rating.

The fund's CCC stake stood at 37% as of March 2018, up from 30% last year. The newly instituted 30% limit on CCC debt is based on S&P credit ratings, but the fund reports either the average or lowest rating across all agencies, which accounts for the difference. By comparison, the median peer had 11% in bonds rated below B. Furthermore, in recent years the average yield on the fund's CCC bonds has been markedly higher than the yield on the average CCC bond in the index, which suggests that the fund's CCC holdings may carry above-average credit and liquidity risk. Indeed, the fund's trailing 12-month yield of 7% is well above the peer median of 5.3% and the sixth-highest in the category on an absolute basis.

Roughly 71% of assets were in high-yield corporate bonds, with another 20% in bank loans. The loans help reduce the fund's interest-rate sensitivity. Common stocks accounted for 3.7%, with another 1% in preferred stock.

The largest exposure in the portfolio was a 6.5% stake in Altice, a media and telecommunications conglomerate, while the second-largest issuer was education company Laureate at nearly 3% of assets. Both companies are large, liquid issuers, but the size of these positions still exposes the fund to considerable idiosyncratic risk. The fund's top-10 holdings have grown to nearly 27% of assets from 21% in March 2016.

Performance Pillar: Neutral | Brian Moriarty 06/08/2018 
From manager Chad Gunther's start date in July 2014 through May 2018, the fund has returned nearly 4% annualized, landing in the top 20% of distinct high-yield bond fund peers. That performance looks impressive, but it is a tale of two different markets. The fund struggled during the credit sell-offs in 2014 and 2015. For example, between June 2015 and February 2016, the fund lost 13% and trailed more than 90% of peers. Over the same period, the median peer lost slightly more than 8%. While that sell-off was driven by the energy sector, which was hit hard by falling oil prices, this fund had a relative underweighting to energy, and its underperformance was driven mostly by its CCC holdings.

But the fund bounced back in 2016 and 2017, landing in the best quintile in both calendar years. Its outperformance was driven by the same overweighting to CCC holdings that dragged it down in prior years. Given the team's comfort with the riskier parts of the high-yield market, it is likely to continue this performance profile in the future, lagging when the market sells off and outperforming during rebounds.

While there are signs of both strength and weakness in Gunther's track record, his still relatively short and mixed track record as manager results in a Performance Pillar rating of Neutral.

People Pillar: Neutral | Brian Moriarty 06/08/2018 
Lead manager Chad Gunther joined Waddell & Reed in 2003 as a high-yield analyst. He was named an assistant portfolio manager in 2008 and became lead manager of this fund in July 2014. Gunther's appointment followed a revolving door at the lead manager level. William Nelson was fired on July 9, 2014, for reasons unrelated to portfolio management. Nelson had run the fund since November 2013, following the departure of longtime manager Bryan Krug, who left Waddell & Reed for a competitor. Gunther also leads the firm's other high-yield strategies and oversees more than $7 billion in assets.

Gunther is supported by eight high-yield credit analysts (up from six last year) and two traders. Hiring additional analysts is an encouraging sign, and the analyst team averages more than 13 years of industry experience. Gunther is happy with the current size of the team but notes that he does have the freedom to hire more if needed. However, the team is still relatively new to Ivy, with four of the eight analysts arriving in the past four years. Therefore, the fund earns a People Pillar rating of Neutral.

Parent Pillar: Negative | 10/24/2017 
Waddell & Reed, parent company to the Ivy Funds, is rebuilding its investment organization after significant setbacks, but continued uncertainty among the investment strategies and broader business pressure on the parent firm lead to a continued Negative Parent rating.

After key manager departures that began in late 2013 and a handful of firm-led severance agreements in 2016, this firm is shifting its corporate culture toward an institutional focus. It is rebuilding its analyst staff under a dedicated research chief and addressing succession by naming comanagers to most of its strategies. A new chief risk officer is helping establish parameters for each fund.

The firm's larger business model also is in transition. CEO Phil Sanders took over from Hank Herrmann in 2016 following a raft of outflows: The firm's mutual fund assets have declined by $30 billion to about $60 billion over the past two calendar years, dimming the firm's profitability. The firm's broker/dealer unit, which previously invested client assets exclusively in Waddell & Reed funds, is diversifying, and the firm plans to merge Waddell & Reed funds into its Ivy Funds siblings. If approved, the mergers may lower fund fees but not to relatively inexpensive levels. While changes are largely positive, the firm is playing catch-up to meet the industry standard for governance. Stability in investment teams and processes are crucial next steps.

Price Pillar: Positive | Brian Moriarty 06/08/2018 
The fund's fees appear reasonable overall, but because there are so many share classes (nine) investors should pick their spots carefully. The A share class is the largest with roughly 39% of assets, and 0.97% expense ratio is below average relative to similarly distributed peers. The Institutional share class is a close second with 38% of assets and a 0.71% expense ratio that is average relative to peers. In September 2017, this fund was merged with Waddell & Reed High Income.

Because the majority of assets are in reasonably priced share classes, the fund earns a Price Pillar rating of Positive.

Brian Moriarty does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.