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When a High Yield Is a Red Flag

Russel Kinnel
Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Everyone loves income, but sometimes a high yield can be a harbinger that a fund is taking a lot of risks in its portfolio. Joining me to discuss that topic is Russ Kinnel. He is director of manger research for Morningstar, and he is also editor of Morningstar FundInvestor.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: In the March issue of Morningstar FundInvestor you wrote about yield and the connection between yield and risks in a portfolio. You wrote that sometimes yield can signal that there are problem spots lurking in a portfolio. I thought it was really timely. Let's talk first about, you advise investors to do a little bit of math to look for the expense ratio, look for the current yield, add them together. Why is that?

Kinnel: A fund's expense ratio is subtracted from its income and therefore, to understand the portfolio's yield, you want to add back the expense ratio. That will tell you what the portfolio is yielding. When you get a really high yield, that's big red flag. Today, we've had such a long-running bond bull market that yields are pretty low, and so, if a fund has got significantly higher yield than its peer or benchmark, that tells you it's taking on significantly more risk and therefore you really want to be sure you understand what those risks are.

Benz: A high expense ratio, high-yielding fund, that can be a particularly scary combination?

Kinnel: Exactly. The higher the expense ratio, the more risks you've got to take on just to get even with the peer group. If you want to do more than that, you got to take on even more risk. We've done studies in the past where we find there is a direct link between expense ratios and risk. The higher the expense ratio, the more risk the fund is going to take on to justify that fee.

Benz: Let's delve into some common sources of yield, ways that managers can bump up the yields from their funds. The most common is simply taking some credit risk, so being willing to delve into junkier bond types. How common is that and what categories should investors be watchful?

Kinnel: It's very common to see junk added to just about any kind of bond fund. Your typical intermediate bond fund might have a 5% or 10% in junk. You really could see it just about anywhere.

Benz: Funds are limited though by their prospectus. So, if I have a core, say, intermediate-term bond fund, it will have limits on how much the manager can put in bonds that are below investment grade, right?

Kinnel: Exactly. There will be limits. They will need to have most of their investments in high-quality bonds. Our categories also have limits. If a fund is mostly in high-yield bonds, we are going to put that fund in the high-yield category. 

Benz: Whether it likes it or not?

Kinnel: Whether it likes it or not. There are some limits. You are right. But even so, it's worth understanding that this fund maybe moving into more aggressive areas to boost yield and to a degree certainly we think sometimes that's a fine thing to do. There is nothing wrong with that when it's done well and as a part of a good process with skilled investors.

Benz: Right, and that risk taking certainly over the past even decade has been rewarded. Is it your sense that--and I know it's a big universe of bond funds--but is it your sense that managers are perhaps, in some cases, too comfy taking credit risk right now?

Kinnel: Probably, and I think individual investors are, too, just because it's been so long since we've had significant credit event. 2015, we saw a bit of a correction. But in general, taking more credit risk has paid off. Individual investors can kind of get lulled to sleep because when things are going well, more credit risk actually mutes volatility. It makes returns look more stable. You don't see that risk showing up in volatility the way equity risk just about always shows up as volatility. It's a little more subtle effect, but it's something you want to keep an eye on.

Benz: Let's talk about interest-rate risk. That's the other main lever that core bond funds have to take a little bit more duration risk than some of their competitors. How common is that today, would you say? Are managers nudging out on interest-rate spectrum knowing that the Fed appears to be in this tightening mode?

Kinnel: I would say that some are, but some have gotten more defensive. It's definitely a mixed bag. The good news is, one, that interest-rate risk tends to show up as volatility. It's a little easier to spot, but also the duration measure is a very simple way to understand a fund's interest-rate risk. If you look at their duration relative to their benchmark and their peer group, that will give you a good sense. And the higher the duration number, the greater the interest-rate risk.

Benz: Another source of yield boosting that may be a little less familiar to some investors is taking leverage into a portfolio. Let's talk about, A, how this works and, B, how that can exacerbate risks even as it plumps up yield a little bit.

Kinnel: That's right. Leverage is most common in the closed-end universe where a lot of bond funds use leverage. The typical way to use leverage is you are borrowing and then you got out and invest the proceeds from that loan out into additional bonds. Thus, you are getting more than 100% invested. And of course, that means you are dialing up the risk based on whatever you are investing in.

Benz: It's a bull market strategy really, but if you get caught leaning the wrong way, it can be problematic?

Kinnel: For sure. It can really backfire, and of course, it really means the fund is just more extended. Another more subtle way is there can be financial leverage where officially the fund is only fully invested, but you can own underlying instruments that really bump up your leverage. And so, therefore, de facto, you see a lot of funds that have a little bit of actual financial leverage in there.

Benz: You brought an example of a fund that actually is, you think, a pretty good example of leverage in a portfolio and perhaps some risks lurking in a portfolio. That's Salient Select Income. Let's talk about that one.

Kinnel: That's right. We rated the fund Negative because it really ticks just about all of the risk boxes. It's got liquidity risk because it invests mostly in REIT preferreds as well as REIT high-yields and REIT stocks. But also, with leverage it consistently is about 10% to 15% levered, but sometimes all the way up to 30%. What really gave us pause was the fund sometimes uses that leverage to meet redemptions. That's signaling that it can have some liquidity issues that maybe it owned some non-rated securities which tend to not trade very easily. And so, when we see a fund using leverage to offset flows, that really worries us.

Benz: Yes. Another source of yield boosting is investing in illiquid bonds. Let's talk about the connection there. Why less liquid bonds might tend to have higher yields and also what the risks might be of such a strategy.

Kinnel: If you look at Treasuries or equities, most funds have all liquidity they want. They trade tremendously. When you go into some bond areas, munis and especially, lower-quality or nonrateds, they don't trade a lot. And so, therefore, the funds are taking on some liquidity risk. In other words, if they get redeemed a lot, they might not be able to sell enough to meet those redemptions. Or if they can sell, maybe they will have to sell at a really bad price and of course, then you start a spiral of bad feedback where the fund sells at low prices, performance plummets, more people redeem, they sell more. And so, it can be a real mess.

The most dramatic example--and again, this is a real outlier--is Third Avenue Focused Credit which ended up having to prevent investors from leaving because they couldn't meet redemptions. They had a very concentrated portfolio in small, low-quality energy issues mostly. When energy had its problems in 2015, the fund couldn't meet redemptions. It just about worked out all of those problems today, which means essentially, it's taken them three years to liquidate that portfolio which is kind of a crazy thing to have in a 40 Act fund that's supposed to have daily liquidity.

Benz: Right. And so, you mentioned that that's an extreme outlier case. But we actually did see during the financial crisis a lot of the issues we saw in bond portfolios were liquidity related, right?

Kinnel: One of the scary things is, there are some bonds where the market looks liquid and then it's not. What we saw in '08 was that some forms of mortgages were liquid and then they stopped being liquid. Funds had the difficult choice of, they could either stop investors from redeeming or they could sell but at a reduced price. Some funds chose one option, some chose the other. But in many cases, it was really ugly. That is one of the quirks of the bond world, is just liquidity isn't given and you really want to understand how the fund does that. But I think it also illustrates the importance of really good management that you trust, a really good process, because the good managers know this is a risk and they view different buckets of their portfolio. They will say, we are going to have some cash, we're going to have some more liquid holdings and they really stress test their portfolio and they understand that today's liquidity might not apply to tomorrow. Really be careful with your bond funds. Pick good managers, pick good processes. Pick a firm you trust. Good stewards are much less likely to have these problems.

Benz: If you see a yield, you are attracted to that yield, definitely dig in, get to know the process, get to know that's driving that yield up.

Kinnel: Yeah. The higher the yield you go for, the more risk you are taking on, therefore, the more research you have to do just as you have to do that with an individual bond. The higher the yield, the more research you have to do.

Benz: Russ, thank you so much for being here. Always great to get your insights.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.