Hotchkis and Wiley's Dream High-Yield Team

Ray Kennedy and Mark Hudoff are happy guys. It's not because they're sitting atop an empire. They're running around $120 million at a small firm that boasts a modest $13.7 billion under management and has the distinction of having undergone two changes of ownership in the past 15 years.

Their lives appear to be more fulfilling than they had been for a while, though. Things went well enough when they started at PIMCO. They were hired and mentored by Ben Trosky to hunt for high-yield bond issuers with hard assets, cash flows, and compelling credit profiles. Kennedy and Hudoff worked together at PIMCO for about 10 years, five as analysts under Trosky, who built a great record and reputation running  PIMCO High Yield . Kennedy eventually joined Trosky as a comanager and succeeded him when Trosky retired at the end of 2002. Kennedy then turned the reins over to Hudoff in 2007. Hudoff left PIMCO last year.

Neither Kennedy nor Hudoff has anything bad to say about PIMCO, and they are big fans of their colleagues who remain at the firm. The pair sound almost wistful when describing their analyst days under Trosky. Yet it's clear that a toll was taken on Kennedy by the time he left in 2007 and that the place no longer suited Hudoff when he departed in 2009. Each reigned atop an enormous pool of high-yield bond assets during his managerial tenure, and the challenges were huge. The fund's relatively conservative strategy meant that they favored better-capitalized issuers and large liquid bonds. But even so, the fund's size made it difficult at times to get as much exposure to a particular credit or sector as either would have liked. And straying from that sweet spot in search of other opportunities wasn't worthwhile with such a large asset base. Their records at PIMCO High Yield argue that they were successful managers, but Kennedy and Hudoff both say that it became more difficult to add value with their efforts, particularly as PIMCO began to put the same macro themes across all of its portfolios regardless of mandate. An evolution of the firm's culture also brought more intensity to the job than either of them wanted, and by the time Hudoff left, PIMCO had become the full-blown pressure cooker that it is today.

A Fresh Start
After some time off, Kennedy started at Hotchkis and Wiley in late 2008. Hudoff followed in mid-2009, just a few months after Kennedy launched  Hotchkis and Wiley High Yield (HWHAX). Hotchkis is 50 miles away from PIMCO in Los Angeles, but it might as well be in another solar system. Kennedy and Hudoff are two of 62 employees, more than half of whom together own a majority of the firm's equity. And although Kennedy and Hudoff are running only a tiny slice of the firm's assets today, their presence is a big deal, not unlike a sports team that signs two established all-stars.

Kennedy and Hudoff talk about going to Hotchkis and Wiley as a dramatic, welcome return to their credit-analyst roots. Kennedy, in particular, talks about burying his head in company research as if it's a calling from which he inadvertently strayed. Starting fresh, with a small asset base, will afford some strategic freedom, as well. Hudoff notes that he and Kennedy prefer the undervalued bonds of hard asset borrowers over the leveraged-buyout debt that dominates much of the high-yield market, and the two believe that working with Hotchkis' large research staff will help those efforts. As a result, they expect the fund to have broader credit exposure, inclusive of smaller firms with public equity, than PIMCO High Yield has offered. That's going to mean a much wider variety of names, given that they peg roughly 55% of the high-yield market as composed of bond issues with less than $500 million in outstanding issuance. And this fund likely will not be as heavily dominated by BB rated debt (the highest tier below so-called investment-grade debt) as was the pair's PIMCO charge. It will have more assets in the B (and perhaps CCC) rating strata that make up the bulk of the high-yield universe.

There Is Work to Do
Kennedy and Hudoff do have challenges. They have two fixed-income-focused investment analysts and may hire a product specialist and trader. But for now, the goal is to leverage the breadth and skill of Hotchkis and Wiley's 25 (until recently equity-focused) investment analysts and research associates to round out coverage of their portfolio. That group comes with its own pedigree. Vanguard's portfolio review group uses Hotchkis and Wiley to manage a $2 billion slice of  Vanguard Windsor II (VWNFX).

Still, bond and stock managers look for very different things in companies. Kennedy found it worthwhile to give the analysts tutorials on subjects like evaluating bond covenants and capital structures. And Hotchkis has stipulated that it wants new analysts--who are typically hired out of business school--to start off focusing on equities before any become dedicated high-yield specialists. That arrangement may work, but its success is by no means guaranteed.

Don't tell that to Kennedy and Hudoff. They're energized by the challenge. Kennedy taught credit analysts in a prior life at Prudential Insurance, and he talks about working with Hotchkis' analysts with the words and passion of a natural educator. It also won't hurt that Hotchkis is well known for managing small-cap value stocks--a universe that is home to much high-yield bond issuance. Roughly 75% of the credits Kennedy and Hudoff held early in 2010 overlapped with stocks that Hotchkis analysts were already covering.

Ultimately, however, the time and attention that Kennedy and Hudoff have to devote to this still-modest portfolio suggest that there is little risk in the need to calibrate the firm's equity analysts to their bond research duties. Meanwhile, it's difficult to come away anything other than encouraged after seeing two proven managers show so much enthusiasm and passion for their work. It's rare in the high-yield universe to have two such investors, together, starting fresh with a small pool of money and so much flexibility. There's never any guarantee that great managers will produce great results, but they almost always do in the fullness of time.