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We Boosted PIMCO High Yield's Rating to Silver

This deep and experienced team's deft navigation of recent energy-sector troubles has boosted our confidence here.

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The following is our latest Fund Analyst Report for PIMCO High Yield (PHIYX). 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.

PIMCO High Yield has largely performed as expected through various market environments. Its deft navigation of the recent energy-sector troubles, along with a deep team and inexpensive price tag, support the fund’s upgrade to a Morningstar Analyst Rating of Silver.

Since taking over in January 2010, lead manager Andrew Jessop has made this fund a straightforward high-yield offering. The fund uses the Bank of America Merrill Lynch U.S. High Yield BB-B Rated Constrained Index as its benchmark, which excludes bonds rated CCC or lower. Other broad-based high-yield bond indexes, like the BofAML U.S. High Yield Master II Index, tend to carry a nearly 15% allocation to CCC rated bonds.

The fund’s higher-quality approach should minimize volatility over a full credit cycle relative to its high-yield bond peers that tend to take on more credit risk, but could lag during risk-on rallies. For example, the fund fell into the bottom half of the high-yield bond Morningstar Category in 2012 and 2013 when the CCC bonds it avoids rallied. On the other hand, Jessop and team were early to spot troubles in the energy and commodities sectors; its move to avoid these sectors and lower-rated bonds in general put the fund in the top quintile of its category during the sell-off in 2014 and 2015. Since Jessop took over management of the fund on Jan. 10, 2010, the fund’s 7.2% annualized return through Aug. 31, 2016, was in the top third of the high-yield category on both an absolute and risk-adjusted basis (as measured by its Sharpe ratio).

PIMCO boosted the management team of this fund with the recent addition of Hozef Arif as comanager in July 2016. Arif joined PIMCO in 2008 and has worked on the firm’s high-yield bond team for several years, first as a dedicated trader and then in a portfolio management capacity. Jessop and Arif are supported by a deep team of more than 50 credit analysts, supporting the fund’s Positive People rating.

The 0.55% charge on the fund's Institutional shares is one of the cheapest in the category.

Process Pillar: Positive | Sumit Desai, CFA 09/29/2016
This fund’s Positive Process Pillar rating is based on PIMCO’s deep credit research capabilities. The team’s process starts by incorporating PIMCO’s top-down macroeconomic framework, but bottom-up credit research drives the process. Management expects security selection to add 60%-85% of the fund’s alpha. Andrew Jessop aims to structure this portfolio with 50%-70% of assets invested in core holdings with a low likelihood of default. Another 25%-35% of the portfolio will consist of tactical holdings that reflect Jessop and the team’s best ideas, while 5%-15% of the fund is reserved for trading opportunities to take advantage of significant price movements.

This fund is generally more restrained than its high-yield peers, and its Bank of America Merrill Lynch U.S. High Yield BB-B Rated Constrained Index benchmark steers the fund toward a higher-quality stance than many rivals. Though the fund does hold lower-rated bonds, management treads lightly in junkier bonds rated B and below. The fund will invest significantly in non-U.S. issuers and held roughly 15% in non-U.S. names, including just less than 1% in emerging markets. Jessop has targeted a cash balance of 6%-8% to ensure they can provide the liquidity to the investor, given the lack of liquidity offered by broker/dealers.

While the team was bearish on the energy sector through most of 2015, it increased its exposure to energy bonds to 10% as of Aug. 31, 2016, compared with 7% the year prior. This reflects a view that oil and other commodity prices have stabilized and balance sheets have strengthened after many firms issued equity to maintain liquidity. The team increased its stake in pipeline and exploration and production firms but maintains a bearish view on oil-services firms. Other notable sector themes in the portfolio include overweightings to the pharmaceutical and hospital industries.  Valeant Pharmaceuticals (VRX) remains a top holding as the team believes the company still owns high-quality assets despite its recent troubles.

The fund is fairly diversified, with the top 10 issuers in the portfolio making up 14% of total assets. The majority of fund assets are in U.S.-based issuers, but 15% of the portfolio is invested in non-U.S. bonds (primarily U.S. dollar-denominated). While the team does not disclose the fund’s allocations across credit ratings, the portfolio’s distribution across different yielding bonds suggests a high-quality bias. For example, 31% of the portfolio was invested in bonds yielding 4% or less, compared with 15% for the broad high-yield market. On the flip side, 14% of the U.S. high-yield bond market yields more than 10%, while only 4% of this portfolio does.  

Performance Pillar: Positive | Sumit Desai, CFA 09/29/2016
The fund has performed admirably under lead manager Andrew Jessop’s watch, helping it earn a Positive Price Pillar rating. Since Jessop took over management of the fund on Jan. 10, 2010, the fund’s 7.2% annualized return through August 2016 was in the top third of the high-yield category on both an absolute and risk-adjusted basis (as measured by Sharpe ratio). The fund’s performance during various stress environments also reflects its higher-quality mandate. For example, the fund dropped 2% during 2013's taper tantrum (May 1, 2013-Aug. 31, 2013), lagging 60% of its category peer group as the fund’s higher-quality focus makes it more interest-rate sensitive than some of its peers that focus on lower-rated bonds. On the other hand, the team was early to spot trouble in the energy and commodity sectors and outperformed its peer group considerably during the commodity sell-off that plagued many high-yield bond funds. The fund’s 2.6% decline during that period (Dec. 1, 2014-Feb. 29, 2016) was better than 80% of its peer group.

The performance history under Jessop suggests the fund is appropriate for investors seeking broad exposure to high-yield bonds while minimizing volatility associated with lower-rated bonds. That said, its higher-quality focus does likely make it more exposed in rising rate environments relative to peers that take on more credit risk.

People Pillar: Positive | Sumit Desai, CFA 09/29/2016
The fund earns a Positive People rating for its experienced management team and deep analytical resources. Andrew Jessop joined PIMCO in November 2009 to head up its high-yield effort. Prior to joining PIMCO, Jessop managed Goldman Sachs High Yield GSHAX from 1997 to 2009. Jessop oversees a team of 10 high-yield bond portfolio managers and reports to Mark Kiesel, PIMCO’s CIO of global credit. The firm recently appointed Hozef Arif as comanager of this fund on July 29, 2016. Arif joined PIMCO in 2008 and has worked on the firm’s high-yield bond team for several years, first as a dedicated trader and then in a portfolio management capacity.

The portfolio managers are supported by a team of credit research analysts, headed by Christian Stracke, head of global credit research. PIMCO grew its analyst team considerably since the financial crisis, from around 30 analysts in 2009 to 50-plus as of June 30, 2016, including 20 outside the U.S. While the analyst team has grown during the past several years, it did shrink by eight analysts between 2015 and 2016 as part of the firm’s broader efforts to rationalize its headcount. This warrants watching, but we continue to have confidence in the firm’s overall credit research efforts and leadership. In total, PIMCO manages just more than $37 billion in high-yield bond assets as of June 30, 2016.

Parent Pillar: Neutral | 06/03/2015 
PIMCO has emerged from a tough 2014 in better shape than many would have anticipated. Its investment teams and processes have largely remained intact under group CIO Dan Ivascyn. Heavy outflows haven't impaired performance of the funds most affected. The firm's investment operation continues to evolve but remains deep, experienced, and well-resourced.

That said, outflows have driven PIMCO's profitability lower and could prompt additional cost-cutting. Corporate parent Allianz has remained supportive, but continued outflows could begin to affect PIMCO's ability to retain talent.

Developments on other fronts are also mixed. Whether the firm can succeed with its alternatives business and rejiggered equity effort--both key to future growth--is an open question. Managers' investment in the funds they run has increased but isn't market-leading. The addition of several more independent fund board members is welcome, but they still need to prove that they'll act in the best interests of fundholders. Fees clock in near average overall but are still high on some funds' noninstitutional share classes.

PIMCO's recent progress is encouraging, but how well it executes on its investment strategies and business development plans in the next few years is critical. That lingering uncertainty underlies the firm's overall Neutral Parent Pillar score and Stewardship Grade of C.

Price Pillar: Positive | Sumit Desai, CFA 09/29/2016 
This fund earns a Positive Price Pillar rating. More than 75% of this fund’s assets are in its Institutional share class, which charges a 0.55% expense ratio--one of the cheapest in the high-yield bond category. The fund’s Admin and D-Class shares do earn Morningstar Fee Level rankings of Above Average and Average, respectively, but these share classes hold only 7% of fund assets. The remainder of assets are held in other share classes that also earn Below Average rankings.

Sumit Desai, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.