2019's Hearty Start for High-Yield Bond Funds

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. High-yield bond funds have gotten off to a strong start in 2019 after a weak-showing last year. Joining me to provide a recap of what's been going on in the category is senior analyst Brian Moriarty.

Brian, thank you so much for being here.

Brian Moriarty: Thank you. Happy to be here.

Benz: Brian, let's talk about what has been going on in high yield. When investors look at their high-yield funds, year-to-date, they might be pretty impressed because returns have been really quite good. Why the reversal? Because there was a big sell-off in high-yield in late 2018. What's been going on?

Moriarty: Yeah. So, the big story, or the reason is, really, statements from the Federal Reserve. So, in the fourth quarter of 2018, the volatility was driven by the trade and tariff concerns along with a Fed that had been steadily rising rates. That changed in the first week of January with statements from chairman Powell who basically indicated that the Fed was taking a more dovish stance. And after that the markets flipped almost like a switch and since then risk assets, especially high-yield bonds, have been performing quite well.

Benz: OK. So, you put high-yield bonds in the category of risk assets. Equities as well, right?

Moriarty: Absolutely. Yeah.

Benz: OK. Let's talk about how investors should think about their high-yield holdings. Because there have been few murmurs so far in 2019 about recession potentially on the horizon. These holdings would typically get hit pretty hard in a recessionary environment, right?

Moriarty: Yeah. It's important to remember that high-yield bonds are still mostly correlated to equities. So, what investors should really pay attention to when they are looking at their high-yield bond fund, if they own one, is the underlying holdings. Don't just look at the performance. And so, you want to pay attention to, is it lower-quality stuff, CCC or below, nonrated, are there actually equities in the fund, which can happen sometimes, or is it more higher-quality, high BB, high B, more defensive quality businesses? And that will really determine how the fund performs.

Benz: OK. So, do a little due diligence on the portfolio itself.

Moriarty: Absolutely.

Benz: You mentioned stock holdings in the bond portfolio. How common is that?

Moriarty: Occasional. So, it's not super common, but there are a couple notable funds that will be comfortable either owning equity out of a restructuring. So, for example, if one of their holdings goes through bankruptcy restructurings, a lot of times they come out with equity and they tend to hold that for a while. Other funds will actually go out and buy equity on the exchanges and in some cases that can be 10% to 15% of the portfolio.

Benz: OK. But it wouldn't typically go up to like 50%.

Moriarty: No, absolutely not.

Benz: It would be capped at a fairly low level.

Moriarty: Correct. Yeah.

Benz: OK. So, if I'm thinking about high-yield in my portfolio and maybe I'm a little concerned about some sort of a weakening economy or a weakening equity market--it sounds like I should be concerned about that, too--should I be favoring the more defensively minded junk-bond funds? Would that be a sane way to go?

Moriarty: It really depends on your risk tolerance and your time horizon. You always have to keep that in mind. If you think that the recovery or the expansion is going to continue for a couple of years, which it could very well, then a more aggressive fund makes sense. If you are legitimately concerned about a recession, then a defensive, more high-quality bond fund does make sense or a high-quality high-yield bond fund does make sense. But it is important to keep in mind, like I said, that they are still correlated to equities. And so, even a defensive fund will be flat to negative in some sort of a recession or a sell-off.

Benz: OK. So, you brought a short list of some of the high-yield funds that you and the team like and they do run the gamut from some of the more defensively minded ones to very aggressive ones. One that is at the top of your list--it's Gold-rated--is PGIM High Yield. Let's talk about that one. It may be a less familiar name to some of our viewers.

Moriarty: Yes. So, that's an interesting one. We just recently added it to coverage within the last year, and its first rating was Gold, which is pretty impressive. So, this fund really checks all the boxes. So, it has a very rigorous process. It's really a broad market high-yield fund. So, it doesn't play preferences. The team is very strong, and then the parent culture is also very strong and very supportive. PGIM has a history as an insurance asset manager. So that really has dictated or colored their approach to managing this fund. Very long-term outlook, deep research capabilities--and it's also very attractively priced, which helps.

Benz: OK. So, PGIM is P-G-I-M, and this fund, some people might look at it and say, "Well, that's a load fund, I'm a no-load investor." You can actually buy it on some of the supermarket platforms, though, without a load?

Moriarty: That's correct. So, the Z shares in particular are available at Schwab, both no-load and No Transaction Fee.

Benz: OK. Let's talk about a more conservative entrant, Vanguard High-Yield Corporate, also a Silver-rated fund and this one does tend to be a little higher-quality than some of its competitors.

Moriarty: That's correct. So, it tends to avoid or at least underweight a lot of the lowest-quality stuff. So, it's normally underweight CCC rated bonds relative to peers and the benchmark. It really focuses on the highest-quality most-liquid names. It also tends to hold a pretty decent chunk of both cash and Treasuries, which helps it hold up in down markets and helps the liquidity profile of the fund. And like most Vanguard funds, it's one of the cheapest, which actually gives it--it's not just attractive on a holdings basis--it actually gives it a leg up relative to more-aggressive peers that charge a higher fee. So, that does play out in the performance of the fund.

Benz: So, is the idea that the management doesn't have to stretch to deliver a competitive yield because the expenses are so low?

Moriarty: That's exactly. Yeah.

Benz: OK. Another fund that you say is sort of at the opposite, more-aggressive end of the spectrum is Fidelity Capital & Income. So, this is one where you'd want to have a nice long time horizon and a good tolerance for volatility.

Moriarty: Exactly. Yeah. So, this [is a] very strong team like all of the funds that we are talking about today. Manager Mark Notkin has led this fund for a long time--one of the more distinguished managers in the high-yield bond category. But this is a very aggressive fund. Like we talked about before, this is the one that tends to hold a decent amount of equities, anywhere from 10% to 20%, that he is going out and buying in the market, especially if he thinks equities are more attractive relative to high-yield bonds, which is an analysis that he does. So, something to keep in mind. But this very much will be at the more aggressive end of a portfolio and will get hit the hardest mostly likely in any sort of equity sell-off or a market recession.

Benz: OK, Brian. Great thorough recap. Thank you so much for being here today.

Moriarty: You're very welcome. Thank you.

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