Ivy High Income Continues to Face Challenges

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Ivy High Income's Negative Morningstar Analyst Rating reflects the challenges this team has had since management changes in 2014. Though the team has shown some signs of stability since then, it still needs to show it can control the portfolio's voracious appetite for risk through a full credit cycle.

Portfolio manager Chad Gunther took over here in July 2014 after parent company Waddell & Reed fired previous manager William Nelson for reasons unrelated to his portfolio management responsibilities. Nelson's departure marked the fund's second management change in less than a year. Nelson had run the fund since November 2013 after Bryan Krug left for a similar role at Artisan Partners. Krug had managed this fund since early 2006 with much success. Gunther has been an analyst with Waddell & Reed since 2003 and was named an assistant portfolio manager in 2008, so his appointment provides some continuity to the fund's process.

This fund has historically courted significant credit risk, but Gunther appears to have turned the dial up even further since taking over. Bonds rated CCC or lower made up an already-high 30% of fund assets in March 2014, before Gunther took over, but skyrocketed to 44% as of June 30, 2016, compared with only 13% for the fund's BofAML US High Yield Master II benchmark. Gunther argues that many of his CCC positions yield less than the average CCC bond in the fund's benchmark. That said, the fund's overall 12-month yield still ranked as one of the highest in the high-yield bond Morningstar Category as of June 30, suggesting the fund does take considerable credit risk compared with its peers.

These bets have yet to pay off. Since Gunther took over through July 2016, the fund's 0.4% annualized decline ranked in the bottom 30% of the category, which returned a positive 0.3% during that time frame, on average. The fund's approach can also create challenges around liquidity management. This was evident over the past few years as this fund faced large outflows and appears to have had difficulty in managing those flows without impacting portfolio composition.

Process Pillar: Negative | Sumit Desai, CFA 08/09/2016 The team's approach tends to take significant credit risk, even compared with most high-yield bond funds. The fund's Negative Process Pillar rating reflects the team's struggles to manage this risk.

Lead manager Chad Gunther and team steer the portfolio to take on significant credit risk while minimizing interest-rate exposure. The team invests across the capital structure, including sizable bank-loan stakes, which also helps to reduce the portfolio's interest-rate sensitivity. The team is benchmark-agnostic and will often deviate significantly from the market by typically underweighting the top 30 issuers in the benchmark (the BofAML High Yield Master II index) while seeking opportunity in smaller and lower-rated issuers. Gunther believes that ratings agencies can be slow to reflect changes in underlying businesses, which leads this portfolio to often carry oversize stakes in lower-quality B and CCC rated holdings. The team will occasionally make concentrated bets (2% to 3%) on high-conviction names but aims to keep the portfolio's top-10 issuer concentration between 15% and 20% of total assets.

The focus on lower-quality and smaller issuers can create challenges with liquidity management. This was especially evident over the past few years as this fund faced large outflows and appears to have had some difficulty in managing those flows without impacting portfolio composition.

The portfolio stands out for its outsize stake in CCC bonds, which stood at 44% as of June 30, 2016, compared with just over 13% for the fund’s BofAML US High Yield Master II benchmark. The exposure to CCC bonds skyrocketed from just under 30% in early 2014 to 48% by mid-2015. Manager Chad Gunther argues that many of his CCC positions yield less than the average CCC bond in the fund's benchmark. That said, the fund's overall 12-month yield still ranks as one of the highest in the high-yield bond category as of June 30, suggesting the fund does have considerable credit risk compared with peers. Gunther and team offset this CCC stake with a large underweighting to BB names, at 15% compared with 49% for the index.

The fund's bank-loan exposure dropped to around 20% of assets as of June 30, down from around 28% last year. The fund is fairly diversified but does hold some slightly concentrated positions; its top 10 holdings make up 16% of assets. The fund's largest holding is a 3% position in Misys, a financial-services software company. Overall, this team did a good job of avoiding the worst of the carnage in the high-yield energy sector throughout 2015 and added positions in Clayton Williams and Encana after the bonds of these firms traded down. Despite avoiding the energy sell-off, the fund still struggled, as it had $2.4 billion in outflows for the 12 months ended June 30, more than any other fund in the category.

Performance Pillar: Neutral | Sumit Desai, CFA 08/09/2016 While the fund's longer-term returns appear attractive, performance since current management took over on July 9, 2014, has disappointed. Over the 10-year period ended July 31, 2016, the fund's 8% annualized return ranked in the top 2% of the high-yield bond category; however the majority of this track record was achieved under previous management. Since Gunther took over in July 2014 through July 2016, the fund's 0.4% annualized decline ranked in the bottom 30% of the category, which returned a positive 0.3% during the same time frame, on average.

Despite trying to maintain a similar process during the management turnover, the fund's behavior during different market environments has also changed. Under previous management, for example, the fund maintained a lower-quality posture but still performed well relative to its peer group, even during periods of distress, such as 2008 and the 2013 taper tantrum. To be fair, Gunther took over at a difficult time, when the entire high-yield bond market was under pressure and this fund faced significant outflows, which would prove challenging for any investor.

It's worth noting that the fund's performance through the first seven months of 2016 has improved, and it is ahead of 70% of its peer group, as lower-quality bonds have rallied. Altogether, though, this team has yet to prove its ability to generate strong returns over a longer-term horizon, earning a Neutral Performance rating.

People Pillar: Neutral | Sumit Desai, CFA 08/09/2016 We've raised the fund's People Pillar rating to Neutral from Negative, as manager turnover seems to have stabilized. That said, the fund would benefit from additional analytical resources and further continuity. Current lead manager Chad Gunther joined Waddell & Reed in 2003 as a high-yield fixed-income analyst. He was appointed as assistant portfolio manager of Waddell & Reed Advisors High Income Fund, Ivy Funds VIP High Income, and Ivy High Income Fund in 2008. He was appointed as 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 took over this fund on Nov. 21, 2013, following the departure of longtime manager Bryan Krug, who left Waddell & Reed for a competitor.

Gunther is supported by seven high-yield credit analysts and two traders. While the analyst team is moderately experienced, two of the fund's analysts just joined the firm in 2014, while another joined in 2013. Given the recent manager turnover, magnitude of outflows, and a tendency to own several lower-quality bonds, we believe this fund's investors could have benefited from an analyst team that worked together running a fund of this type for a longer period of time.

Parent Pillar: Negative | 03/02/2016 Waddell & Reed, parent company to the Ivy Funds, has recently taken a few steps in the right direction. Oversight of its captive advisor network has improved with new technology, and though risk management remains largely left up to portfolio managers, the firm has enhanced its risk-monitoring procedures.

Nonetheless, continued turnover reinforces the firm's Negative Parent rating. On Feb. 2, 2016, Michael Avery, president and lead portfolio manager on the firm's largest strategy, announced his plans to retire in June 2016. That marks a meaningful and unforeseen loss, as Avery was expected to take over as CEO once Hank Herrmann, 73, retires. This news comes on the heels of three prominent portfolio manager departures between November 2013 and July 2014. Furthermore, outflows have in part prompted a cost-reduction plan.

Other concerns remain, including a previous lack of investment in fixed-income resources when one of the firm's high-yield strategies had grown to more than $14 billion in mid-2014. Overall, the firm generally charges above-average fees, and it has never closed a fund despite significant asset growth in a number of strategies. Moreover, Waddell & Reed's bonus structure has maintained a relatively short-term focus, with bonuses paid on one- and three-year results, equally weighted. That said, 30% of that bonus is deferred for three years and invested in firm funds, helping align manager interests with shareholders'.

Price Pillar: >Positive | Sumit Desai, CFA 08/09/2016 The fund's fees appear reasonable relative to similarly distributed peers, giving the fund a Positive Price Pillar rating. The fund's institutional share class holds 36% of fund assets and earns a Morningstar Fee Level of Below Average for its 0.70% expense ratio, compared with 0.75% for the median high-yield bond fund with similar distribution. Another 30% of assets are held in the fund's A share class, which earns a Low fee level for its 0.96% expense ratio. However, this share class charges a 5.75% front load, which is extremely expensive on an absolute basis. Similarly, the fund's C share class charges a relatively low 1.66% expense ratio but also charges a 1.00% deferred load and 1.00% 12b-1 fee.

Investors should feel comfortable in the fairly priced institutional share class but should avoid other options for this fund.