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A Unique Proposition in High Yield

Bronze-rated Diamond Hill Corporate Credit has been far more resilient than peers during periods of market stress.

The following is our latest Fund Analyst Report for Diamond Hill Corporate Credit Fund DHSTX. 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.

Diamond Hill Corporate Credit's benchmark-agnostic, high-conviction approach and its avoidance of the junk-bond market's lowest-quality names make it a unique proposition within the high-yield bond Morningstar Category. This fund's Morningstar Analyst Rating has been upgraded to Bronze.

Bill Zox and John McClain lead this fund's management team. Zox joined Diamond Hill in 2001 as an equity analyst. He was named a portfolio manager on this fund in April 2006 before taking over lead management in 2008. McClain joined the firm in June 2014 as a credit analyst and was named comanager of this fund in February 2015. Despite the firm's deep pool of experienced research analysts, the managers' partnership is still relatively young at three years, and the lack of additional dedicated fixed-income resources tempers our view for now.

The team's investment approach stands out relative to its category peers. The managers seek absolute nominal gains between inflation plus 3% and 7% measured over rolling five-year periods while minimizing downside volatility. To do so, they tend to hold concentrated positions (up to 7%-8%) in their best ideas, while relying on thorough fundamental research and their valuation discipline to limit risk. For example, the fund's top five names as of April 2018 took up 27% of assets, including some smaller deals that could be less liquid in stressed environments. While this approach courts significant concentration risk, the managers balance that with a higher credit-quality profile and a larger allocation to cash than the fund's typical peer.

Consequently, this fund has thus far been more resilient than most of its competitors in periods of market stress. Most recently, the fund lost roughly half as much as its typical peer during the energy-led downturn from June 2015 through February 2016. Overall, through April 2018, this fund's trailing five-year performance landed in the best decile of its category while its Sharpe ratio--a measure of volatility-adjusted performance--ranked third out of 159 (distinct) peers during the same period.

Process Pillar: Positive | Benjamin Joseph, CAIA 06/13/2018 This fund's process combines an intrinsic value-driven and contrarian approach to build a benchmark-agnostic portfolio. While the fund's concentration and idiosyncratic risk is considerable, the managers' analytical rigor and responsible balancing of the risks support a Process Pillar rating upgrade to Positive.

Co-lead managers Bill Zox and John McClain take the classic approach to value investing that marks all of Diamond Hill's investment offerings: They buy issues when their market prices are lower than their estimate of intrinsic business value and sell them when their initial thesis has played out or when there are better opportunities in the market. When valuations get rich and opportunities get scarce, the managers may run a sizable allocation to cash or investment-grade bonds to reduce risk and to be ready to profit from market corrections.

The team focuses on relatively small issues and tends to make sizable bets on their best ideas (up to 7%-8%), thereby increasing idiosyncratic and liquidity risk. The compact portfolio of 40-80 holdings has on average about 35% of the fund's assets concentrated in the top 10 positions, leaving the fund with a very thin margin of error when it comes to security selection. That said, the team offsets those risks somewhat by treading lightly in the market's lowest-quality names and limiting how much they'll own of an individual issue.

Because the fund is not managed against a benchmark, its allocations can significantly deviate from the BofAML U.S. High Yield Master II Index and from its typical peer's. It's also not afraid to take big positions in its favorite names. As of April 30, 2018, for example, the portfolio was concentrated in 71 issues, with the 10 largest positions accounting for 40% of the fund's assets.

Historically, this fund has also been willing to hold relatively large stakes in investment-grade securities and cash to partially offset the high level of concentration in the portfolio and to provide dry powder that the team can put to work during high-yield market sell-offs. So, for example, the fund maintained a sizable allocation to investment-grade securities from 2010 to 2013 (29% on average) and raised its cash allocation up to 9% as of June 2014. In the third quarter of 2014, volatility began to increase in the high-yield market, and the team used its stash of cash and investment-grade debt to fund purchases of junk-rated bonds.

The absence of exposure to distressed names and a reluctance to hold a lot of securities among the lowest-quality fare of the high-yield market assuage our concern about downside risk. As of March 2018, the fund's 4% exposure to securities rated CCC or lower was almost a third that of its typical peer, while its 7% cash allocation was roughly double the category median.

Performance Pillar: Positive | Benjamin Joseph, CAIA 06/13/2018 Under longest-tenured lead manager Bill Zox's decade-long supervision, this fund has kept pace with its peer group median while performing better in stressed periods, earning a Positive Performance Pillar rating. Through April 2018, this fund's trailing 10-year return landed just ahead of its typical peer while its Sharpe ratio--a measure of volatility-adjusted performance--ranked second out of 113 (distinct) peers.

The team's willingness to take less credit risk than its peers has helped it hold up much better during high-yield sell-offs. The fund held a sizable stake in cash and investment-grade bonds as high yield came under pressure in late 2014, for example, which put the team in the position to increase its exposure to high-yield bonds, including hard-hit energy issues, as the high-yield market's losses mounted in 2015. That year, while the ICE BofAML U.S. High Yield Index suffered a 4.6% loss, the fund gained 1.5%, ending 2015 ahead of all but five of its 178 (distinct) peers.

The fund may not always behave defensively, though. By early 2018, for instance, the managers hadn't positioned the portfolio as cautiously as they had heading into the last downturn, despite a strong high-yield rally since early 2016. A misstep in one of the fund's top holdings could also cause the fund to struggle. Overall, though, investors who are comfortable with these risks should continue to be rewarded here.

People Pillar: Neutral | Benjamin Joseph, CAIA 06/13/2018 Even with support from the firm's deep pool of experienced research analysts, the duo at the helm of the fund has only run it together for three years, and the fund could benefit from additional dedicated fixed-income resources. The fund retains its Neutral People Pillar rating.

Co-lead managers Bill Zox and John McClain, with assistant manager Suken Patel, form this fund's management team. Zox joined Diamond Hill in 2001 as an equity analyst. He was named a portfolio manager on this fund in April 2006 before taking over lead management in 2008. In February 2013, Patel was named assistant manager, replacing Chris Bingaman, currently CEO of Diamond Hill Capital Management. Patel has been with the firm since 2006 and is a sector leader within the research team. McClain had seven years of experience in the high-yield and distressed credit markets when he joined the firm in June 2014 as a credit analyst. He was named comanager of this fund in February 2015, replacing co-CIO Austin Hawley.

Diamond Hill's investment team counts eight equity managers and four fixed-income managers. The portfolio managers are supported by five traders and 30 research analysts with an average investment experience of 13 years. Analysts are sector specialists, but they cover the entire spectrum of the capital structure, supporting equity and fixed-income offerings.

Parent Pillar: Positive | 03/21/2018 Publicly traded Diamond Hill continues to demonstrate dedication to its fundholders, earning it a Positive Parent rating.

Virtuous practices include frequent and transparent shareholder communication and strong alignment of investment teams’ compensation with the long-term success of the strategies. For example, the firm’s universal intrinsic value philosophy as well as its model are available for public consumption on its website. Although Diamond Hill stock is distributed (and restricted for five years) through year-end bonuses, employees are otherwise prohibited from investing in equities and can invest in mutual funds offered only by Diamond Hill. Manager compensation is based on rolling five-year returns. Despite an uptick in 2017 when two analysts and one associate left the firm, retention is exceptional, and portfolio managers and analysts tend to spend their careers at Diamond Hill. Succession and transitions are handled well--CEO Chris Bingaman took the reins in January 2016, after a five-year transition between him and previous CEO Ric Dillon, for example. Investing is at the forefront of the firm: Bingaman still spends most of his time managing money, the firm has been responsible with fund launches and typically seeds strategies well in advance of a formal launch, and capacity management has been thoughtful. Diamond Hill continues to be an exemplary steward of capital.

Price Pillar: Positive | Benjamin Joseph, CAIA 06/13/2018 All the fund's share classes carry Morningstar Fee Levels of Low or Below Average, supporting a Positive Price Pillar rating.

The I shares, which hold 83% of assets, are priced 9 basis points below the 0.72% median of the institutional high-yield bond fee group. The similarly distributed Y shares, which represent 4% of fund assets, are priced 21 basis points below the median. Finally, the A shares hold 10% of the fund's assets, with an expense ratio of 92 basis points, 10 basis points lower than the median of the front-load high-yield fee group.

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