Thorough credit research is key. High-yield bonds are more vulnerable to default than investment-grade bonds. Taking the time to research companies can reveal hidden gems and expose concealed weaknesses. A competitive company with solid management and a sound business and financial strategy will likely prosper – even though its credit rating may not be high. A struggling company with weak management and a reluctance to adapt to changing business situations is obviously a much higher risk.
At Trimark, we use the expertise we developed analysing companies for our equity funds to evaluate companies whose bonds we're considering for the Trimark Advantage Bond Fund. We use a bottom-up, long-term approach to search for bonds undervalued by the market and then buy and hold them until the market recognizes their inherent value.
One of the most critical steps in our assessment process is to visit a target company and meet the management. We ask a lot of questions and listen carefully to the answers. We examine the track records of key executives and determine whether they are what we expected from reading the company's annual report and other literature. And we see first-hand if they are confident, if they have a vision. I can't overemphasize the importance of this on-site investigation to our decisions. It's easy to put together a flashy annual report. We need to know if there's substance behind the flash.
Through our internal resources at Trimark, we conduct an in-depth analysis of the company. We look at its profitability and evaluate its assets. And we put our prospect to the test by changing key variables to see, for example, what would happen to key credit if pulp prices rose. One question we always want to answer: Is the company a low-cost operator? If a company produces a product at a lower cost relative to its peers in the industry, it will probably survive and prosper.
We also thoroughly analyze the industry a specific organization functions in because no company operates in a vacuum. No matter how solid the management and balance sheet of a company are, its profitability will be affected by the strength of its rivals. So we examine the competitors to see what kind of threat they pose. And we look for any key developments likely to hit the industry – for example, innovations in technology. Because we invest for the long term, we want to make sure the company we choose can adapt to changing situations.
The last step is to determine the relative value of the bond – in contrast to the agency-determined rating. We compare the credit statistics of the company to those of its peers to get a true sense of the rating. And we analyse the indenture (terms and conditions) of the bond: its covenants, corporate structure, security and redemption features. Finally, we examine the pricing of the bond in relation to alternatives in the same industry, and to bonds in other industries with comparable ratings and credit statistics.
Only after this intensive research is complete do we make a purchase decision. If a bond continues to look attractive after our thorough evaluation, we buy it. By this point, we are confident that a given bond has an inherent worth that will ride out the ups and downs of changing interest rates. And then we continue to monitor the investments we've made to ensure they provide the value we expect of them and to determine when we should make changes to our portfolio.
In conclusion, when compared to traditional government bond funds, a well-researched high-yield bond portfolio gives the individual investor some important advantages:
Over the past 17 years, high-yield bonds have outperformed government bonds by an average annual rate of 2.5 per cent.* That return advantage can make a big difference over the long term.
Between 1985 and 1996, almost 94 per cent of the total average annual return for high-yield bonds was income return.* Achieving such a high percentage of their return through income means high-yield bonds will be affected less by changes in interest rates.
Between 1985 and 1996, the average monthly return of high-yield bonds (1.01 per cent) fell square between small capitalization stocks (1.36 per cent) and intermediate treasuries (0.71 per cent), while the standard deviation of these high-yield bond monthly returns (1.54) was far less than small capitalization stocks (5.21) and essentially the same as intermediate treasures (1.64).*
Combined with thorough research and a patient investment approach, the benefits high-yield bonds offer to investors can lead to extremely satisfying performance over the long-term.
* Source: Merrill Lynch & Co.
Article by: Patrick Farmer
Vice-President, Trimark Mutual Funds
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