A Value Approach to High Yield
DWS High Income Fund
US > Non-Investment Grade >
Oct 17, 2012
52 Week HL
140.84 - $105.54
Sep 16, 1996
Q: How would you define the objective of the fund?
A : The fund invests in high yield bonds issued by domestic companies.
Q: What is the composition of the fund?
A : The fund is anchored in high yield bonds issued by U.S. corporations, with a smaller exposure to international issuers and invested in bank loans of corporations. In the portfolio, loans can be anywhere from zero to 10% of the total asset base.
We occasionally buy emerging market sovereign bonds in the fund and we may hold some emerging market corporate bonds as part of the broader high yield universe. However, the fund predominantly invests in high yield bonds issued by U.S. corporations.
Q: What core beliefs drive your investment philosophy?
A : As we review our investable universe on a risk-adjusted basis, we believe that strong risk-adjusted performance can be achieved in high yield through a strict value discipline and a rigorous credit analysis. Being focused on value, we exploit market inefficiencies and evaluate capital structure in search of the best relative risk adjusted opportunity.
Q: What makes investing in high yield bonds different from investing in fixed income securities?
A : Investing in high-yield bonds is similar to investing in equities with the added benefit of a high level of income. We like the high-yield asset class given we do not need a lot of economic growth in order to get equity-like returns; whereas, in equities we generally need more significant economic growth in order to see a sustained high level of returns. So, high-yield bonds have historically had more attractive excess returns in a low growth environment, such as today's.
In fact, investing in high yield bonds falls between investing in investment-grade bonds and equities on the risk scale. However, returns are not as sensitive to macro economic growth as are equities. In short, it is a combination of both the bond and equity markets; however, the individual security behaves more like an equity than a bond.
Q: What is your investment process?
A : We have a bottom-up investment approach, where relative value and fundamental analysis are used to select the best securities within each industry. Moreover, we use our top-down approach to assess the overall risk and return potential in the market as well as the macro trends in the economy.
In addition, we employ a communication tool called G-Cube, which distributes ideas or recommendations from analysts, holds analysts accountable and measures the recommendation.
Q: Would you describe your research process?
A : Our process is designed to achieve consistent excess returns with risk management and accountability integrated at every step.
There are three distinct stages in risk management – research and decision making; portfolio design and construction; and implementation into the portfolio. Furthermore, we have process management that actively monitors a lot of the inputs to keep checking risk exposure along different steps.
As far as the individual credit research methodology is concerned, we have three different variables – quantitative, qualitative, and specific security.
On the quantitative side, we look at three financial statements and financial ratios. We take into account the historic balance sheets, income statements and cash flow statements while searching for patterns of how various accounts are evolving or how a company is doing in improving its abilities to meet debt obligations.
On the qualitative side, we primarily concentrate on management and their experience in dealing with companies that are in a leveraged structure. We also examine the regulatory environment along with specific industry and company risks.
At the individual security level, we carefully review the debt offering prospectus and covenants. We also pay close attention to where the debt falls in the capital structure and what the seniority in the debt ladder turns out to be. We are also concerned about debt liquidity and the internal debt rating of the security. It is important for us to determine where the credit is trending – whether it is improving, degrading or holding stable.
We have an experienced global team of 11 analysts in the U.S. which supports both bonds and bank loans research. Additionally, there is a team of six analysts and two portfolio managers for high yield bonds in Europe, and we also have a couple of analysts in Asia too.
Q: How do you select securities?
A : To select securities, we analyze the economic conditions in improving or undervalued sectors and industries; we use independent credit research to evaluate individual issuers’ downgrade and upgrade potential; and we also seek issuers within attractive industry sectors and with strong long-term fundamentals and improving credits.
While trying to figure out fair value for securities, we evaluate the upside and the downside scenarios before assigning probabilities to all different outcomes.
We live in an asymmetric world with limited upside, but the downside potential in every security that we invest in is zero. That is why we have to evaluate each security carefully.
We spend a lot of time looking at terms and restrictions on covenants and how these conditions may affect bond value. By using all the data that we collect in our one-on-one discussion with the analyst, we understand the risks that we are taking and how we are likely to be compensated.
Q: Could you illustrate your research process with a couple of examples?
A : HCA Inc., the hospital chain operation, is a good example of how we scour companies across the capital structure, senior secured loans and bonds. A couple of years ago, their senior secured loan was actually trading at a higher yield than the bond even though the senior secured loan was senior to the bond in the company's capital structure . We thought that the senior secured loan was even more attractive because it traded at a discount to par and we believed the company would address this issue by refinancing the senior secured loan at par value in the near future. So on a total return basis, we found the potential return very attractive with relatively low risk.
Another example is Kabel Deutschland Holding AG, the largest cable television operator in Germany. The company also had senior secured loans and bonds as part of the firm's capital structure as well as a HoldCo payment-in-kind "PIK" bonds outstanding.
We like investing in the cable industry because of the low volatility and stickiness of revenue and high generation of cash flows. We thought that the market was pricing the PIK incorrectly because of the perceived risk to the German cable company. However, we believed that the risk for Kabel Deutschland was much less than priced in because of the growth opportunity in Germany with limited downside to those growth prospects. The typical cable subscriber was paying around $20 per month while the typical US cable subscriber can spend over $100. We knew that much of Kabel Deutschland's network was built and the company was starting to successfully sell telephone and internet services. We thought that Kabel Deutchland had significant revenue upside, by taking away business from Deutsche Telkom, which would lead to a potentially improving credit story. We invested in the most junior part of the structure in the HoldCo PIK bonds. Deutsche Bank having an analyst in Germany covering this sector allowed us to better understand the credit and take advantage of a mispricing in the market.
Q: How important are re-rating opportunities in your process?
A : It is important to look at the upside. We spend a lot more time worrying about our downside scenario since bonds have asymmetric risk with a limited upside.
For the most part each bond has unlimited downside, and because it can go to zero and limited upside, we have to be more focused on our downside scenario.
Q: Have your views changed since 2008?
A : Generically, our process has not changed to any large degree. However, we are now concentrating more on the liquidity of individual securities. The high-yield market doesn't have the same liquidity as it once did given the constraints on banks balance sheets today.
A focus on market tail risks has always been a part our process and part of security scenario analysis. However, it has become even more important following the events of 2008.
Q: How do you build your portfolio?
A : There are between 180 to 270 issuers in the fund, with the top ten issuers being around 25% and the top 20 accounting for around 40% of the fund.
In terms of diversification, we do not go over 5% for any issuer, whereas from a sector perspective we limit our holdings to no more than two times the industry weighting in the index. In reality, we will rarely ever go over 3%. Right now, the biggest position in the fund is a little less than 3%.
We like certain aspects of the healthcare sector and less cyclical plays such as cable and telecom businesses. In general, we like sectors where we have high entry barriers, stable competitive landscape and low substitution risk.
Our benchmark for the fund is the Credit Suisse First Boston High Yield Index.
Q: What is your sell discipline?
A : We sell a security for a couple of reasons. First, when a security hits a fair value target and gets to a point where we think the bond is just expensive, we will generally sell the security. Second, if we see a better opportunity in another security we may look to trade out of the most expensive security into a security which may offer more attractive risk-return basis and returns.
Q: What kinds of risk do you focus on? How do you contain risk in the portfolio?
A : We measure risk in the fund at several levels. First of all, our entire investment and research process is embedded with risk analysis. Specifically, we evaluate risk at the portfolio level, the issuer level, and the security level.
We size positions in the portfolio by focusing on the downside or expected recovery of a bond and the expected return of the bond. We want risk in the portfolio but only risks that we understand and are compensated for. We want a well diversified portfolio and limit position size in an issuer to a maximum of 5% but in reality rarely exceed 3%. We also limit our sector weightings to the greater of 10% or 2x the sector weighting. It is extremely important to maintain a diversified portfolio to minimize downside and the potential impact of negative surprises.