Taking a Holistic View of High-Yield Bonds

by Laurie King, Wells Fargo Asset Management

Margie Patel explains: The whole economic picture looks pretty encouraging for investors.

Margie Patel: I think investors are too preoccupied with very short-term developments and need to step back a little bit and look at the whole economic picture.

Laurie King: Thatā€™s Margie Patel. Iā€™m Laurie King and you are On the Trading Desk. Margie joined us to explain how to rise above the headlines for a clearer view of high yield. As Margie views the marketā€”a couple economic factors point to optimism.

Margie: I try to look at whatever indicators we can see that indicates if thereā€™s a change in the market outlook, and the indicators I look at, especially relating to employment, suggest that the economy is on pretty firm footing and we should continue to look for growth ahead in jobs and income, relatively modest, to be sure, but sustainable. Thatā€™s a pretty good backdrop for investors.

Laurie: High yield comes with risks; Margie explains which risks she feels are appropriate and not appropriate now.

Margie: I think that better-quality high-yield bonds, Iā€™d say bonds rated in the top half of the high-yield universe, look like a pretty good relative part of the market to be. I think the bad risk to take is in the very bottom tier of the high-yield market. The troubled commodity-oriented sectors of the market, the very low-quality-rated issues or distressed issues, because those companies have very, very little margin for error and I think you really arenā€™t being paid appropriately. The yields there I think are too low for the risk that we might see over the next one to two years.

Laurie: Margie is well known in the industry for her stance on and preference for quality companies. Sheā€™s said, ā€œGiven a choice between a higher-yielding bond and a higher-quality bond, I tend to prefer bonds that yield less in order to reduce the risk of capital impairment.ā€ So, we asked Margie, how does quality factor into that?

Margie: So if you invest in a very risky bond and you lose part of that principle, you donā€™t have the huge amount of income weā€™ve had in previous years to make up for that loss. So, therefore, less yield, less risk means youā€™ll get to keep more of that income and not have to give back hopefully none or very little in terms of principle losses.

Laurie: And, if given the choice, Margie explains why she selects companies with niche expertise.

Margie: Well, within every industry there are certain segments of the industry that have long-term advantages. In these days, virtually all sectors of the market are under price pressure. Very few companies can raise prices and the companies that have a unique, special product or process are the ones that have pricing power. So they can raise their prices or hold their prices steady and have better cash flow than the industry as a whole.

Laurie: Margie continues by explaining how she finds those types of companies.

Margie: I like to start with a top-down investing approach, look at industries that I think have good fundamentals, preferably growing faster than the economy or have been cyclical, that theyā€™re beginning a long-term cyclical upswing and the reason for that is simply these companies have the ability to grow their revenues, to grow their cash flow faster than the market overall, even more important in a time when economic growth is relatively low.

Laurie: Also unique to Margieā€™s approach to high yield is the ability to be flexible and invest in the equities of a companyā€”about 10% of the fundā€™s weighting. She explains how thatā€™s an advantage for investors.

Margie: This gives us a few advantages over funds that are strictly high-yield bonds. We can give the client exposure to an industry and still get income from the whole portfolio and have a possibility for capital appreciation. The second point is it gives us a chance to have potential upside capital appreciation, and I think itā€™s easier to get appreciation from our equity exposure than from investing in the very distressed, very low-quality part of the high-yield market, which many people invest in for capital appreciation. I prefer the equities because, at a time when the market and the regulators are very focused about liquidity in funds, we feel that 10% in equity gives us another opportunity for liquidity, should financial conditions change and we need liquidity.

Laurie: As a parting thought, Margie explains how her approach helps investor rise above the headlines.

Margie: I think investors are too preoccupied with very short-term developments and need to step back a little bit and look at the whole economic picture. Itā€™s true, every month we see some data point or another that may look very negative and cast out sort of investment assumptions. But when you step back and look at the broad picture, you really have to be pretty encouraged about the outlook for investors.

Laurie: If youā€™d like to learn more about Margie Patel and the funds she manages, visit wellsfargofunds.com. Weā€™ll keep you current on markets and the economy throughout the week on our blog AdvantageVoiceĀ® and right here On the Trading Desk. Until next time, Iā€™m Laurie King. Take care!

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