Ray Kennedy and Mark Hudoff, self-described "credit geeks," are back doing what they enjoy most: finding cheap credit bonds and plowing through the details as portfolio managers of Hotchkis and Wiley Capital Management's new high-yield fixed-income fund.

The two men honed their credit skills for ten years each at Pimco, where they managed the firm's high-yield assets. Kennedy retired from Pimco in 2007 and spent the next year and a half working on charitable endeavors. In October 2008, longtime friends who are principals at Hotchkis and Wiley in Los Angeles asked him to start up a high-yield business at their firm. He came on board the next month, and began trading in February 2009. In June, the SEC-registered Hotchkis and Wiley High Yield Fund opened and in July Hudoff joined him there.

Pimco's high-yield business had some $35 billion under management when Kennedy left, and was larger still when Hudoff departed two years later. "Both of us loved Pimco," says Kennedy, "but starting with a small business, watching it grow and then growing to a big business, things change. You have to change your style, your approach to the market. When we started in high yield, an $800 million business, we were able to buy unique off-the-run issues that were very credit intensive."

Hudoff recalls "the halcyon days at Pimco, when we had a relatively small footing [and] very close relation to the clients and products. But when you get to the size we were at, we were spending our days managing cash flows, managing reports to explain everything that was going on, which is responsible portfolio management in a big organization. But it was less of a credit job and much more of managing the landscape."

At Hotchkis and Wiley, he says, "we're looking for the best risk-reward ideas that we can find in the marketplace. Rather than being driven from the top down from a macro perspective, we're much more focused on the bottom-up stock picking of individual securities." Kennedy adds, "That's what attracts both of us because we're both credit geeks and grew up looking at companies, and that's fundamental to this business."

Another attraction of the smaller firm is that it's run by its owners, he says. "Everyone is working toward the greater good of everyone's equity ownership," says Hudoff. The company is small, with a total of 63 employees. "Ray and I love building businesses, but with a real craftsmanship approach toward both the product and the client," he says.
They also like the fact that Hotchkis and Wiley isn't bashful about closing funds to new investments if size starts to drag on returns.
"Ray and I have talked about this a lot," he says. "When a fund gets to be large enough so that becomes an issue, we won't have any kind of problem, and no one at Hotchkis and Wiley would have a problem with us closing it."

The High-Yield Strategy
By keeping the sizes of their funds under control, Hudoff and Kennedy say they have greater freedom to delve into the smaller segment of the market-deals that are less than $500 million in total debt at a company.

"One of the things you'll see in our strategy now is to take advantage of some smaller cap names-very credit-centric stories," Hudoff says. "We have 22 analysts covering the U.S. market. ... That plays very strongly to a small-cap shop having an edge over a large-cap firm."

The high-yield market historically has comprised fallen angels, core names and small caps, according to Kennedy. From 2004 to 2007, the differences between those segments were relatively small, owing to low volatility in the market. But as volatility picked up in 2008 and 2009, the separation between them increased significantly, creating opportunity, he says. Hotchkis and Wiley has a value orientation on the equity side, so its analysts know the fallen angels very well. Likewise, the analysts know small-cap names because the firm offers a small-cap product. "That's where our alpha is going to come from our strategy-from those wings," he says.

The Hotchkis and Wiley high-yield investment philosophy is defensive, the managers say. "You start with the premise that you're looking for an improving credit and want to avoid the losers," says Kennedy. "Along with that, we're looking for improving companies-companies with significant asset coverage and companies that have a reason to exist."

To implement this philosophy, Kennedy and Hudoff build on a three-level pyramid that has three styles of assessment ideas. The first is core names, which represent 50% to 75% of the portfolio. These tend to be defensive or improving names, whose yields are at least half the index average. Most of them will remain high-yield for a long time, says Kennedy-Tenet Healthcare, for example. Their performance will not surprise, either on the upside or the downside, he says. "They are basically the workhorse of the portfolios, the ballast," he says.

The bonds in the core category generally have a 12- to 18-month investment horizon. Their prices tend to be slightly higher, at index price or over par. "But that's where you're going to be getting the core income from your portfolio," says Kennedy. "You'll beat the index with those names because they don't blow up on you; so, in a down market, they tend to outperform."
The fund's alpha comes from the pyramid's other two categories. One consists of the high-return names-Office Depot, Valassis Communications and Quicksilver, for example-that made up 25% to 40% of the portfolio eariler this year. Here the fund is buying something at a price significantly lower than the index price, says Kennedy. These are rapidly improving situations or ones in which a turnaround is imminent. The investment horizon is shorter-six to 12 months-than for core names. The yields are going to be higher, but there is going to be more risk than with the ballast names, he says.

The pyramid's other alpha-producing category consists of special situations, such as CIT Group, the commercial and consumer finance company that is attempting to emerge from bankruptcy with the help of TARP funds. This is the smallest part of the portfolio, ranging from zero to 25%. These trades are usually short-term, three to six months, involving names bought to a call or to a takeout. An event may be driving the bond, such as refinancing activity.

Risk Controls
The fund restricts itself to a maximum 5% per name, a maximum of 10% in bonds rated CCC or lower and a maximum of 20% per industry. Bonds in the portfolio have a maturity expectation that falls within 50 basis points of the index. No more than 10% of assets are held as cash. There are also soft guidelines in terms of what Kennedy and Hudoff are looking for in companies: 125% asset coverage and free cash flow. They like to see companies with a minimum of 7% free cash flow to debt.

"At the end of the day, it's the credit risk that drives performance and downside in a portfolio," says Hudoff. "It's looking at those positions on a daily basis, monitoring the spread duration of those positions and the volatility of the issue that incorporates your risk assessment of the overall portfolio. Beyond that, it's pretty straightforward."

Kennedy and Hudoff run a more concentrated portfolio than they did at Pimco-between 75 and 100 positions versus more than 150 at the larger firm, says Hudoff. "We don't have anything other than high yield in the portfolio, generally speaking. There may be some investment-grade bonds in there, but they're trading in anticipation of being downgraded to high yield," he says, adding that there are no complex or exotic securities in their portfolios.

For a client who wants exposure to high yield, he says, "this is pure beta high yield, and then the alpha of Ray and me with nearly 20 years' experience sitting on top of this portfolio and working it daily."

In addition, high yield provides a big coupon the client can reinvest in other things, and it offsets any other kinds of very low-yield exposure that high-net-worth investors might have, says Kennedy. Cyclically, it has proved to be a very strong-performing asset class for several periods into an expansion, he says.

The fund's benchmark is the Merrill Lynch BB/B Constrained Index. "We're running against a higher quality benchmark, so if the market does sell off, we had better run a better quality portfolio because otherwise we'll underperform," says Kennedy.