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.