Quick Take: With the high-yield bond market splitting into a higher-quality camp and a more-distressed segment, Kent Gasaway, manager of Buffalo High Yield Fund (BUFHX), is betting on better-quality issues, figuring that low-credit bonds aren’t worth the risk. Gasaway says he can’t find enough quality bonds, but he’s hopeful that the improving economy will lead to more high-yield bonds with credit ratings he’s comfortable with. The fund’s average credit quality is B+, although Gasaway says it’s getting closer to BB.
Upside gains in the high-yield market may be limited this year, Gasaway advises, since he feels a lot of the good credit bonds have already moved up, but he’s hoping for an “equity kicker” from his convertible-bond holdings, currently about 20% of the fund. On top of a 6% to 7% gain from his core positions, Gasaway believes he can get an additional 2% rise from convertibles.
Gasaway’s focus on quality has helped over time, although recently he has taken a hit, primarily from K-Mart, which he’s not giving up on. For the three-year period through May, the Buffalo fund was one of the top-performing high-yield offerings, gaining an annualized 5.0%, versus a 0.8% loss for its peers. More the recently, the fund was up 1.3% for the one-year period through May, versus a 0.4% decline for its peers.
The Full Interview:
S&P: What is your approach to high-yield bonds?
GASAWAY: We follow a two-pronged strategy of core holdings with strong long-term trends and additional holdings in more cyclical industries. We’d like to fill the portfolio with bonds with good prospects, but many industries are healthy and don’t have a lot of debt.
About 60% of the portfolio is in core long-term holdings, and the rest is in cyclical areas we aren’t necessarily married to after they reach their peaks.
S&P: Is your approach primarily top down?
GASAWAY: That’s where it starts. Our top-down approach is a little different, since we focus on trends in industries rather than the direction of interest rates. Right now, we’re following 18 trends for the next three to five years in a number of industries.
S&P: What are some of those trends?
GASAWAY: One is demographics, where we’re focusing on the sweet spot of the growing population — the 45 to 65 years age group. That segment will grow three times as fast as the overall population, and since they have more discretionary income, they’ll boost the travel, gaming, and hotel sectors. In debt land, we own a lot of hotels, casinos, and cruise lines.
S&P: Those areas have been growing for some time.
GASAWAY: The gaming industry is traditionally a debt-financed industry, but it’s been deleveraging and paying down debt as it matures. Gaming is getting to the point where it is self-funding, but it’s in the early stages, so there’s been a lot of debt financing. Some gaming subsectors are new, like riverboat gaming, so there are opportunities.
S&P: What other trends are you following?
GASAWAY: The pharmaceutical area is also benefiting from demographic trends, but the larger players don’t issue much debt. We own some smaller, specialty pharmaceutical players, but not a lot since there aren’t very many.
S&P: What are some of your cyclical plays?
GASAWAY: Our cyclical holdings have underlying trends causing the industries to grow faster than the GDP. In this area, we’ve been selling energy bonds since oil prices are high, and buying homebuilders, automakers, and auto suppliers, like Cummins Inc.
S&P: What kinds of returns do you aim for?
GASAWAY: We’re in the middle of pack, probably with above-average yield. We don’t look for the highest yield, since that can come back to bite you if you’re always on the edge. We typically have above-average yield, solid cash flow, and a little of an equity kicker from convertibles.
S&P: Would you call your approach conservative?
GASAWAY: It’s more conservative in that we’ve been moving toward higher quality instead of only looking for yield. We’ve taken the higher road. Ultimately, people will judge you by total return. In the end, if you have a lower default rate, you have a better credit history.
S&P: Have you had problems with defaults?