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Mutual Fund Q&A: 
Seeking Relative Value in High Yield
Prudential High Yield Fund
Interview with: Robert Cignarella, Chris Nicholson

Author: Ticker Magazine
Last Update: 5:19 PM ET March 03 2017

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High yield bonds can offer an attractive risk reward profile but the asset class is not without risks and potential volatility. The Prudential High Yield Fund seeks relative value in primarily higher-quality, high-yield bonds that are carefully researched by analysts and portfolio managers.

Q: What is the history of the fund?

A: The Prudential High Yield Fund, which was launched in March of 1979, is one of the 14 high yield funds of the nearly 200 funds in its category with a track record prior to 1980.

Prudential Financial has been around since the 1800s, and the fund’s subadvisor, PGIM Fixed Income, has been managing assets since 1875. Prudential Investments is the distributor and manufacturer of this fund as well as all of PGIM’s other retail mutual funds, with about $82 billion in assets under management as of December 31, 2016.

The fund focuses on carefully-researched, performing credits and relative value analysis using a ranking process that is essentially real-time and ingrained. The approach focuses specifically on high yield bonds, not equities, preferreds, or convertibles. The investment philosophy is underpinned by an appreciation that the higher-quality part of the high yield market can provide more attractive risk-adjusted returns and, in many cases, better total returns through a market cycle.

A key differentiator is the depth of PGIM Fixed Income’s resources—a 49-member global leveraged finance team with 18 portfolio managers/traders and 31 senior credit analysts, supported by 13 junior analysts as of December 31, 2016. The team actively researches more than 500 U.S. issuers; each issuer is then ranked using a proprietary relative-value matrix which helps to guide buy-and-sell decisions.

Q: What core principles guide your investment philosophy?

A: High yield bonds can be volatile due to their higher risk of default relative to investment grade corporate bonds. However, we believe that building well-researched, well-diversified portfolios from the bottom-up with a focus on downside protection allows us to capture the additional spread offered by high yield bonds. Furthermore, focusing on the upper quality tiers of the high yield market, which historically have generated the best risk-adjusted returns, can lead to consistent outperformance versus a broad market high yield index over time.

The investment process is research-intensive. We research and rank the relative value of industries, assigning each one a fundamental outlook. We then research and rank the individual issuers within each industry, assigning each an internal credit rating.

Although our high yield bond portfolios tend to invest in B and BB-rated companies, if our risk view differs from that of the market, we may choose to invest in a CCC-rated issuer that we believe is undervalued. Similarly, we may invest in a bond with a tight spread that is offering less yield if we believe the risks for that company are smaller than what is priced into the market.

Q: How do you organize your investment process around this philosophy?

A: Since our strategy is focused on maintaining principal and mitigating downside risk, we invest in, what we consider to be, stable-to-improving companies that should survive market cycles. These tend to be larger-sized companies. In addition, we prefer companies with earnings that are less volatile than the overall market—which is one reason the strategy has been underweight commodities.

While the approach is predominantly that of bottom-up credit selection, the firm’s top-down views helps us assess the global macroeconomic backdrop and the risk appetite of investors. Political, interest rate, and industry scenarios are evaluated at weekly meetings that include the CIO, economists and strategists, heads of the fixed income desks, and the risk management team. The outcome, and resulting biases for the credit-sensitive sectors of the market, helps to influence the risk profile of portfolios.

The credit analysts conduct ongoing screening of the high yield universe using multiple criteria, narrowing the target U.S. universe from more than 1,000 to about 500 issuers. Screening factors include asset/collateral quality, financial profile, sustainability of the capital structure, management experience, competitive position, and industry trends.

The high yield bond portfolio managers and credit analysts are aligned by industry, providing in-depth coverage on each issuer—bottom-up fundamental analysis as well as market, spread, technical, and liquidity considerations. Together, they evaluate the relative value of each issuer.

From the target investment universe, portfolio managers seek to maximize relative value via security selection and position sizing. The process is governed by a comprehensive risk management framework. Daily risk reports measure both systematic and non-systematic risk and quantify the impact from various scenarios and market stress.

Q: What is your research process?

A: PGIM Fixed Income considers credit research to be a career. The high yield bond analysts are highly experienced with each one specializing in three to four industries, developing opinions on both their industries and issuers. They analyze each industry’s current fundamentals and future prospects. For each issuer, they analyze revenue trends, cash flow generation, profitability, management strength, market position, covenants, and the propensity for mergers and acquisitions, among other factors.

Direct dialogue with the issuing companies often provides the most valuable source of information. The high yield analysts conduct more than 1,000 meetings and conference calls per year with company management and representatives. Further, analysts maintain written research reports and valuation models for each issuer, which they update quarterly.

Portfolio managers analyze the same industries and issuers from a portfolio management and trading perspective, evaluating current versus historical spread levels and value propositions across similar and different securities. The joint ranking process mentioned earlier is a collaborative process whereby the portfolio managers and analysts identify what they consider to be the best relative value within the asset class.

High yield bond portfolio managers and traders meet daily with the credit analysts to discuss new market data and trends, earnings releases, issuer developments, and buy/sell decisions.

Q: How do you construct your portfolio?

A: We believe diversification is essential in high yield investing. All portfolios are constructed using on a risk budget that stipulates the risk biases/exposures that may be assumed. Risk budgets are in tracking error terms relative to a benchmark.

Industry, issue, and position sizes are based on the risk budget thresholds, the rankings in the relative value matrix (with the highest-ranked issuers typically becoming the largest positions), as well as other factors such as the size and liquidity of the issuer, the team’s top down view of the economy, stage of the credit cycle, industry trends, and market valuations.

The fund’s benchmark is the Bloomberg Barclays U.S. Corporate High Yield 1% Issuer Capped Index. As of December 31, 2016, there were 677 issues and 377 issuers in the fund. Generally, the number of issuers ranges from 325 to 375, so currently we are at the high end of the range. Of the issuers, 81.7% were U.S.-based and 13.9% non-U.S. or domiciled, with cash and equivalents roughly 4.4%.

As an actively-managed portfolio, turnover is historically around 50%. In the fiscal year ended August 2016, the turnover rate was lower than average at 28% predominantly due to inflows. In 2015, turnover was 48% and in 2014 it was 51%.

Q: How do you approach and manage risk?
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Sources: Data collected by and from company press releases, filings and corporate websites.
Market data: BATS Exchange. Inc.

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