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Mutual Fund Q&A: 
Relative Value in High Yield Bonds
Rainier High Yield Fund
Management: Matthew Kennedy

Author: Manish Shah
Last Update: 7:19 AM ET March 23 2012

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A diversified portfolio of high yield bonds has the potential of offering returns that can rival solid performers in the equity market. Matthew Kennedy, portfolio manager of the Rainier High Yield Fund, combines a disciplined overlay of risk management with a careful selection of bonds issued by companies with trustworthy management and improving business operations.

Q:  What is the history of the company?

A : Rainier's roots extend back to 1973 through predecessor organizations. Five partners started working together in 1986 as principals at Rainier Bank. The firm became independent in 1991 and has served as the subadvisor for the Rainier Investment Management Mutual Funds since 1994.

In 2007, Rainier opened a second office in New York City in response to a growing client base within the Eastern US. As we matured from being a regional to nationally recognized firm, many of our new clients over the last few years have been located outside the Pacific Northwest. The New York office is used to better serve clients by providing access to client service professionals.

In addition to relevant portfolio management experience, Rainier is experienced in serving a wide range of clients including institutional investors, corporate retirement plans, independent broker/dealers and RIA’s.

Q:  What are the benefits of high yield investing?

A :
Currently, investing in high yield is attractive because of the additional yield and total return potential. From a risk profile standpoint, in the current interest rate environment high yield is attractive given the excess yield or spread risk premium it can offer relative to Treasuries or investment grade bonds.

For instance, if the economy begins to do better, the companies that issue high yield bonds are likely to improve their ability to repay their debt, which leads to better valuation of these bonds. The benefit of an improving economic cycle is that it leads to better returns for high yield bonds, something we cannot say for sovereign bonds or investment grade bonds given the greater proportion of interest rate risk.

Q:  Would you highlight the core beliefs behind your investment philosophy?

A :
We emphasize yield and quality of the issuer to maximize long term risk-adjusted returns in the fund. By concentrating on higher quality high yield bonds that have ratings of B or BB, we minimize the downside volatility in any macroeconomic environment.

We take a full business cycle approach as we seek to outperform the broader market over time. In an upside market we aim at index-like returns, and in a down market we look to significantly outperform the index.

Q:  How do you convert this philosophy into an investment process?

A :
The cornerstone of our investment process is the intensive fundamental credit analysis that we conduct to identify issuers with improving trends, strong liquidity and cash flow, and access to capital.

This rigorous process has four components to it - idea generation, research and analysis, portfolio construction and monitoring and risk control.

As a starting point, our idea generation is driven by quantitative screening of new issuers in the high yield market. We screen such potential investment opportunities based on spread valuations, sector or maturity, in order to provide a list of candidates for in-depth research and analysis.

Next, we review corporate events like earnings, mergers and acquisitions or spin-offs that could lead to mispricing and relative value opportunities.

Once we have identified an issuer with potential from a fundamental credit perspective, we move on to the valuation phase. After narrowing the selection of companies with good business fundamentals, improving cash flows and catalysts in place to improve their credit profile, we start taking a closer examination of these companies to build our portfolio.

What we employ is a bottom-up portfolio construction process that reviews one company at a time. Although we are benchmark aware, we do not allocate funds based on sector weights that are in the index. For example, right now, we are significantly overweight in energy and telecom sectors and we do not own any companies in the financial sector.

Based on our fundamental analysis of the macro environment, we will tweak the weightings over time so that we may be more defensive or aggressive based on the valuations of different high yield bonds on the ratings ladder. If we have a strong view on the economic momentum, we will not be hesitant to increase our exposure to lower rated bonds, meaning we are not always restricted to higher quality of bonds. For us, it is relative value that always matters.

Our maximum issuer limit in the portfolio of 5%. We are not always driven by the quantitative aspects of investing and do focus on several qualitative aspects as part of our process.

The qualitative aspect really comes down to being able to trust management, especially that of a high yield issuer. Above all, we want to make sure management executes what they say. We certainly do not want to be surprised by a company that suddenly undertakes a transformational acquisition or re-leveraging of its balance sheet to buy back stock, which would be a negative factor from a fixed income return perspective.

As far as risk control is concerned, we search for companies that have the ability to generate consistent free cash flow over time. In our view, that is where the deleveraging, outperformance and downside risk protection is likely to come from. If a company can generate free cash flow, we feel confident that it is going to be able to not only improve its credit profile over time but will also lead to lower spreads. Furthermore, we also scrutinize the revenue and margin trends.

Generally speaking, we want to be certain that all the companies in the portfolio have adequate sources of liquidity to address refinancing risk either through cash on the balance sheet or with the help of a significant untapped credit revolver. We need to have the confidence they have sources of liquidity to ensure that they can survive a period in which they cannot access the capital markets.

Q:  Would you give a few examples to better illustrate your investment process?

A :
An example of a company that is representative of the type of credit that we look for is HealthSouth Corporation. It is the owner and operator of inpatient rehabilitative hospitals.

Although it never filed for bankruptcy protection, the company’s credit profile deteriorated significantly following the corporate accounting scandal in 2002. Richard Scrushy, who was Chairman and CEO of the company at the time, ended up in jail. Consequently, the company’s management team was replaced.
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