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Mutual Fund Q&A: 
Avoiding Underperformers
Touchstone High Yield Fund
Management: Brendan M. White

Author: Manish Shah
Last Update: 10:56 AM ET February 28 2012

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Investing in high yield bonds can be especially rewarding if the economy is growing moderately while the default rate is low. Brendan White, portfolio manager of the Touchstone High Yield Fund, explains how the proper selection of sectors and companies with appropriate capital structures translates into an attractive risk-reward ratio for investors in high yield bond funds.

Q:  Would you provide an overview of the Touchstone High Yield Fund?

A : Touchstone Investments is a mutual fund company that provides access to well-known and respected institutional asset managers through extensive sub-advisory relationships.

The Touchstone High Yield Fund is sub-advised by Fort Washington Investment Advisors, Inc, and I lead a team of analysts that manage the Fund.

Q:  What are the key advantages of investing in high yield bonds?

A :
We believe that high yield is an asset class with solid risk-adjusted returns and upside-downside tradeoff. Generally speaking, this class provides income and consistent returns on an efficient basis with a lot of downside protection.

In the current market environment, high yield bonds appear to be very appealing. The fundamental backdrop for the high yield market looks appealing with default rates projected to remain at very low levels. Additionally, high yield spreads to treasury bonds are above historical long-term averages.

We have a moderately expanding economy and, more importantly, a rather low default rate, below 2% with a default forecast expected to remain low. We see that as a nice value proposition for high yield.

With yields and rates at their current levels, we feel that it is going to be very difficult for core fixed income funds that invested in U.S. Treasuries to generate attractive returns because of a lack of yield and the potential for higher interest rates.

When comparing high yield to equities, the latter prove to be better returning assets in the longer term. But in the current environment where we have low economic growth with limited upside, we think that high yield can deliver most of the returns that equities can but without a lot of the volatility.

Q:  What is your investment process?

A :
There are actually two parts in our process. The first few steps are top-down, risk control evaluation steps and the final step is the credit selection step, which is bottom-up.

Starting with the top-down steps, we initiate the process with a sector bias that is always in place. There are a variety of sectors that we think are appropriate to be managed with leveraged capital structures because of the stability and predictability of cash flows and revenues.

Oftentimes, these are sectors that are less cyclical, or more hard-asset in nature. Such examples might include sectors like energy, utilities, healthcare, and others. As a rule, we tend to be overweight in these sectors.

There are also a variety of sectors that we consider inappropriate in the high yield market because they are very difficult to manage with leveraged capital structures. They are often characterized by cyclicality, volatility, and have limited asset protection, such as technology, gaming, banking and financials and other cyclical sectors. We tend to be underweight in such sectors as part of our risk control strategy at the portfolio level.

Another component of the top-down portion is a macroeconomic step where we may lean the portfolio in one direction or another based upon our macroeconomic outlook. All of our portfolios are constructed with an orientation to hold securities for a long-term and across a full business cycle.

The final step in the top-down part of the process is the structural avoidance step in which there are a variety of securities that we avoid from a structural standpoint. We focus on the BB and B rated securities in the market because we believe BBs have delivered the best risk-adjusted returns, whereas lower quality bonds rated CCCs have risk-adjusted returns that we believe are inadequate.

Moreover, we do not think we are compensated for the additional risks that occur in the CCC rated segment of the market and therefore do not purchase CCC rated securities. We also de-emphasize the zero-coupon bonds primarily because they tend to be issued by companies that do not generate free cash flow. In our view, generation of free cash flow is critical in high yield.

We focus on the higher quality part of the market because that is where the best risk-return tradeoff exists, and that is the best way to manage high yield bond portfolio.

The first three steps in the first part assist in reducing downside volatility significantly in times of stress. The final part is the credit selection when our team of analysts conducts a deep dive into a particular credit. Our team is very experienced and is a key attribute of our high yield strategy.

The team starts with the industry analysis. We search for industries that have favorable cash flow characteristics that are more stable and predictable. Once we get there, we like to assess the competitive advantages among industry participants. We want to make sure that the industry will continue to grow, that there are no undue competitive forces from the market, and that the industry has the need to exist.

Next is the analysis of management. At this stage, we want to get comfortable with a management team’s track record, reputation, and integrity. We want to get a clear idea on the compensation and governance structure of management. This is a very critical and important part of the process.

The focus then shifts to the capital and debt structure of a particular company.

An important part of the process for us is the assessment of liquidity or the ability to access capital through external means. Ideally, we want companies that have generated liquidity internally and have the ability to access capital through external sources, which means accessing the equity markets, debt markets or the bank loan markets. We are always looking for companies that can survive times of stress with sufficient liquidity throughout such periods.

As a next step, we dive into the income statement to determine the ability of a company to generate cash flow. Here, we will focus not only on stability but also the predictability of cash flows. In the end, we evaluate the business and financial metrics in the research report, which is put together by the analyst for sharing with the entire team.

The team will then assess and determine if the idea makes sense. At the end of the day, I decide which bond to buy, sell or hold, but do so with considerable deference to our research team.
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