05/25/2013

High Yield – A Different Approach

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Within the high yield corporate bond market, it is feasible to implement a conservative investment strategy.

The high yield corporate bond market consists of bonds issued with a rating below investment grade, and those bonds that have been downgraded to a rating below investment grade.

Aquila Three Peaks High Income Fund pursues the investment objectives of the Fund while implementing a conservative high yield investment strategy. To explain the conservative strategy, and why an investor might find it appealing, let’s first look at characteristics of the high yield asset class relative to other asset classes.

High yield versus equity

Research conducted over more than two and a half decades has demonstrated that the high yield asset class has produced returns that are very competitive with equities, and that it has done so while generating roughly half the volatility of equities. This characteristic makes the high yield bond market appealing to both individual and institutional investors who hope to achieve attractive rates of return without experiencing the degree of volatility that is characteristic of the equity market.

High yield versus investment grade bonds

Generally, the value of an outstanding bond will rise as interest rates fall, and decline as interest rates rise. Duration is a measurement of the variability in the value of a bond associated with a change in interest rates. A bond with a lower duration will experience less variability in value relative to a bond with a higher duration, given the same change in interest rates. Duration is determined by the time remaining to the maturity date of the bond, and the coupon payments on the bond, so that a longer maturity and lower coupon will produce a higher duration, while a shorter maturity and higher coupon will produce a lower duration. High yield bonds, which are lower rated bonds that involve a greater degree of credit and default risk, typically have higher coupons than investment grade bonds, and they are typically issued with maturities of 10 years or less, whereas investment grade bonds may be issued with maturities of 20 years and longer. Lower duration is a characteristic that makes the high yield bond market appealing to both individual and institutional investors who hope to earn income without experiencing a high degree of volatility in value, should interest rates rise.

There is nothing uniform about high yield bonds

The U.S. high yield corporate bond market includes more than 1,900 issues valued collectively at more than $1 trillion dollars. The three major rating agencies, Standard & Poor’s, Moody’s and Fitch, rate high yield bonds from lower medium grade (BBB) through speculative (BB), highly speculative (B), extremely speculative (CCC), approaching default (CCC- to C), and in default ( D). Every industry sector is represented in the high yield market, along with many well-known companies. Some companies issue bonds in the high yield market, while the bonds of other issuers fall into the high yield category due to a credit downgrade by one or more of the rating agencies. Some high yield issuers are in highly-cyclical industries and experience a significant degree of variability in revenue at different points in the economic cycle, which may make it difficult to keep up with principal and interest payments in a weak economy. Other high yield issuers are in industries that experience a lower degree of variability in revenue throughout the economic cycle, making them better able to support high yield debt. Many bonds issued in the high yield market include terms, or covenants, that restrict the financial decisions of corporate management, while investment grade bonds that are downgraded into the high yield market often include no such restrictions. The wide degree of variability among issuers and bonds represented in the high yield market is a characteristic which makes it critical that investors in high yield bonds know what they own.

A conservative high yield strategy

Given the characteristics of the high yield corporate bond market, it is feasible to chart a course that would reduce potential sources of volatility, and implement a conservative high yield investment strategy.

By investing in high yield corporate bonds, an investor can take advantage of the lower volatility of the high yield market relative to the equity market. Adding assets with equity-like volatility to a portfolio of high yield bonds, such as preferred bonds, convertible bonds, payment-in-kind bonds, zero-coupon bonds or distressed bonds would reduce the benefit of the high yield market’s lower volatility relative to equity.

By investing in high yield corporate bonds, particularly those with a shorter maturity, an investor can take advantage of the lower duration and higher income producing capability that is characteristic of high yield bonds relative to investment grade bonds that often have a higher duration and lower potential for income generation.

By investing very selectively in high yield bonds, an investor can choose issuers in less cyclical industries that can better support debt payments. Investors can also choose bonds that align with their tolerance for risk, and search for those bonds that may benefit from a positive event such as an improved earnings report or a rating upgrade. The research required in order to select appropriate high yield issues is the most demanding aspect of a conservative high yield strategy.

Aquila Three Peaks High Income Fund

Through the conservative investment strategy implemented in Aquila Three Peaks High Income Fund, we seek to take advantage of the high yield market’s lower volatility relative to equities, and lower duration and higher income potential relative to investment grade bonds. The strategy is also characterized by efforts to reduce potential sources of volatility, and by rigorous research.

  • Within the high yield market, we focus on those industries that are able to deliver more consistent revenue throughout the economic cycle, and we avoid those industries that experience a high degree of cyclicality in revenue generation.
  • Within the high yield market, we search for corporate management teams that are focused on reducing leverage by using free cash flow to repay debt, and that have placed a priority on improving the corporate balance sheet.
  • We conduct rigorous initial and on-going research in order to understand the full corporate capital structure, the bond covenants under which management must operate, the range of variables that could impact revenue generation and corporate performance, and to search for the characteristics that we believe will support principal and interest payments, and in some instances, result in a rating upgrade.

We invest in the high yield asset class, because it has generated returns that are competitive with equities while demonstrating less volatility than the equity market, and less interest rate sensitivity and higher income potential than investment grade bonds. We then attempt to diminish potential sources of investment risk while searching for potential positive events. This investment strategy is a good fit for the investor who finds the characteristics of the high yield asset class appealing, and who prefers a high yield corporate bond strategy designed to reduce, rather than increase, exposure to potential sources of volatility.

Once you take a close look, you may find that Aquila Three Peaks High Income Fund is just what you were looking for.

Before investing in the Fund, carefully read about and consider the investment objectives, risks, charges, expenses, and other information found in the Fund prospectus. The prospectus is available from your financial professional, and when you call 800-437-1020 or visit www.aquilafunds.com.

Investment Considerations: Mutual fund investing involves risk; loss of principal is possible. Investments in bonds may decline in value due to rising interest rates, a real or perceived decline in credit quality of the issuer, borrower, counterparty, or collateral, adverse tax or legislative changes, court decisions, market or economic conditions. The Fund’s portfolio will typically include a high proportion, perhaps even 100%, of high-yield / high-risk securities rated below investment grade. High-yield corporate bonds generally have greater credit risk than other types of fixed-income securities and may be especially sensitive to economic and political changes or adverse developments specific to the company that issued the bond. The return of principal for the bond holdings in this fund is not guaranteed.

Not FDIC Insured | No Bank Guarantee | May Lose Value | Not NCUA Insured