12/02/2014

Observations & Lessons from Joe Mysak and the Muni Meltdown that Wasn’t

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The ever-illuminating (and often entertaining) Joe Mysak knows some things about the municipal bond market.  Mr. Mysak is Municipal Market editor for Bloomberg, and author of the Encyclopedia of Municipal Bonds: A Reference Guide to Market Events, Structures, Dynamics, and Investment Knowledge, and has spent 33 years observing and writing about the municipal bond market.  He was recently inspired to compile some of his observations in an article titled The Muni Meltdown that Wasn’t, published as a Bloomberg Brief in November 2014.

In this article, Mr. Mysak chronicles the “inexpert testimony” regarding the municipal bond market that was widely offered and quoted during 2010, 2011 and 2012 by those he describes as “tourists in MuniLand”.  And, he raises reasonable questions such as, why were those who were not experts on the municipal bond market taken so seriously, why were the opinions of those who are knowledgeable regarding the municipal bond market discounted during that period, and what lessons can investors learn from the episode?

Among the lessons investors can learn, Mr. Mysak offers these:

  • The municipal market is particular and specific to a remarkable degree, so that broad generalizations are likely to be inaccurate.
  • We should recognize that not all points of view offered on the Internet are legitimate and credible, and beware inexpert testimony.
  • Not all states allow municipalities to file for Chapter 9, and where it is allowed, municipalities will do all they can to avoid filing.

The Muni Meltdown that Wasn’t is not a quick read, but it is very much worth the time invested in order to gain an understanding of the municipal bond market from a man who actually does possess expertise on the subject.

11/15/2014

Trustees: The Shareholders’ Watchdogs

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Mutual fund boards are the champions of shareholders. But boards and their trustees are still not well understood by investors or their financial advisors. We spoke with three longstanding trustees of the Aquila Group of Funds—John C. Lucking, Thomas A. Christopher, and James A. Gardner—during the September, 2014 quarterly board meetings to learn more about what they do.

Tom Christopher and James Gardner

Tom Christopher and James Gardner

What do mutual fund board trustees do—and why should we care?

TC: We oversee the management and operations of each Aquila fund on behalf of shareholders. We’re the shareholders’ watchdogs. Aquila Group of Funds subcontracts a variety of services—from fund accounting to transfer agency services and, in some cases, to investment sub-advisors (including portfolio managers). As trustees, our job is to review and oversee the performance of those service providers, to verify that agreements with them represent an arm’s-length deal, that they are fair, and competitive.

John Lucking

John Lucking

Every Aquila board includes a member of Aquila’s management team. But by law, a majority of the trustees are independent, as the three of us are.

We’re also shareholders. Every trustee has invested in the funds he or she oversees, oftentimes in substantial amounts. We have skin in the game.

JL: For every decision made by the funds, our job is to ask, “is it good for shareholders.”

JG: That independence is critical. I clearly remember an occasion on which [Aquila founder] Lacy Herrmann realized he wasn’t going to get his way on an issue. He somewhat ruefully commented, “Well, I always said I didn’t want a rubber stamp board.” And I said, “Lacy, we’re your dream come true.”

What convinced you to become an Aquila trustee?

JG: Lacy approached me about helping to build the Oregon board when I was president of Lewis & Clark College in Portland. What sold me was the quality of the operation. I felt I could help fill out the board with people who had the experience, stature, and quality needed.

JL: After getting my PhD in financial modeling at Stanford and working for Phelps Dodge, I became chief economist at Valley National Bank in Phoenix, AZ. At Lacy’s request, I began presenting at Aquila shareholder meetings on the economy and soon was asked to join the board.

One of the big attractions was the people—there’s a variety of backgrounds. The trustees are very concerned with doing a good job and carrying out their fiduciary responsibility. So the variety and the character of the trustees are what I found most attractive.

TC: After a stint at Arthur Young, I relocated to my hometown of Danville, KY to open my own CPA firm. Lacy found me through what was then Aquila’s sub-advisory partner in Kentucky.

The attraction to me was the integrity of the people up and down the line. I recognized the value proposition based on my practice, which included advising wealthy individuals to whom I was already recommending municipal bonds.

In your experience, what makes Aquila unique as a fund manager?

JL: Its integrity. Beyond that, what’s really distinctive about Aquila is its local representation, including on the boards.

The other thing that’s always struck me about Aquila is the annual outreach and shareholder meetings for the municipal bond funds. We learn what shareholders are interested in. And it’s a rigorous exercise to present to a crowd of people with a financial stake in what you’re saying. We’re very prepared.

Is a local portfolio manager really better than a portfolio manager in New York City?

TC: I think so. All the action around state municipal bonds is in the state. Our in-state portfolio managers know the issues way beyond what someone in Manhattan could possibly know. They’ve got access to the local markets and they know the legislation.

How are local trustees important to the funds?

TC: Among the board members, we often have representatives with prior experience in local government. The former Kentucky state budget director for many years, Dr. James Ramsey, is a board member. He knows many of those municipal bond issues inside and out. That’s unique, and makes for strong quality control.

JG: Shareholders are reassured when they attend a shareholder or outreach meeting and they know the trustees. Or they’ve heard about us in the local media.

JL: I’ll see people I’ve known for 20 years at these meetings. That relationship and my investments in the funds are additional incentives in fulfilling this role.

JG: We oversee the analysis of holdings in the funds. We’re aware of the risks and the capacity of the issuers to pay on the bonds. In times of investor fear about municipals, for example when Puerto Rico and Detroit have been in the news, this oversight can be reassuring to shareholders.

You’ve all been trustees for 20 years or more. What has changed the most?

JG: Governmental and regulatory oversight has increased exponentially. That puts a premium on the independence and strength of vision of each board. Take the nominating process. This involves an independent search for people with experience, integrity, and background—people who will contribute as independent trustees. The quality of boards is enhanced by the process.

Another change is the quality of legal, accounting, and other service providers to the funds. It’s a much more sophisticated, demanding environment.

JL: You want to be at the forefront of change, not dragged into it. We’ve made a real effort to be up-to-speed on regulatory, legal, and financial issues.

TC: The most positive change I’ve seen in the last couple of years is the chief compliance officer (CCO) function. He reports directly to the boards, and we ask him very pointed questions about potential risks. Again, we’re looking at matters from the perspective of shareholders. We hired the CCO, and he reports ultimately to us.   In fact, we approve a portion of his salary in order to reinforce that alignment.  That’s a major change.

He’s the watchdog’s watchdog?

TC: Yes!

JL: That due diligence Tom and Jim describe is something that financial advisors and shareholders may not be familiar with. It’s very important and we devote a lot of time to meeting with the CCO.

TC: The focus on the CCO role, including the CCO’s relationship with the board, was greatly enhanced about a decade ago—it’s a good, healthy thing for shareholders.

Who else assists with your watchdog role?

JG: Our legal counsel.  Tom and I chaired the legal succession committee, which was created to address the reality that, several years ago, a number of lawyers with the law firm that represented both the funds and the independent trustees were about to retire. The succession process took a year. We reached out to the best law firms in the country and scrutinized their expertise, commitment, fee structure. As a result, we’ve hired what we believe to be some of the nation’s best lawyers specializing in the fund industry. This process involved all the trustees of each board, was carefully deliberated, and by consensus we got a really good result.

Let’s say something goes wrong in the operation of a fund. What’s your role as trustees?

TC:  Again, we represent the shareholders. If an error were to occur, we would seek to understand the cause, how the error was made, and who would pay to get the error corrected if there were a cost involved. We wouldn’t allow shareholders to foot the bill.  And, we would expect the responsible party to put steps in place to make sure it doesn’t happen again.

Do you meet quarterly?

TC: We meet quarterly in person. We have many phone meetings throughout the year, as needed. If an important matter comes up, we’ll meet. We act immediately.

JL: I’ve been on a conference call from southwest Africa. We also meet by phone—for example, before our quarterly in-person meetings—so we’re better prepared.

TC: Hurricane Sandy is a good example. As Sandy was about to hit, we were on the phone—ensuring that appropriate safeguards were in place and being implemented, and determining how our systems would function in the midst of the crisis. There was constant contact.

What will you accomplish in today’s meetings?

JG: It’s a big weekend. It’s the annual contract renewals for advisors and sub-advisers. This comes after intensive scrutiny—we hired independent consultants to look at our advisors’ performance, expense ratios, and profitability. They did superb work.

TC: I’m on a subcommittee that reviews the advisor’s financial statements in thorough detail. I’ll report tomorrow on our analysis. We want to make sure that our advisor is financially sound.

JL: Before arriving here, we read a number of documents, one 567 pages and another 205 pages. We’re expected to voice any issues we come across.

JG: The expectation is that everyone will have read the materials and will participate in the meeting. After thorough discussion and consideration, we will ask legal counsel whether there is anything else we should consider.

What’s really important about these meetings is the insight around the table. We’ve got the experience and the sophistication to dig into the substantive issues.

TC: Right—everyone has a specialty. I don’t try to analyze the economy; I let John do that. If it’s an accounting issue, they look to me.

We did this before it was required by the SEC—just the independent board members, spending a few hours together before the full board meeting. We’ll call in the CCO, the CFO, the auditors as needed—all independently and without Aquila management present. Everything is handled at arm’s length to make sure that the independence is there and that we know the full story. At the end of the day, it’s for the shareholders.

JG: While the SEC was deciding whether to require a greater level of board independence, we went ahead and did it.

JL: We also go through a process of assessing the board every year to, among other things, make sure the trustees feel they’re getting what they need to do their jobs.

It sounds like a lot of work. What do you enjoy about being a trustee?

JG: Other trustees. Their different backgrounds, the seriousness with which they do their jobs.

JL: Exactly. I enjoy the association.

TC: Ditto. And regarding backgrounds, I think it’s critical in the mutual fund business to have experienced, knowledgeable trustees. This is a difficult industry to get your arms around. Very few people know how funds get distributed, or how the landscape and the rules change. It’s important to have a seasoned, experienced group of trustees. People like Dr. Ramsey.

JL: And Gary Cornia, who’s done research on municipal bonds.

JG: Or on the Oregon board, Ed Jensen, the former COO of US Bancorp; Ralph Shaw, who served as Chairman of Governor’s Council of Economic Advisors of State of Oregon; and John Mitchell, a leading economist in the northwest U.S.

JL: And Lyle Hillyard, who is a Utah state senator.

Tell us what accomplishments you’re most proud of as trustees?

TC: Cutting expenses for shareholders’ benefit. And, restructuring various funds into separate series of one trust. This project was designed to result in efficiencies in the administration and oversight of the funds for the ultimate benefit of the shareholders.  And, shareholders should experience additional savings.

JL: Restructuring the funds has taken the longest amount of time and the most dogged determination to get accomplished. And it’s our most significant accomplishment.

JG: I’m proudest of the quality of the people we’ve been able to attract and retain on the Oregon board. That, and a quarter century of clean audits.

What are your biggest goals for the next few years?

TC: To replace knowledgeable trustees as they retire in line with our retirement policy with competent, experienced trustees. It’s challenging.

JL: We’re going to see more change in this industry, and we need to make sure we’re prepared—to be aware of what’s changing and determine how best to react. I don’t think the change will be revolutionary, but it’s going to be evolutionary, at a pace that’s going to keep us busy.

JG: The nominating process is a challenge and really important for the future. Finding the right experience, expertise—and then, on top of that, the diversity, youth, geographical representation.

Another challenge is how the boards relate to each other. Bringing them together, but in a way that still respects each board’s legal autonomy and fiduciary duty. It sounds abstract but it’s a big challenge and a big opportunity.

What has Lacy’s legacy been on the organization?

TC: Lacy was innovative and definitely ahead of his time on a lot of things. And Diana Herrmann has significantly improved the organization in the last five years. She’s doing an excellent job of moving Aquila forward as a fund family, and as a member of the individual boards that we all serve on. I think Aquila has the highest level of true professionals on its staff today relative to any time in its history.

So my compliments are to Diana. Like her father, she’s doing the right things for the right reasons, and it’s all in the shareholders’ interests. I want to be on the board that has that attitude, and with an advisor who shares that attitude.

JG: I agree—and the board has had a role there, too. Lacy’s legacy is real, vital, and central to the firm. But the boards’ innovations and changes have also been very valuable to shareholders and the organization.

Aquila is maturing, in cadence with what’s going on in the economic, regulatory, and legal environments. And the trustees have been innovative the whole way.

11/01/2014

Please Log In, Call, or Write in Order to Protect Your Account

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Your State Requires some Demonstration that You’ve been in Contact with Us

“Escheatment “, as described on the SEC web site, is the process by which a state becomes the owner of an account held by a financial institution that is considered to be abandoned or unclaimed under circumstances that may include a period of inactivity.  Generally, activity may be demonstrated by contact with the financial institution holding the account, and in some states, is not demonstrated solely by the existence of an automated investment program.

On a regular basis, to establish contact and maintain the active status of your account, please:

  • log into your account at www.aquilafunds.com, or
  • call the shareholder servicing agent at 800-437-1000, or
  • send written correspondence to the shareholder servicing agent.

Your professional financial adviser may also establish contact on your behalf.

The shareholder servicing agent for Aquila Group of Funds periodically sends correspondence to the last known address of any shareholder whose account appears to be abandoned or inactive.

In the event that you receive a letter from the shareholder servicing agent asking you to contact them, please do so at your earliest convenience, following the instructions provided.

We very much appreciate having you as a shareholder, and we hope to continue serving you for many years to come.

10/29/2014

Moving Retirement Plan Assets in 2015? Exercise Caution

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The IRS has announced that “beginning as early as January 1, 2015, you can make only one rollover from an IRA to another (or the same) IRA in any 12-month period, regardless of the number of IRAs you own”.

There are some terms to be familiar with here:

  • Rollover – in the context used here, this means that you have “constructive receipt” of assets from a retirement plan – i.e. they come into your possession.  You then have 60 days to complete a rollover into your IRA account.
  • Trustee-to-trustee transfer – assets from your retirement plan account are sent directly from the current trustee for your plan to the trustee for your IRA account, without coming into your possession.

Beginning January 1, 2015, an IRA participant will be allowed only one rollover in any 12-month or 365-day period.  This applies across all IRAs (Traditional, Rollover, Roth, SEP, SARSEP and SIMPLE IRAs).

As an alternative, a participant can make an unlimited number of trustee-to-trustee transfers where assets are delivered directly to the new trustee.

You are likely to receive information on this new restriction from a number of sources, including a mailing from the shareholder servicing agent of Aquila Group of Funds, BNY.

Please discuss your options with your professional tax adviser before you move a retirement plan account, and visit the IRS web site for details regarding the IRS IRA One Rollover Per Year Rule.

07/11/2014

Municipal Bonds for America coalition – educating Congressional policy makers

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The Municipal Bonds for America (MBFA) coalition conducted a “Municipal Bonds 101” seminar on July 2, 2014 for an overflow crowd of US Congressional policy makers and staff.  The seminar is the second such event hosted by MBFA with the purpose of educating policy makers on the benefits provided by the municipal bond market and the problems associated with reducing or eliminating the tax exemption applicable to municipal bond income.  Panelists speaking during the seminar included Ron Bernardi, Principal, President and CEO, Bernardi Securities, Mayor Steve Benjamin, Columbia, South Carolina, and Kevin Burke, President and CEO, Airports Council International, North America.

Information regarding the Municipal Bonds for America coalition can be found on their website.

04/15/2014

Are You Free of Your Tax Bill for the Year?

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As you put the 2013 tax season behind you, think about how much of what you earn is allocated to pay taxes each year. This year, Americans will pay a total of $4.5 trillion, or 30.2% of their income in taxes. Consider how many days of work will be dedicated to paying that bill. Every year the Tax Foundation1 establishes Tax Freedom Day®, which marks the day when the nation has earned enough money collectively to pay its total tax bill. For 2014, Tax Freedom Day® falls on April 21st; three days later than 2013 due to the country’s delayed economic recovery. This means the average taxpayer will spend 110 days working to pay their taxes. If federal borrowing is included in the equation, it moves Tax Freedom Day® out another 15 days to May 6th.

Take a look at our full report, Have you paid your taxes yet?, which includes the Tax Freedom Day® for each of the seven states where we manage a single state municipal bond fund. Check out the entire 2014 Tax Freedom Day® report to see where Tax Freedom Day® falls for all 50 states.

1The Tax Foundation is a nonpartisan educational organization founded in 1937 to educate taxpayers about sound tax policy and the size of the tax burden borne by Americans at all levels of government.  For more information, visit www.taxfoundation.org.

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.  Fund performance could be more volatile than that of funds with greater geographic diversification.  

For certain investors, some dividends may be subject to federal and state taxes, including the Alternative Minimum Tax.  Consult your professional tax adviser. 

Before investing in a 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 advisor, when you call 800-437-1020, or visit www.aquilafunds.com.   

 

04/04/2014

One Hundred Years of the Federal Income Tax

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It was 100 years ago this year that the first Form 1040 was Sixteenth Amendmentsent out to taxpayers as ratification of the Sixteenth Amendment to the US Constitution made it possible for the federal government to tax personal incomes.

The new tax started at 1% on personal incomes of more than $3,000 (over $71,000 in today’s dollars) for single filers or $4,000 for couples and included a surtax of 6% on incomes over $500,000. Taxpayers were required to complete the new form and submit it to local tax collectors for review by March 1, 1914, where it was forwarded to Washington for a second review at Bureau of Internal Revenue (predecessor of the IRS) headquarters. The total tax due was to be presented to the taxpayer by June 1, 1914 and final tax payment received by June 30, 1914.

Much like today’s taxes, the process was confusing to all involved and prompted the LA Times to lament “The present income tax law is so confusing to the ordinary taxpayer that assistance in the preparation of the income statement is almost necessary.”

The maximum income tax rate has been up and down throughout the last 100 years starting at 7% in 1913 and rising to a high point of 94% during the final years of World War II (1944-45). It stayed over 90% until 1964 when under President Johnson, it was reduced to 77%. Highest Marginal Tax Rates 1913-2013 with SourceIt was reduced again in 1965 to 70% where it stayed until 1981. In that year, Congress enacted the largest tax cut in US history by dropping the highest marginal rate to 50% under The Economic Recovery Tax Act of 1981. The trend continued downward until the maximum income tax rate hit 31% in 1991 and 1992, the lowest point since 1931 when rates were 25%. It is probably safe to say that our current rates which range from 10% to a marginal rate of 39.6% will undergo future changes.  As recently as 2013, we saw the addition of the Net Investment Income Tax (NIIT – see our report Certainty of Taxes for more information on this tax) and changes to the capital gains rate.  There may be more changes to come.

For a more expansive history of our tax structure see our report on the Sixteenth Amendment.

03/27/2014

Individual Stock Selection

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Individual stock selection and active management are strategies that returned to prominence recently, according to a March 9, 2014 Wall Street Journal article.  “After years of moving in lock step on the back of global economic shocks, individual stocks increasingly have been dancing to their own tune” as evidenced by the steep decline seen in correlations1 between individual stocks in the S&P 500 since the financial crisis.

S&P Dow Jones Indices looks at active management from a different perspective in their S&P Indices Versus Active Funds or SPIVA Scorecard, which evaluates the performance of active versus passive management across multiple categories.  Through year-end 2013 their SPIVA Scorecard reported that, for the one-year period, 63% of funds in the Mid-Cap Growth category and 62% of funds in the Multi-Cap Growth category outperformed their benchmarks – the only two out of twelve style-specific equity categories to outperform passive strategies by such a wide margin over the 1-year period.  Those one-year results were not matched in any of the twelve categories over 3- and 5-year periods.2

Aquila Three Peaks Opportunity Growth Fund employs a fundamental investment strategy focused on measures of corporate performance and balance sheet improvement – characteristics that we search for and evaluate, one company at a time.

“We believe that we take a unique approach to selecting equity investments”, said Sandy Rufenacht, Co-Portfolio Manager.  “We have a long history of conducting research in the high-yield corporate bond market, and investing in high-yield issuers when our research indicates they are successfully and prudently managing leverage and the corporate balance sheet. The characteristics we look for in high-yield debt issuers have helped us identify opportunities for improvement in the equity performance of those companies.  Our experience, research, and strategy in the high-yield debt market is the foundation on which we built the strategy of Aquila Three Peaks Opportunity Growth Fund”.

Take a closer look at the individual stock selection approach of Aquila Three Peaks Opportunity Growth Fund – you may find it is just what you were looking for.

 

1Correlation:  A statistical measure of the movements of two securities in relation to each other.  If perfectly correlated, two securities will move up or down to the same degree and in the same direction. 

2Past performance does not guarantee future results.  An investment cannot be made directly in an index.

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 on this site, from your financial advisor and when you call 800-437-1020.

Investment Considerations: Mutual fund investing involves risk; loss of principal is possible.  An investment involves certain risks including market risk, financial risk, interest rate risk, credit risk, and risks associated with investments in highly-leveraged companies, lower-quality debt securities, foreign markets and foreign currencies, and potential loss of value.

08/17/2013

Mutual Funds and Yield Calculations

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The rate of income provided by a bond fund is affected by several variables and may be calculated in a number of ways.

Investors looking for an income-producing investment may choose a mutual fund which invests in bonds. There are a number of distinctions between bond funds which should be considered, one of which is the rate of income provided.

Fund Holdings and the Markets Change Daily

A mutual fund is a collection of many individual securities in which a number of individual investors share ownership. The investment manager of a bond fund may continually buy and sell individual securities as money flows into, or out of, the mutual fund, and as individual securities become more or less attractive based on the objectives of the fund and changes in the securities markets. The concept of holding an individual bond to maturity is seldom applicable within a mutual fund since the amount of fund assets invested in a particular bond may be increased or decreased, or the bond may be eliminated from the fund holdings, prior to the maturity date. Variations will occur within a bond fund over time, including the number of securities held, the percentage of the total holdings represented by each individual security, and the daily market price (and therefore, yield) of each individual security. Due to these variables, there is no yield calculation that will accurately reflect the rate of income that will be received by an individual mutual fund investor over the period of their investment. There are several calculations that may provide reasonable approximations.

Current Yield

Current yield is a very simplistic calculation. If applied to an individual bond, the current yield would be equal to the annual dollar coupon interest divided by the price. Since the annual coupon interest on a bond is known, this calculation provides an accurate representation of the income rate that will be received based on the purchase price of the bond. It does not indicate the effect of compounding, in the event that the income received were invested at a similar rate, and it does not indicate the impact of a gain or loss on a bond that might be sold prior to maturity.

Distribution Yield

Distribution yield is provided for many bond funds. A 30-day distribution yield is usually calculated by adding the trailing 12 months dividends per share, and dividing the sum by the fund’s month-end price. This makes the result backward looking, rather than indicative of the expected income going forward. In a falling interest rate environment, this can overestimate the income paid to shareholders. In a rising rate environment, this can underestimate the income rate.

SEC Yield

In 1988, the SEC developed what is referred to as the 30-day SEC Yield. This is a standardized calculation that all bond funds are required to use so that potential investors can compare funds based on a consistent method of calculating an income rate.

What does that mean?

If applied to a bond fund that pays a monthly dividend, the SEC yield calculation does the following:

  • It uses the income, net of expenses, at the end of a month (i.e. the most recent monthly dividend)
  • It assumes that the outstanding shares (represented by an average of the number of outstanding shares each day in the month) were all purchased at the maximum offering price on the last day of the month
  • It compounds the income rate over a 6 month period
  • It doubles the compound income rate to approximate income earned over 12 months

Bringing it all together

Distribution yield describes income payments made over the prior 12 months, relative to the fund price on a particular day, with no assumed compounding of reinvested income. The 30-day SEC Yield approximates an annual income rate relative to the fund price on a particular day and assumes compounding of the most recent dividend payment. The portfolio holdings in a bond fund change over time while the market price (and yield) of those holdings are also changing. As a result, the price per share and the income received by an investor can, and typically will, vary over the period of time in which the investor owns a fund.

In general, after a period of falling interest rates, the distribution yield (which is backward looking) of many funds will be higher than the 30-day SEC Yield (which compounds the most recent income distribution). The reverse is true in that, after a period of rising interest rates, the distribution yield of many funds will be lower than the 30-day SEC Yield.

The 30-day SEC Yield is calculated in the same manner by each bond fund. It provides an approximate compound income rate based on a snapshot taken on a specific day under a set of actual and assumed conditions. When considering bond funds for investment, it is informative to compare the 30-day SEC Yield along with the fund objectives, strategies and risks described in each fund prospectus.

 

 

Consideration should be given to the risks of investing. Investments in bonds involve certain risks including a 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. Fund performance could be more volatile than that of funds with greater geographic diversification. For certain investors, some dividends may be subject to Federal and state taxes, including Alternative Minimum Tax (AMT). Please consult your professional tax advisor.

 

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