This month, Bond Fund Intelligence speaks with Brad Camden, Director of Fixed Income Strategy at Northern Trust Asset Management. Camden oversees the $3.7 billion Northern High Yield Fixed Income Fund, among others, and gives us an update on the high yield bond fund market. With high yield, he says, "It's all about avoiding the blowups." Our discussion follows. (Note: This "profile" is reprinted from the August issue of our Bond Fund Intelligence publication. Contact us if you'd like to see the full issue, or if you'd like to see our BFI XLS performance spreadsheet, our BFI Indexes and averages, or our most recent Bond Fund Portfolio Holdings data set.)
BFI: Give us a little history. Camden: Northern Trust Asset Management has been managing bond funds for decades. The Northern High Yield Fixed Income Fund (NHFIX) was launched in 1998. This year will mark its 20th anniversary, during which time we're most proud of its strong, consistent performance, including largely avoiding problem investments. Overall, the high yield fund is part of our broader fixed income management capabilities…. We have about $5 billion of assets under management in dedicated high yield strategies. I joined Northern Trust Asset Management in 2002, and I joined fixed income in 2005. I've been part of the high yield fund and strategy team in a variety of capacities since 2005, and I was named a co-PM in 2016.
BFI: It's been a good run for high yield. Camden: It's been a great stretch. High yield returns have been outstanding, just like most risk asset returns have been. Since the crisis, we've seen strong and stable returns in the high yield market with [some] exceptions...for example, the commodity credit cycle of late 2014 thru February 2016. More recently, we saw very strong returns in 2016, a nice return in 2017, and the index is up about 1.6 percent so far YTD. Performance has been strong despite investor concerns regarding tight valuations, market liquidity, and an aging credit cycle.
BFI: Tell us about the fund's objective. Camden: The main objective of the fund is to generate high current income with the potential for capital appreciation. We aim to meet it by primarily investing in non-investment grade securities; those are securities that are rated by ratings agencies such as S&P, Fitch and Moody's below triple-B minus. The fund also invests in some investment grade securities. Often, those are in the financial sector in subordinated bank debt where we see nice risk-return profiles. However, the majority of the fund (95-96%) is invested in non-investment grade fixed rates securities, or "junk bonds."
BFI: Talk about your investment process. Camden: We implement a top-down, bottom-up investment process. The top-down is focused on the macro environment: What's going on with growth, inflation, and monetary policy? Where are interest rates and credit spreads headed? These variables are used as inputs into our portfolio construction process. However, it is bottom-up issuer selection that drives returns in the high yield market.
We're fortunate to have an experienced fixed income research team that works closely with us to identify securities with strong risk return characteristics.... In high yield, it's about accessing a mix of securities that provide a yield similar to, if not higher than, the benchmark index. More importantly, it's about avoiding the blowups.
With our investment process and our strong fundamental research team, we've been able to do so since the inception of the strategy in 1998.... Since inception, the fund's default rate is roughly 9 basis points (0.09%). When you compare that to the market, [the average is] north of 4%.... Furthermore, we haven't had any defaults in the fund since 2005.
BFI: What strategies can/can't you use? Camden: The prospectus is relatively broad, so we have many tools at our disposal to achieve the fund's objective. However, our main area of focus is in U.S. dollar denominated fixed rate instruments in the non-investment grade space. We also invest in floating rate instruments (bank loans), preferreds, and convertible securities. We are a traditional high yield manager.... We don't use derivatives or leverage, and we are prohibited from buying equities.
BFI: How diverse is the high yield market? Do you have issuer limits? Camden: The market has matured over the last 10-15 years or so. If you go back to the turn of the century, high yield was a relatively niche asset class with roughly $250 billion in debt outstanding and about 1,000 issuers. Today, there is about $1.3 trillion of debt outstanding and 2,000 issuers, so it's grown and matured. If you look at the quality spectrum, it's also moved up in quality. This is the result of some downgrades from investment grade but it is also due to an increase in higher quality issuers who are comfortable being classified as a high yield issuer.
We believe the negative stigma of being a junk bond issuer has gone away and today the market has become an important source of funding for many issuers. As a result, there is a nice variety of issuers across all the sub-sectors in the space. The biggest sectors are energy, communications, and consumer cyclical. Also, unlike with money funds and the investment grade space, the financial sector doesn't play as big a role.
We have internal limits. If you look at the regulations for registered investment funds, you'll likely notice that there is a max issuer concentration of 5%. We think that is way too high.... We believe the industry standard in the high yield market is 2% max per issuer. Our limits are much less than that. Typically, the fund owns anywhere from 175 to 200 names, with the average size ranging around 50 basis points or 0.50%. We also have internal sector limits, country limits, etc.
BFI: What are some big issuers? Camden: Sprint, Charter, Dish, and HCA. One of the challenges in the market is that the large issuers, the top 100 issuers, make up about 47-48% of the overall index.... That means the top 10-11% of the issuers represent the bulk of the outstanding debt.... So, when you're trying to access the market and execute trade ideas in smaller issuers, it's often very difficult due to market liquidity.
BFI: Who are the big investors? Camden: It really runs the gamut.... It ranges from retail to high net worth to institutional investors such as pension and insurance funds. Historically, the market had been more retail, but it's evolved, particularly in the post crisis environment where investors are seeking more income in portfolios. The other thing that's important to understand is that with the growth and maturation of the high-yield market, it [is now] carved out as a dedicated asset class in multi-asset class portfolios; therefore, attracts a more diverse investor base.
BFI: How important is the Fed? Camden: The Fed is very important to the financial markets. The Fed controls short-end rates and indirectly financial conditions, investor confidence and risk appetite... So, from that perspective, the Fed is important to the high yield space, because high yield is conducive of risk taking, etc. It's a risk asset.
Beyond the Fed, the metrics we look at on a monthly and/or weekly basis include growth and inflation, as well as the political and regulatory environment. Understanding the macro environment informs our investment decisions and helps with portfolio construction. We want to know: Where are we in the economic cycle? The credit cycle? What industries are going to have favorable tailwinds, and what industries are going to [have] headwinds?
Our top-down, bottom-up investment process is crucial to fund construction and ultimately drives performance. In all risk markets, you need to have a strong forward-looking investment process that identifies changes in economic and market trends; this is especially true in the high yield market given its asymmetric return profile. For example, if you decompose high yield returns over the last 25 years ... all of the return is driven by the yield carry or the coupon; price is negative due to defaults. Thus, avoiding the blow-ups is crucial to having stable and consistent performance.
BFI: Tell us about your team. Camden: At Northern Trust Asset Management, we believe that having a strong team with a diverse set of experience is important for success. On the fund we have three PMs -- myself, Richard Inzunza, and Eric Williams. We've all been working together for over a decade. We're also supported by a fixed income research team led by three team leaders that have extensive fixed income research experience, particularly in the high yield market. Having their insights as well as a detailed, highly informed perspective on the macro environment is vitally important. Our analysts are very good at identifying risks as well as opportunities and, ultimately, they are the ones we rely on to keep us out of trouble.
BFI: What's your outlook going forward? Camden: We're optimistic on high yield at the moment. Our base case on the Fed is much different than the market consensus. We continue to think that this recovery is still relatively fragile.... We think the Fed will have to slow its pace of rate hikes, particularly if the yield curve continues to flatten. We expect the Fed to raise rates in September and one more time next year. Thinking about this environment and what to expect out of high yield, we essentially expect to clip the coupon.
