Riding the Wave Part 2

www.ticker.com March  2003 Cover Story TICKER Staff

High Yield Funds

If there were years when high-yield bond buyers were afraid to listen to the news, 2002 was definitely one of them. While there have been other years when high-yield funds posted negative returns, posting a negative 3-year annualized average is a rare occurrence. For 2002, the Lipper high yield category reported a 3-year return of - 2.9%, which was the third consecutive year that category had negative 3-year returns. For 2001, the return was -1% and for 2002, it was - 1.6%.

“The prices of high yield bonds can still go down significantly,” said Mark Vaselkiv, a manager with 15-year tenure in T.Rowe Price and Affiliates, running the T.Rowe Price High Yield fund. “The positive spin here is they’ve been going down for four years. We are just starting the fifth year of a bear market in high yield debt - it started in 1998 and continued through most of 2002. Fundamentally, this market is pretty undervalued.”

The depressed state of the high-yield category - the largest in terms of number of funds - widened the performance gap between the consistent performers and the average fund. During 1999, the consistent top performers returned 2.2% more than the category average, while in 2002, the top performers exceeded the average by 5.2%.

Columbia Management’s Company’s (CMC) institutional and retail high-yield portfolios take the take the top two spots for consistent top performers. Managed by Jeffrey Rippey and Kurt Havnaer, CMC High Yield and Columbia High Yield outperformed its peer group for the 3-year period ending 2002 by margins of 8% and 6.9%, respectively. The managers’ approach is to screen companies using a combination of qualitative, financial-statement and relative-value analyses and come up with a batch of 150 issuers, generally companies with market capitalizations above $100 million. The list is then submitted to the portfolio managers, who reduce it to between 50 and 70 names that are included in the portfolio.

CMC maintains its credit quality well above its benchmark Merrill Lynch High Yield Master index. While the index listed no BBB rated bonds as of Sept. 30, 2002, Columbia had 11.7% of its assets invested in BBB. Subsequently, Columbia had no bonds in the C, CC, and CCC categories, while the index was 12.3% exposed to these deep junk issues.

Janus High Yield weathered the high-yield storms in mint condition. By December 2002, it was the third-best consistent performer with a 7.66% average annual return. By the end of 2002, manager Sandy Rufenacht kept the fund 80.6% invested in high-yield bonds, 6.3% in investment-grade, and 9.6% cash, with 90% of the fund’s bond holdings rated BB or B. His top three preferred industries were Casino Hotels, Residential and Commercial Buildings, and Oil Companies.

T.Rowe Price High Yield is the highest-ranking fund in the consistent group with net assets above $1 billion. Mark Vaselkiv’s portfolio reports an 8.45% average annual total return measured since its inception in December 1984. At the end of 2002, its quality weighing was 18.3% BB and 68.1% B, with the balance being lower-rated issues.

“The way to excel in the high yield area is to avoid defaults, bad companies, and credit problems,” said Vaselkiv. “As I look historically, the basic metric to gauge success in this business is the aggregate default rate. The reason we have consistently outperformed the market is that we seem to make fewer mistakes than many of our competitors.”

“We focus on the higher quality companies in the marketplace. On average, we have much lower weightings in the most speculative, highest risk bonds,” Vaselkiv explained. “We tend to be a little bit more conservative than our rivals. Our funds will not report the highest yield in the category, but on a total return basis, we give up less in principal because of our good security selection.”

“The average annual return for BBs has been 9.5% over the 1990 to 2002 period, while Bs have returned 8% and CCCs have returned about 4%. There are times when investing in CCCs is highly rewarding, particularly when they’ve been beaten up like they have over the last three years. But to make that a long-term strategy has never worked,” said Vaselkiv.

Moderate strategies are better suited for larger portfolios, where it is harder to constantly keep one’s finger on the trigger - an absolute must for the high-yield manager. “High-yield companies blow up. That’s the reality of the market and the basic risk that you face. You need to quickly move out of a position when you anticipate trouble, when you see the fundamentals of a company deteriorate, when management is taking a risk in a new strategy, when the competitive dynamics of an industry change, or when there is a concern about the integrity of the management team,” Vaselkiv added.

For many retail investors, Pimco and William Gross are synonymous with bond fund safety in uncertain times. For institutional money, however, the Pimco High Yield I, managed by Raymond Kennedy, has provided consistent top performance in the risky times. Since its inception in December 1992, the fund has reported a 7.72% average annual return, with only two negative years - 2000 and 2002. Mr. Kennedy’s preferred sectors as of November 2002 were telecommunications, domestic banks and healthcare services. He also spiced up his portfolio by allocating 14% of the portfolio to investments in rated A and AAA debt.

The smallest portfolio among the consistent top performers is Nicholas-Applegate High Yield Bond, which is also the only fund in the group that ranked number one in any of the past four years. The institutional portfolio has a $250,000 minimum initial investment and has returned 8.5% from its inception in 1994. Managers Douglas Forsyth, William Stickney, and Michael Yee keep the average credit quality of the portfolio at BB, or a notch above its benchmark, which is the Salomon Smith Barney High Yield.

The largest two funds occupy the bottom two spots in the high-yield group. Lord Abbett Bond Debenture A invests 57% of its $3 billion assets in corporate bonds and notes, 48% in BB and B rated. The portfolio is diversified with 13% common stocks and 13% convertibles. American Funds High Income Trust A invests 71.7% in corporate issues and 12.2% in foreign currency denominated paper. Portfolio counselors David Barclay, Abner Goldstine, and Susan Tolson lean towards the more-speculative end with 31% invested in bonds rated B, 21.2% in BB, 16.8% in BBB and 12.2% in issues with credit ratings below B.

Global Income Funds

For many investors, the international credit markets are becoming more attractive due to globalization and the broad decline in interest rates. The declining dollar and the sluggish equity markets has also fueled the interest in world debt. During 2002, the weaker dollar increased the dollar value of many investments. The J.P. Morgan Global Government Bond, Non-U.S. Index rose 22.1% for the year.

According to Merrill Lynch, bonds issued in the U.S. currently account for only 52% of the global bond market primarily because of the rise of euro-zone corporate bonds and the increase of Japan’s government debt.

Global income funds are probably the least risky category among world bond funds because they keep their investments close to home. Funds in this category must invest in at least three countries, one of them being the U.S. These funds are suitable for investors who want to have some international exposure but do not want to invest entirely overseas.

The fund with the highest rank among the consistent top performers is ISI North American Government Bond (NOAMX). Despite being in the global income category, NOAMX is not different from a long-term government bond fund.

It invests in government obligations of three countries (US, Mexico, and Canada), with the majority of its bond holdings kept in U.S. government bonds. NOAMX has an unusually big position in cash - about 41% of its portfolio. U.S. Treasury notes and bonds account for about 45% of its net assets, Mexican Bonos 9%, and Canadian government obligations 5%. The performance of the fund is mainly due to the strong performance of the treasury market.

Alliance Americas Government Inc (ANAGX) also ranked high on the list. The fund changed its name last year from Alliance North American Government Income Trust. With large positions in Argentine and other Central and South American bonds, ANAGX was not complying with a SEC’s requirement that mutual funds must hold at least 80% of their holdings in securities suggested by their name. So, instead of selling the South American bonds, the fund decided to drop the “North” part of its name.

Despite its stellar performance in the past six years, investors should be warned that the fund crashed in 1994 when it lost more than 30% of its value. Shareholders sued the fund’s manager, Alliance Capital Management, partially because it had invested 25% of its assets in Argentine securities. However, the court dismissed the accusations because at that time funds were required to invest only 65% of their assets in the securities suggested by their names.

Like NOAMX, this fund invests primarily in long-term government bonds issued by the United States, Mexico, or Canada, but it is more diversified and therefore more risky. Currently, the fund invests about 53% of its assets in the U.S., 22% in Mexico, 11% in Canada, but it also has investments in Brazil, Panama, and nine other countries.

The majority of its portfolio, or 58%, is invested in high quality AAA bonds, while 33% of the holdings are invested in bonds with BBB rating or lower.

The manager of the fund, Paul J. DeNoon, has been in the position only 6 months. ANAGX is more expensive than its peers with an expense ratio of 1.96% and a front-end load of 4.24%. International Income Funds

International income funds are more diversified than global income funds. They invest in debt securities of issuers located in at least three countries, excluding the U.S.

PIMCO Foreign Bond I (PFORX) has consistently ranked second or third in this category since 1997. Its holdings include government and corporate debt, mortgage-backed and asset-backed securities. The fund invests in investment grade foreign bonds with an average duration of 3 to 7 years.

European debt, which has relatively high yield due to central banker policy, is the investment of choice for the Pimco’s Foreign Bond Portfolio. German bonds occupy an unusually large 76% of the fund’s holdings. Sudi Mariappa, manager of the fund since November 2000, believes that European interest rates have a long way to fall and that this will boost the value of its bonds.

A major strength of Pimco’s Foreign Bond fund strategy is in hedging its dollar exposure. Because currencies are so volatile, the fund either provides currency exposure or attempts to hedge that exposure. Pimco was wise enough to favor the euro last year and expects the strength of the currency to continue well into 2003.

“We’ve already seen a fairly substantial move in the euro and expect to see the trend continue,” said manager Sudi Mariappa in a recent interview. “In our view, the dollar is going to be more prone to sell off on a secular basis while the yen is going to be range-bound. So we like the European currency.”

In addition to Europe, Pimco Foreign Bond favors Japan, where the fund invests about 20% of its assets. With regard to a potential rise in Japanese interest rates, the management acknowledges that there is some risk, but it expects that rates will stay unchanged.

“We think Japanese interest rates, as a whole, will probably stay where they are because their monetary authority has been fairly accommodative,” Mariappa said. “The Japanese are not dependent on foreign purchasers of their bonds. So they’re self-funding, in essence, they should just muddle along.”

This is one of the cheapest international funds available, with an expense ratio of 0.50% and no loads. The minimum investment in the institutional class is $5 million.

Emerging Markets Bond Funds

Investing primarily in debt securities issued by the developing nations, the emerging market bond category is the most risky segment of the bond universe. Emerging markets may be highly volatile, less liquid, and subject to currency fluctuations and political disruptions. But they can also provide investors a very handsome return.

Emerging market bonds have had a very strong performance recently. The gains have been broad-based with the majority of country components registering positive returns.

Of course, there were also a number of countries with problems. Argentina, for example, was in a state of total economic collapse and political turmoil. Venezuela still faces political unrest and debilitating strikes. Brazil has elected a former left-wing union leader as president, while Turkey has elected a leader from a traditional Islamic party.

Nevertheless, emerging markets debt has avoided the crisis common during the last decade and much of it has registered strong demand. Some analysts also believe that the emerging debt markets are gradually maturing in terms of market infrastructure and availability of information.

After the Russian debt crisis of 1998, the International Monetary Fund began publishing detailed credit reports on each market. At the same time, many countries realized the importance of providing more information to investors. While problem do still arise, the impact is usually confined to that specific country.

The only fund in this category, which has consistently been among the top performers, is Salomon Brothers Institutional Emerging Market Debt Fund (SEMDX). The fund is fully invested in fixed income securities and holds less than 2% of its assets in cash. Manager Peter Wilby has been managing the fund since 1996. The minimum investment in the fund is $1 million and the fund charges 0.75% for expenses.

Intermediate Investment Grade Debt Funds

The intermediate investment grade category has had a good run during the last three years. Funds with healthy investments in TIPS, or Treasury Inflation Protected Securities and higher quality corporate debt have performed better than their peers. On the other hand, funds invested heavily into mid- and low-quality corporate debt have suffered as the corporate scandals took their toll. Similarly, funds that held positions in telecom have had a rough time with the WorldCom bankruptcy and problems at Qwest.

One of the category’s most consistent top performers has been the PIMCO Total Return Inst. (PTTRX). With net assets in excess of $39 billion, it has reported returns of 10.7%, 8 %, and 8.3% over the 3-year, 5-year, and 10-year reporting periods. While this fund does own some government debt, the bulk of its assets are invested in top quality corporate debt.

Managed by Bill Gross, this fund has consistently invested in the right sector. While it pursues only a moderately aggressive strategy, it has one of the best track records in its category.

Short Investment Grade Debt Funds

Lower interest rates have been a real boon for the short-term debt funds, and this category continues to represent one of the safer investment bets in fixed income segments. A few of the funds had exposure to the problem sectors, such as telecom and airlines, and suffered as a result. But as a category, they performed relatively well vis-‡-vis there longer-term cousins.

Vanguard Short-Term Bond Index fund (VBISX) has generally outperformed its category peers over the last few years. Tracking the Lehman Brothers 1-5 Year Government/Corporate Index, the fund has maintained a diversified investment mix, with exposures to both government and corporate debt. However, the fund does not invest in mortgage-backed securities. While it faced some problems in 2002 when some of its swapping strategies went awry, it did manage to earn a return of 6.1%. Over the most recent 3-year period, the funds return of nearly 8 % gave it the second rank in the category.

Multi-sector Income Funds

The very name of this category suggests diversification, lower volatility, and stable returns. But, during the last six years, the category has been less than outstanding. The poor performance can be traced to funds in the category that have had exposure to either junk bonds or emerging market debt. Industry estimates suggest that the multi-sector funds category had a huge 29% exposure to junk bonds in August of 2002.

Even so, there are a few balanced multi-sector funds that have had good, consistent performance over the years. The Fidelity Advisor Strategic Income T (FSIAX) is one such fund. It has reported returns of 6.1% between 2000 and 2002, and gains of 5.9% between 1997 and 1999.

Strategically, the fund focuses on high-income debt and looks for capital appreciation as a secondary objective. Generally, its assets are spread among a number of debt classes, such as high yield securities, U.S. government and investment-grade securities, emerging market securities, and foreign developed market securities.

GNMA and other U.S. Mortgage Funds

GNMA funds, or funds which invest primarily in mortgage bonds by the Government National Mortgage Association, have the advantages of relatively high yields combined with a capital guarantee from the government. Vanguard GNMA (VFIIX) has been one the top performers in this category, posting solid returns of 8.3%, 9.8% and 7.1% over 1-year, 3-year, and 5-year periods. A strategy of limiting prepayment risk combined with a low expense ratio has helped the fund to maintain steady gains. However, not only does this fund focus largely on GNMA securities, generally investing 80% or more of its assets in these bonds, but it also invests only in plain vanilla GNMAs, bypassing the potential higher returns available from non-conventional GNMAs.

TCW Galileo Total Return Bond Inst. (TGLMX) has also been one of the top performers in the mortgage fund category, delivering a return of 11.3% over the last three years, as well as an 11% return in 2002. While this fund invests at least 65% of its assets in long-term mortgage securities backed by the government, it also invests in a number of riskier securities such as inverse floaters. Nonetheless, the fund’s experienced and well-reputed management has performed consistently over the years.