Analyst report

Hanif Mamdani, lead manager of PH&N High Yield Bond, attempts to mitigate the inherent peril of high-yield bonds by focusing on the area of the credit spectrum where “junk” meets “investment grade.” There are significant risks in the fund right now, stemming from the point we’re at in the credit cycle, and the nature of the current meltdown. But Namdani’s skill and experience – and that of his team – combined with very low fees, continue to make this one of our top choices in this space.

In the parlance of fixed income markets, high-yield bonds include any rated below BBB- by Standard & Poor’s. Investors should be aware that this fund isn’t exactly what its name implies: it’s actually a hybrid in that it invests mainly in BB and BBB securities. That should make it less exposed to the ups and downs of the high-yield market than its peers. Indeed, over the last five years, its volatility was second-lowest among 28 funds in the high-yield fixed-income category. Boosted by the lowest MER of any high-yield fund in our database, it has also managed to post the very top return during that time, although over short periods it could lag peers in a pronounced rally.

Being defensively positioned relative to his peers also helped Mamdani avoid heavy losses this year: although the fund is down 4.3% year-to-date, the median fund is down 15.9%. Still, there are considerable risks at the current juncture. Liquidity has completely dried up in the high-yield market, so any repositioning of the portfolio is extremely difficult. Because there are several large positions maturing next year to bolster Mamdani’s cash position, we don’t anticipate significant pressure, but in the near term, a wave of redemptions that force him to sell any holdings could be damaging.

Mamdani has a 39% position in financial issuers. Recently, this has included some of the particularly hard-hit U.S. banks such as Bear Stearns, Morgan Stanley and Merrill Lynch. As we have seen, default has become a distinct possibility in this sector and credit ratings have proven untrustworthy. For the most part, he purchased these bonds in the fall of 2007, when some of the bad news had already emerged. With the benefit of hindsight, the move was early, but Mamdani still sees the bonds as being fundamentally secure.

There are plenty of sources of risk in credit markets right now, and this fund is certainly sensitive to those. But we consider PH&N to have one of the best and deepest fixed-income teams in the country, so we like their chances of getting through what still might be some pretty troubled waters ahead.

OF NOTE Through a combination of market impact and net redemptions, the fund’s assets are down more than 15% year over year.

Roughly three-quarters of the fund is in Canadian names. As a general rule, the currency risk on foreign bonds is hedged.

Out of 64 rolling three-year periods since inception, this fund has beaten the category median 100% of the time.

Bear Stearns debt – representing 4.6% of the fund – has been fully assumed by J.P. Morgan as a result of the acquisition in March, on equal footing and with the same rating as the bank’s other senior obligations.

BULLS SAY • The fund’s five-year beta is below that of 90% of funds in the category, meaning more of what unitholders have received for their MER has been alpha.

• The MER is well below median, giving the fund an immediate advantage over peers.

• Mamdani and his team have been able to limit volatility without sacrificing performance: the five-year Sharpe ratio is highest in the category by a wide margin.

BEARS SAY • A severe lack of liquidity in the Canadian high-yield bond market means the fund could face considerable downward pressure if redemptions continue.

• Recovery rates on financial bonds – should they default – are probably lower than those in sectors with more hard assets.

• The defensive nature of the fund means it might trail higher-beta peers when the credit cycle turns.

Al Kellett is a fund analyst at Morningstar Canada.