Making the Grade
Jeffrey Koch has helped make the Milwaukee-based Strong Funds a player in the bond fund business.
Koch, now 33, joined Strong in 1989 right out of MBA school. He has been managing portfolios for the company since 1991 and since 1995 has headed Strong’s high-yield bond sector, which now is a small but fast-growing segment of the company’s $14-billion bond fund business.
As a bond manager, Strong has become best-known for its emphasis of shorter-term portfolios that attempt to deliver above-average yields without subjecting shareholders to significant share price volatility.
As the lead manager in the high-yield, or junk, bond business at Strong, Koch has been riding that sector’s surging popularity with small investors in recent years.
Koch talked with Times markets columnist Tom Petruno about Strong’s high-yield bond philosophy and the market in general.
Times: How did you get into the high-yield bond business?
Koch: We started up the Strong High-Yield fund at the end of 1995. But we’ve always been involved with high-yield in our investment-grade portfolios. Three of those funds can go up to 25% in BB-rated securities, so we’ve always been involved in the highest-quality part of the high-yield market.
That’s about half the high-yield market. People don’t usually realize that, because if you look at the typical high-yield fund it’s 80% B-rated bonds on average, 10% BB-rated bonds and 10% or 5% cash. But the high-yield market [overall] is 46% BB-rated issues, 47% Bs, and the rest is CCCs.
We looked at our product lineup, and we had domestic investment-grade bond funds, we had international bonds, and then we needed high-yield. I volunteered. I liked the market and saw it as a challenge and an interesting change from what I was doing.
Times: Well, there obviously were a lot of high-yield funds out there before yours, but it looks like you may have already made up for lost time, given the huge inflows into high-yield funds in recent years.
Koch: That’s right. The sector has been getting tremendous inflows. Our High-Yield fund started with $1 million in December 1995. It’s over $500 million now.
High-yield is the only [bond sector] that’s come close to competing with equity returns. Our High-Yield fund was up almost 27% in total return last year. This year it’s up almost 12%.
Times: And now you’ve rolled out a Short-Term High-Yield fund. Where did that idea come from?
Koch: Our view was that here you have this high-yield market, it’s a big market, $360 billion in securities and growing pretty rapidly. You’ve got 204 high-yield mutual funds which are almost $80 billion in size. But they’re all lumped together in the same category [by fund-rating services].
If you look at the investment-grade bond market, which is much more mature and well-developed, you’ve basically sliced and diced it as an industry to the point where you have ultra-short-term funds, short-term government funds, short-term corporate funds, intermediate-term funds . . . and so on.
Yet high-yield is just one wide-open universe. We have a lot of shareholders in our biggest funds, which are in the short end of the interest rate curve. Our Advantage Fund and our Short-Term Bond fund together are just over $3 billon in assets. So we have a lot of people in our shareholder base who are interested in a higher level of income than you can get in money market funds. Our thought was that they would be interested in a fund that would offer an even higher level of income, with low share price volatility.
Times: When you say short-term high-yield bonds, how short-term are we talking?
Koch: We want to run the fund with a one- to three-year average maturity, with a volatility in share price that’s probably going to be half the volatility of our High-Yield fund. And in terms of yield, the Short-Term High-Yield fund should provide another 100 basis points [1 percentage point] in yield . . . over our Short-Term bond fund, the investment-grade fund.
Times: What is the yield on the Short-Term High-Yield fund now?
Koch: Right now it’s 7.6%, but that’s a little deceiving because it’s a 30-day look back. We started the fund July 1. It’s still a small fund, with $30 million in assets, $14 million of which came in from the Strong Advisor program [an asset-allocation service]. It’s taken us a little time to get that money invested, so we’ve had quite a bit of cash. I think when all is said and done in the next 20 days the yield will probably settle out around 7.8% or 7.9%. Our Short-Term Bond fund, which owns investment-grade bonds maturing in one to three years, yields about 6.75%.
Times: And what about the main High-Yield fund?
Koch: That yields about 8.8% now.
Times: Besides the obvious difference of focusing on shorter-term bonds in the Short-Term High-Yield fund, how else does it differ from your main High-Yield fund?
Koch: We are running it as a more conservative fund. Our High-Yield fund is wide-open--we can buy defaulted securities in there if we want to. With Short-Term High-Yield, at least 80% of the fund has to be B-rated bonds or above, so we are limiting our ability to invest in the depths of the credit-quality spectrum.
With the Short-Term High-Yield fund, the objective is high yield and low volatility.
Times: But can you demonstrate that your investment formula for the new fund really will limit volatility in the share price? Isn’t this untested?
Koch: Well, we don’t know for sure, but we combined two Merrill Lynch bond indexes for one- to three-year bonds, a BB-rated index and a B-rated index, to see what kind of volatility and what kind of return profile this area of the market should expect.
Even in the depths of the high-yield bond [crash] of 1989-90--when it looked like there may no longer be a high-yield market--even in that, you had basically three negative quarters [of total return], but you never had a negative annual total return [on the combined index].
In 1994, when the Federal Reserve raised interest rates by 3 percentage points over the course of a year, you still had a positive 4.5% total return [on the index]. And if you remember in 1994, there weren’t many bond funds of any kind that had positive total returns.
Times: In other words, the high income generated by the bonds has been more than enough to make up for any decline in principal value when times got tough.
Koch: Right. Bond math tells you that income wins in the short end of the curve.
Times: OK, let’s talk about the fundamentals of the high-yield bond market. What are the most appealing high-yield bonds in the market, in terms of industries?
Koch: Our High-Yield fund has about 65 individual issues. The media and telecom industry is about 16% of the portfolio, financial companies are about 10.5%, airline and other transportation companies are 9%, and we’ve got about a 5% position in cable TV.
The Short-Term High-Yield fund has about 45 issues, with media and telecom about 14%, banking and finance at 12.5%, energy at 8.9% and airlines/transports at 5.5%. After that it drops off to 4% or smaller positions.
Times: What are some specific issues that you own?
Koch: We own First Nationwide Bank bonds in both of the high-yield portfolios. First Nationwide bought CalFed Bank this year and created a California-wide “footprint” of a thrift institution. Not only has the bank been doing well on its own, but management is positioning the company for sale, in our opinion [as the banking industry continues to consolidate].
In the media business we own PageMart Wireless bonds. PageMart is a wireless-paging company that has done things a little differently than other companies in the industry. There was a tremendous amount of consolidation in the industry a few years ago, but a lot of mergers were between companies that didn’t really fit together. So the industry really fell out of favor on Wall Street.
PageMart is the fifth- or sixth-largest company in the business, but they’ve never made an acquisition. And now they’ve reached the point where their growth is [translating] into free cash flow.
Times: While many other paging companies still aren’t generating cash flow to support their bond payments in the long run?
Times: Well, that brings us to the risk issue. Obviously the high-yield market has done very well in recent years because the economy has continued to roll along. But there’s a reason why these bonds pay higher yields--they’re supposed to be riskier than bonds of more established companies. Where are the big risks today in high-yield?
Koch: One of the things that will probably creep up on the high-yield market is not a result of leveraging businesses that are susceptible to bad economic times, but rather more of the venture capital side of the market.
For example, the media and telecom business now is 30% of new high-yield issuance. You’ve got a lot of companies that are financing in the high-yield market that don’t have cash flow and aren’t likely to have cash flow any time soon. But they’ve got an idea or product that they want to build out, and they don’t want to give up equity, so they come to the high-yield bond market.
You’ve got a lot of this that has been financed over the last year and a half. Typically they’re financed with zero-coupon bonds or pre-funded coupon bonds, where they escrow the proceeds from the deal to pay a coupon [initially]. So that even if they have problems, you don’t really see them in terms of the impact on the market for three or four years down the road.
Times: What about the generic risk from a downturn in the economy--another recession, as in 1990? After all, the difference in yield between high-risk bonds and safe Treasury bonds is pretty narrow now, isn’t it?
Koch: Yes, we’re at or near historical tightness in spreads. But it should be that way, given what we have to work with [the strong economy]. We’ve got a default ratio for high-yield issues that is barely over 1% [of the market, annually], versus a 3.5% average over the last 25 years.
One of the big factors that I think will be different this time is, if we go into recession, the financial system is so much healthier today than in 1990. Back then Citibank was going to go broke. There were some serious problems in our financial system happening at the same time that Drexel Burnham Lambert [the now-defunct high-yield bond brokerage of the 1980s] dominated the market, blew up and went bankrupt.
People have a tendency to look back at a bad period and say, “That’s going to happen to us again.” But the high-yield market today versus what it was back then is dramatically different.
Times: Is that, to a large degree, simply because the market is so much bigger--there are so many different high-yield bonds today and so many more investors in them than in 1990?
Koch: Right. First of all, almost every bond in the high-yield universe begins its life as a 10-year final maturity with a five-year “call” [the earliest the issuer can pay off the bond]. That’s about 90% of the structures. So if you let three years pass in the high-yield market and let’s say you had average issuances of 10% of the market’s size issued new every year, and you let three to four years pass, the composition of the market is completely different than four years earlier.
You have a lot of companies that over four years have improved enough that they’ve been able to refinance their bonds, they call them out early or they’re going to call them out. So instead of the original 10-year bond you’ve got a six-year bond with a one-year call. That [is valued] completely different than a 10-year piece of paper.
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Strong High-Yield Fund and Strong Short-Term High-Yield Fund
Strategy: Both funds invest in high-yield corporate junk bonds, which are issues rated below investment grade (i.e., rated BB or lower by major credit-rating services). The Short-Term High-Yield fund further limits itself to securities maturing in one to three years.
High Yield Fund (started December 1995)
1996 total return: +26.7%
Avg. high-yield fund: +13.7%
1997 total return, through Aug. 31: +10.2%
Average high-yield fund: + 9.0%
Current annualized yield: + 8.8%
The Short-Term High-Yield fund is new (started July 1)
Current annualized yield: + 7.6%
Sales charge: None
Min. Investment: $2,500 either fund
Phone: (800) 368-1030
Sources: Lipper Analytical Services, Morningstar