The third obstacle to high-yield managers was the high dollar price of the bond. However, the reason for the high dollar price was the high coupon and because it was not callable. But that’s actually beneficial, since you’re not giving the company the option to take the upside away from you. And there was upside. Given the cash flow, there was a good chance that the company would do something about these bonds. That’s not why we bought them but that was an extra reason. Eventually, the company did tender for the bonds and the return, relative to the standard generic TRW bond that all our peers love to chase, was substantial.

Inside the U.S. we’ve been invested for quite a while in a company called OM Group, a processor primarily of nickel and cobalt chemicals. The company ran into a number of problems a couple of years ago when it built up too much cobalt inventory before the price, collapsed. The management was completely replaced and the metals trading operation was sold to a German company. OM just kept the high-demand business that processes nickel and materials for batteries and all the micro electronics. Basically, they became a specialty chemical company. We saw that their strategy was going to be quite beneficial, given what was going on with their end markets. The market was very skeptical because of the history of trading at very high yields but that has gone away.

Q: Would you explain your portfolio construction process in terms of number of holdings, benchmarks, turnover, etc.?

A: We run between 80 and 100 issues, which provides adequate diversification for the portfolio, especially since we draw our securities from a number of different high yield markets that are not correlated with each other. That approach allows us to concentrate and really know the issues in the portfolio rather than spread ourselves across 500 different issues. The turnover has moved steadily downward since we first set up the portfolio. It’s quite competitive with our peers and moving downward.

We benchmark ourselves against Merrill Lynch Global High Yield Constrained Index. As many index providers, Merrill Lynch created constrained indexes after the whole Enron debacle, when huge fallen angels represented 10% or more of the market. Through these constrained indexes they limited the percentage that any single issuer could comprise. We use the global version of that constrained index, which basically reflects 88% of U.S. high yield and 12% of non-US high yield, mostly European.

Q: What do you think that highyield investors should be mostly aware of? Is it the credit analysis, the market characteristics such as liquidity, or something else?

A: First of all, I think that the high yield market is still an esoteric market where it’s difficult to get information on some of the companies. An event can happen that can move the prices quite abruptly. That is why it is extremely important, more than in many other asset classes, to invest through a mutual fund. It also can be very expensive if you invest directly, since bid-offered spreads on bonds for the retail investor can be quite heavy. So it’s a market that you need to navigate through mutual funds, and the mutual fund should be able to maneuver through the occasional difficulties of the high yield market. The nature of the high yield market puts a premium on flexibility and liquidity, which is something that we pay attention to both in terms of the size of the fund and the securities we buy. We try to have a portfolio that we could move out of fairly quickly at a reasonable price. Being diversified across a number of different high yield asset classes helps in that process and being relatively smaller helps.

We do believe there is value to investing a portion of the portfolio in relatively smaller names, but you need to have a substantial portion of the portfolio invested in names that have real liquidity. Some of the names with the best liquidity are companies that are non-US issuers, such as Norilsk Nickel, for example, a Russian nickel company or some Brazilian issuers. Although the non-US issuers can be volatile, they are larger than many U.S. issues. You can trade these bonds, especially if you’re not a huge high yield fund, which we’re not.

Q: How large is the U.S. high yield market?

A: It is about $600 billion in market cap with about 1,800 existing issuers, most of which don’t trade by the way, so it is not such a liquid market. By expanding into the allied high yield markets, we end up addressing a $2.2 trillion market with about 5,000 issues.

Q: What kind of risks do you perceive and how do you mitigate them?

A: I think that the general public perceives more risk in high yield than is actually there. Let’s not forget that high yield is senior to equity. If you worry about a recession, you’d better worry about your equities first because the high-yield bonds will not be as volatile as the equity. We have an independent risk management group that is measuring our tracking errors and our concentration levels, and they alert us when they see problems. But that’s really done independently.