Morningstar Advisor - October/November 2009 - 57

beat the benchmark in all phases of the credit cycle; a near impossible task if one genuinely adheres to a consistent investment philosophy and process. The management at Harbor Capital Advisors understood the merits of this process well when that firm selected Shenkman to serve as subadvisor to the Harbor High-Yield Bond Fund HYFAX in December 2002, which is one of the best vehicles for investors to gain access to the team’s talent. From Principles to Process formally presenting the idea to the full credit committee. Then, the 15-member credit committee will debate the merits of the bond—a two-thirds majority vote (by secret ballot) is required to add the security to the firm’s approved list. Added weight is accorded to the votes of the three most senior members of the committee: Shenkman, Frank Whitley, and Mark Flanagan (all managers of the Harbor fund). When selecting securities for individual portfolios, management will also carefully consider specific mandate restrictions, industry/sector allocation weightings, and relative value attractiveness between issues on the approved list. And Shenkman argues that successfully navigating the pitfalls present in high-yield markets depends equally on not only the purchase decision, but also on the careful monitoring of credits and the ultimate decision on when to sell. For example, near the end of 2007, the Harbor fund held a small position in Yellow Pages publisher Idearc Inc., but the team grew increasingly concerned as the fundamental story behind the credit began to deteriorate. As a result of some of the firm’s automatic credit-review triggers and a re-evaluation of the issue’s fundamentals, the firm sold at an average 79 cents on the dollar price level, a significant loss. Still, while trouble can take time to unfold, Shenkman is quite pleased at the hard choice made then: Idearc filed for bankruptcy protection on March 31, and its bonds trade near 2 cents on the dollar. The firm has an excellent track record of avoiding trouble like this. In fact, the Shenkman Capital High Yield Bond Composite portfolio, which is a close proxy of the Harbor fund’s holdings and performance profile, only saw six credits default during the 10-year period between 1999 and 2008. According to J.P. Morgan data, the high-yield universe overall had more than 600 defaults. From Process to Results Shenkman’s process has produced competitive risk-adjusted results. It’s important to bear in mind, however, the style’s idiosyncrasies. For example, because of its conservative nature, the Harbor fund will typically lag behind its more aggressive rivals when low-rated junk debt is rallying strongly, such as in 2003 and the first half of 2009. Conversely, the fund tends to hold up much better than most during bear markets for low-rated debt, as displayed by the fund’s resilience to 2008’s brutal market, when the typical fund in the category declined 26.4%. This fund saw losses only half as steep (13.7%), ranking it ahead of 98% of rivals. Moreover, the fund’s style results in some of the lowest return volatility levels (as measured by standard deviation) of any fund in the high-yield bond category. That in turn helps keep investors on board during difficult periods. Over the trailing one-, three-, and five-year periods ended July 31, the Harbor fund’s Morningstar Investor Returns (dollarweighted returns that display the typical return experienced) all land in the category’s top decile. In many respects, Shenkman is one of the last investors standing from the high-yield market’s pioneering generation, and that is undoubtedly due both to the caution he has pursued in his investment approach and to his strict and disciplined adherence to that style regardless of market fad or fashion. Investors would do well to carefully consider his caution toward highly leveraged markets. The past couple of years have proved its wisdom, and we are likely to see its value again in the future. K Lawrence Jones, a contributing editor of Morningstar Advisor, is a senior mutual fund analyst with Morningstar. He formerly worked as a senior research analyst for Lexecon Inc., an economic consultancy once owned by a Michael Milken-affiliated firm. Unlike many fund managers in the highyield universe who will often stretch for the highest-yielding (and lowest-rated and lowest-price level) issues to produce a high relative total return during periods of credit bull markets, Shenkman and his team use a consistent and risk-averse approach during all parts of the credit cycle. In addition to avoiding the most distressed issuers and industries, Shenkman looks for bonds that are well structured by a committed underwriter and, when possible, ones that contain covenants protective of bondholders’ interests. He makes the point that it is not enough to identify a company displaying improving credit fundamentals, although this is also vital, but the bonds they issue must also have other attributes. Moreover, instead of attempting to purchase distressed bonds at low price levels in hopes of riding a recovery to strong total return results, Shenkman is focused on purchasing improving credits and allowing interest income to compound over time. The process begins with intensive research conducted by the firm’s 15-person credit research team, which use a proprietary credit scoring system and credit risk analytics. Twenty-five issue-specific factors are evaluated, such as cash-flow predictability and capital structure complexity, among others. Team members also will speak to company management and will conduct on-site visits before MorningstarAdvisor.com 57

http://www.MorningstarAdvisor.com

Morningstar Advisor - October/November 2009

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2009