Pioneer A Tale of Two Funds
Bull markets don’t treat all investors equally. At Pioneer Investment Management in Boston, last year’s high-yield rally lifted one junk bond fund manager to the top of the rankings and left another far behind. The $320 million Pioneer Global High Yield Fund run by Andrew Feltus returned 15.8%, or 4.8 percentage points more than the Bear Stearns High Yield Index, making it the second best performing junk bond fund according to Morningstar Research. The $8 billion Pioneer High Yield Fund, managed by credit veteran Margaret Patel, returned 6.8%, or 4.2 percentage points less than the Bear Stearns benchmark, making it one of the worst performers.
Granted, a 6.8% gain in a bad year is none too shabby, and Patel still reigns as the second best junk bond performer over five years with a 13% return. Feltus’s fund by contrast is just over three years old, although in that period it has consistently outperformed its peers.
Why did two junk bond managers at the same house with similar investing philosophies and economic outlooks perform so differently in 2004?
Feltus may have had an advantage because he invests up to 45% of his assets in emerging markets, and he says the fund benefited from the ability to play two asset classes. “Having the flexibility to move between emerging markets and US high yield allows you to reduce your exposures if you’re not being paid for the risks you’re taking,” says Feltus, who traded high-grade and emerging market bonds at Boston-based MFS Investment Management before joining Pioneer a little over 10 years ago.
Feltus estimates that the Global High Yield Fund added about two to three percentage points in gains through its emerging market holdings, and that the currency exposure which comes with international investing helped lift the fund by another one percentage point. Typically when high-yield or emerging market assets are falling in value, the dollar is also depreciating, says Feltus. This means that even if real asset values decline, losses are mitigated by a favorable exchange rate.
Patel, who has managed junk bonds for over 20 years and built the Pioneer High Yield Fund from scratch in 1998 when she was still at Third Avenue Investments in New York, concedes that she underperformed in 2004.
“That really reflects that the fund was a lot more conservative last year. And if you look at where performance was, it was in the bottom tier of the high-yield market and in emerging markets,” she says. “I don’t do emerging markets and I spent the year reducing my exposure to the bottom tier,” which brought the share of triple-C rated bonds down to 4.6% of her portfolio, compared with the 19% they make up in the Bear Stearns High Yield Index. Because lower-tier credits contributed most of last year’s returns, this strategy cost investors dearly.
But Patel, who says she keeps most of her personal savings in the High Yield Fund, seems unfazed and argues that returns aren’t compensating investors for the added risks. Her main priority, she says, is protecting shareholders over time and adding value by taking risk in proportion to the return. Shareholders seem to appreciate her perspective, and have poured more money into her fund than into any other at Pioneer. “I think if I’m out of step with the market that just means I’m ahead of the market,” she says. “If you manage a fund trying to beat the index, you’re doomed to underperform in the long run because you’re not looking at the right fundamentals.”
Patel has a point. In 1999, when many high-yield funds held large amounts of telecom bonds in line with the benchmark indices, Patel exited the sector altogether and was spared the meltdown of the years that followed.
“You had too many competitors with negative cashflow who continually tapped the capital markets, and who were high cost providers of a generic commodity product,” recalls Patel. “They actually got to be 20% of the total outstanding high-yield bond universe, and it seemed to me that even a small change in sentiment would cause a big change in prices because everybody was overweighted.”
In 2000, the Bear Stearns High Yield Index dropped 7% but her fund returned 12.8%, making it the year’s second best performing and solidifying her current position as the second best performer on a five-year basis.
Pioneer’s high-yield funds have come a long way. Just five years ago, the Boston-based investment house barely had a credit department at all. When the head of fixed income Kenneth Taubes joined in 1998, Pioneer was a 70-year-old $22 billion mutual fund catering mainly to equity investors, with 850 employees and just $1.4 billion in fixed-income investments.
After its acquisition in 2000 by UniCredito Italiano, Italy’s second largest financial institution, Pioneer became part of a new entity called Pioneer Global Asset Management with $175 billion in assets and 1,900 employees worldwide. The US operations constitute just a slice of the pie with $43 billion in assets, of which nearly $16 billion are in fixed income.
For the first time, the Pioneer brand can compete in Asia, South America and eastern Europe. It has catapulted itself into the top five ranks of pension fund managers in Chile and grown into the largest mutual fund company in Poland. Many of Pioneer’s American investment products, including offshore versions of the High Yield and Global High Yield Fund, are also sold out of Luxembourg since Pioneer Asset Management serves many more clients internationally than in the US. “The acquisition has been very good for Pioneer on several levels. [UniCredito] is a very well-capitalized institution and they have provided capital in a number of ways to support Pioneer’s activities,” says Taubes.
The international market expertise and distribution network of Pioneer Global Asset Management have lent the US fixed-income operations an edge, he says. “Many traditional US asset managers, when they buy European bonds, buy German Bunds or French OATs or British gilts. But our skill set in Europe is really very deep because of that local money management aspect,” says Taubes. “We can do asset-backed securities, mortgage-backeds, high-yield corporates and other areas of the corporate sector better than the typical US-based asset manager.”
In the US, Pioneer’s fixed-income business has grown organically, excluding the acquisition of Safeco’s $1 billion municipal bond funds last year, and Taubes plans to at least double the US fixed-income assets to $32 billion by 2010. “We had headwind early in the year, with people taking money out of fixed income and putting it into equities. Yet we were still able to grow assets by several billion dollars organically,” says Taubes. “I’d like to see us grow again this year by several billion dollars through organic growth. Any acquisitions would be on top of that.”
Pioneer plans to reach out to more institutional investors as part of the expansion effort. About $20 billion or a little over 10% of the parent company’s $175 billion in assets belong to 240 institutional clients around the world. In the US, Pioneer only manages $2 billion for 33 US institutional clients, with less than $200 million in fixed income. Taubes explains that the battle for institutional clients has just begun, because Pioneer’s bond funds are only now acquiring the five-year track record sought by most professional investors.
It promises to be a difficult year for attracting investors. Junk bond spreads tightened by about 130 basis points last year to about 330bp over Treasuries, according to Bear Stearns credit research, to their tightest level since 1998. Wall Street analysts did not expect the move, and predict that the majority of any spread compression in 2005 will be outpaced by interest rate increases.
“We’re not expecting much more return,” says Hunkar Ozyasar, high-yield debt strategist at Deutsche Bank in New York. “The market is up more than 45% in the past two years, and the 2004 return surpassed a lot of people’s expectations anyway. Spreads are at very tight levels and approaching historical lows, and underlying Treasury rates are increasing.”
Like most economic forecasters, Patel and Feltus expect economic growth to ease from the current 4% to about 3–3.5%, and the Federal Reserve to continue hiking interest rates in measured 25 basis point increments. As 10-year Treasury rates continue to inch upward, high-yield spreads will have less room to tighten.
Patel says that, “Last year it was the coupon income plus some capital appreciation. This year it’s likely to be just the coupon, or the coupon ‘less’, meaning a little price depreciation.”
One risk on the horizon which Patel and Feltus have priced in but don’t seem very worried about is the expected rise in default rates over the next few years. Default rates have slipped from a peak of 10.9% in January of 2002 to about 2.2% and will soon start rising again, according to Moody’s Investors Service.
“The fact that we’re expecting a higher default rate compared to what is a rock bottom rate shouldn’t be of major concern at this point,” says David Hamilton, director of corporate default research at Moody’s, predicting a rate of 2.7% by the end of this year. But he concedes that the credit quality of new issues plunged last year, raising the prospect of higher defaults in the future.
“It seems as if the default rate isn’t going to be sharply trending higher anytime soon. But on the other hand, these very low Caa and below rated deals should be expected to default at least at the average rate, which is 25%. If by dollar volume close to a third of these are in that rating category, then you’d expect the default rate to increase sometime down the line,” he says.
While high-yield issuance hit a record high at $141 billion in 2004, the ratio of junk bonds rated single-B minus or lower jumped to a record 40%, from 30% in 2003.
Low-tier borrowers took advantage of generous liquidity last year and sold risky bonds at inflated prices, while the higher-quality issuers had already taken care of their financing needs early in the bull market. Because risky bonds outperformed the market last year, investors have been unwisely taking on too much risk, says Patel. “That’s partly a function of what happens when you open the floodgates of liquidity: the best issuers have other options that are cheaper, and you’re left with the people financing at last resort,” she adds.
Feltus and Patel complain about the deteriorating quality of issuance, warning that the consequences will not appear for another three to four years when companies start running out of money. By definition, Patel says, indexers lower the quality of their portfolio when they should be raising it—during the most liquid segment of the credit cycle, when lower-tier issuers have easy access to capital.
“As long as everything stays exactly as it is—which is a stretch—it works,” she says. “But if credit cycles tighten up or the economy slows down, the fundamentals will come into play for the weaker links in the credit chain.”
Due to the higher risk and tighter spreads, Patel and Feltus advise investors to pick their bets carefully this year. While the two fund managers to some extent share economic outlooks and philosophies, they construct their portfolios independently and follow different investing approaches. Patel likes to invest top-down and focuses on industry selection. Once she sets her economic parameters, she picks strong companies within promising sectors much like a stock-picker would. “I started as an equity analyst and I think that’s why I’ve always run my fund more the way an equity person manages money, looking at industries and companies,” she explains.
This year, Patel is betting on sectors which should outperform as the economy continues to recover: basic materials and industrials, expected to benefit from rising capital expenditure, as well as health care and real estate, which should profit from favorable demographic trends. Companies in these areas can offset the pain of higher interest rates with improved pricing power and higher operating rates, she predicts.
One of her biggest holdings is Freeport-McMoRan, a New Orleans-based miner and one of the world’s largest copper and gold producers. While Freeport-McMoRan’s heavy exposure to mines in Indonesia carries political risk, Patel defends her choice based on the company’s experience in the region and her expectations for continued strong demand. The High Yield Fund contains several Freeport-McMoRan issues, including $187 million in 5.5% preferred convertibles which Patel bought last year.
She also owns $235 million of 9.625% 2012 bonds issued by Tesoro, the Texas-based refinery, most of which she accumulated at a discount in 2001 and which are now trading at 115. “The outlook for refineries is still fairly bright because the demand for fuels is still relatively strong,” says Patel. “Because making gasoline in their markets is so complex due to environmental regulations, the amount of import competition will be very muted.”
Health care is another of Patel’s favorites as the US population continues to age and younger consumers demand more health services as well. Her fund owns $22 million of the 6.75% 2013 bonds issued by giant hospital operator HCA, downgraded to junk in October after the company announced plans to buy back $2.5 billion in equities by issuing new debt. The move sparked concerns that the company is trying to appease shareholders at the expense of bondholders.
“That’s one of the disadvantages of being a bondholder: you find out that shareholders always come first,” she says. “But [HCA] is still the largest private health-care chain and it’s well run...so I don’t think money paid out to shareholders is going to materially impair the quality of their bonds.”
When Patel finds a name she likes, she looks at both high-yield and convertible bonds, making her choice based on valuation. As a result, about 42% of her exposure is currently in convertibles. “In a world where everything has gotten richer, converts represent a better value than a year ago,” says Patel. “Because the premiums of convertibles have dropped a lot over the past year due to lower stock volatility, I think that you get a better bargain now.”
When it comes to security selection, Feltus has a little bit more choice. He attributes much of his fund’s success to the added flexibility of moving between various asset classes, and in using currency exposure as a hedge. “Having the foreign currency exposure reduces your overall volatility, and having the emerging markets exposure increases your overall return,” he says.
The Global High Yield Fund has allocated 53% of its assets to US-domiciled issuers and 47% to foreign borrowers, almost half of which come from emerging market countries. About 13% of the portfolio is in foreign currency bonds, while the rest is in US dollars. In the US, Feltus expects the weak dollar to benefit exporters of industrial goods, so he is betting on industrial companies such as Cleveland manufacturers Hawk and Park-Ohio. But the real growth, says Feltus, lies in emerging markets, particularly Russia, which he describes as a controversial overweight that he “struggles with on a daily basis”.
“The negative story on Russia is that Putin is becoming a dictator and becoming more aggressive in using state power to interfere with private business,” he says. “The bull case is with oil at anything over $20, the government is running very large surpluses...Reserves are growing like crazy and the average consumer has a ton of disposable income.” Feltus points out that Russia is currently rated investment grade by Moody’s, and likely to be upgraded by S&P this year. Many emerging market investors have bought Russian bonds recently in anticipation of a rally once Russia becomes a bona fide high-grade credit.
The Global High Yield Fund is heavily invested in Gazprom, the largest producer of natural gas in the world, with $3.9 million of 8.625% 2034 bonds. Feltus says he likes Gazprom’s high reserves and European dependence on Russian energy. Feltus also carries $3.8 million of 8.875% 2014 bonds of Alrosa, the 80% government-owned maker of diamonds which produces almost all of Russia’s diamonds and about a fifth of the global supply.
Arguing that Russian consumers have more than their average share of disposable income, Feltus has also bought wireless companies Mobile TeleSystems and VimpelCom. Because the cell phone business was never public, Feltus says there is no risk that the government will try to repatriate it. At the same time, foreign partnerships in the sector have resulted in higher disclosure, and poor landline development has kept demand for cell phones high.
Feltus also likes India and China, “two countries where the entrepreneurial spirit is very strong”. In China, he owns $4 million of 9.125% 2011 Sino-Forest bonds, a Canada-based company with a near-monopoly over forest management in China, as well as $5 million of 8% 2011s in Asia Aluminum, a Hong Kong-based venture that he believes will benefit from China’s continued industrial growth. For Indian exposure, Feltus bought $3 million of 6.625% 2010 bonds of London-listed miner and smelter Vedanta Resources, rated BB. “Given the quality of the company and the relatively short tenor of the debt, we felt that was an attractive issue,” says Feltus.
But not all fund managers deal in emerging markets, and for investors one of the biggest questions this year is whether to buy into high yield at all. The Pioneer team says there’s still value to be had. “While spreads are narrow, you still get more yields than you do in Treasuries,” says Patel. “And although spreads are narrow, with the economy great and liquidity great, there’s no reason in the world why we can’t set new lows in spreads.”
Whether Patel or Feltus will come out on top in 2005 remains to be seen. While emerging market returns are expected to shrink further, convertible bonds are expected to have a better year. At the same time, Patel has a knack for outperforming the market during tough years, but Feltus’s top-three record since inception is nothing to scoff at either.
The real coup would be if Pioneer could lead the high-yield rankings with two fund managers in the top five ranks in 2005. Investors will have to wait another year to find out.
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