Peter Schwab joined the Pax World team as Portfolio Manager of the Pax High Yield Bond Fund in October of 2015. In this Q&A, Mr. Schwab shares his views on high yield investing, the outlook for 2016, and where he is seeing value today. Learn more about Mr. Schwab’s background and the Pax High Yield Bond Fund here.
Q: How would you describe your investment strategy?
At Pax World, we are very particular when it comes to finding companies for the portfolio. There are three traits that have to be just right: companies need to possess a lasting competitive advantage, credible management teams, and a viable capital structure.
First we look for companies with proprietary technology, patent protection, dominant market shares or another sustainable competitive advantage. Then we look for management teams who we believe can realistically balance the interests of shareholders and lenders. Finally, we spend a lot of time analyzing the viability and appropriateness of the company’s capital structure.
Q: Pax World was one of the first to offer a high yield fund that employs a sustainable investing approach. How can a sustainable approach to high yield investing benefit a client’s portfolio?
First, let me state that I’ve always had a personal interest in environmental issues and have wanted to do more in the Environmental, Social and Governance (ESG) space. Joining the Pax World team allows me the opportunity to do just that.
We believe that ESG research helps provide a more thorough assessment of a company’s risks and prospects. The work of our sustainability research team provides us with a more holistic sense of a company’s history, track record and potential challenges. This additional layer of research is especially important with high yield rated companies that may not have deep financial resources to overcome a misstep.
Q: Should the high yield asset class form a key part of a long-term investor’s portfolio?
The asset class provides high current income levels that help soften short-term principal fluctuations and can contribute to strong total returns over time. From a diversification1 standpoint, High Yield bonds typically have lower interest rate sensitivity than both Investment Grade and Municipal bonds as well as very little correlation2 to Treasury bonds.
Q: Historically, this Fund has maintained a more conservative profile relative to the benchmark and peers.3 Could you describe some of the ways you look to manage risk?
The incorporation of ESG factors can help reduce certain risks but we also manage the Fund with modest exposures to lower-rated credits. The primary focus of the Fund is on the higher quality tiers of the market, BB and B rated companies, with less emphasis on CCC-rated companies.4
We have minimal emerging market and derivative exposures and we strive to keep the portfolio’s interest rate sensitivity relatively close to the benchmark, the BofA Merrill Lynch U.S. High Yield – Cash Pay – BB-B (Constrained 2%) Index.5
Q: The high yield market was volatile in 2015, primarily due to falling commodity prices. What are your expectations for 2016?
Looking into 2016, much will depend on the health of the U.S. economy but if commodity prices remain depressed we are likely to have higher default rates in the energy and metals & mining sectors. This could cause instability for the overall high yield market despite most non- commodity sectors performing well. Heightened volatility could also come from a Fed “lift off.”
While High Yield bonds typically absorb rising rates well, it is difficult to know how investors will adjust to a period of potentially rising (albeit slowly) interest rates after such a long period of stability.
Q: Where are you seeing the greatest value?
On a positive note, recent volatility has created good value in sectors that have fallen out of favor, such as select metals and higher quality energy names. We are also finding good opportunities in a number of CCC-rated companies that have high coupon bonds which are callable in the next year or two. These companies are very motivated to reduce their cost of capital given historically low interest rates. We are overweight in several sectors that have a domestic focus, such as Media and Real Estate as well as Airlines which are benefiting from lower oil prices.
1Diversification does not eliminate the risk of experiencing investment losses.
2Correlation is a statistical measure of how two securities move in relation to each other.
3Conservative profile is measured using Standard Deviation and/or Volatility. Standard Deviation measures a fund’s variation around its mean performance; a high standard deviation implies greater volatility. As of 09/30/2015, the Pax World High Yield Bond Fund – Individual Investor Class’s (PAXHX) 5-year standard deviation is 4.83% vs. the benchmark5 of 5.46%, and Lipper High Yield peer average of 5.80%. The Lipper High Yield Average (“Lipper Average”) is the average return of the entire Lipper High Yield classification. The Lipper High Yield Funds Average is a total return performance average of mutual funds tracked by Lipper, Inc. that aim at high (relative) current yield from fixed income securities, have no quality or maturity restrictions and tend to invest in lower grade debt issues. One cannot invest directly in an index.
4Credit quality ratings by Standard & Poor’s assist investors by evaluating the credit worthiness of many bond issues. BB: An obligation rated ‘BB’ is less vulnerable to nonpayment than other speculative issues. It faces ongoing uncertainties and adverse business, financial, or economic conditions could lead to the obligor’s inadequate capacity to meet its obligation. B: An obligation rated ‘B’ is more vulnerable to nonpayment than obligations rated ‘BB,’ but the obligor currently has the capacity to meet its obligation. Adverse business, financial, or economic conditions will likely impair the obligor’s capacity to meet its obligation. CCC: An obligation rated ‘CCC’ is currently vulnerable to nonpayment, and is dependent upon favorable business, financial, and economic conditions for the obligor to meet its obligation. Adverse business, financial, or economic conditions could cause the obligor to be unable to meet its obligation.
5Benchmark – The BofA Merrill Lynch U.S. High Yield – Cash Pay – BB-B (Constrained 2%) Index tracks the performance of BB- and B-rated fixed income securities publicly issued in the major domestic or eurobond markets, with total index allocation to an individual issuer limited to 2%. One cannot invest directly in an index.