Archives for March 24, 2015

Vanguard High-Yield Corporate Bond Fund Review (VWEHX)

“The editorial content on this page is not provided by any of the companies mentioned, and has not been reviewed, approved or otherwise endorsed by any of these entities. Opinions expressed here are author's alone.”

vanguardinvThe Vanguard High-Yield Corporate Bond Fund (VWEHX, VWEAX) is a low-cost, actively-managed bond fund that invests in medium- and lower-quality corporate bonds and is advised by Wellington Management Company. I don’t own any in my retirement portfolio, but while reading the book The Affluent Investor by Phil DeMuth, I was intrigued by this interesting tidbit:

If you have settled on buying them anyway, at least wait until the spread between treasury bonds and junk bonds of the same maturity is wide (say, 4 percentage points). The fund to own is Vanguard’s (ticker: VWEHX), which has a gimmick: it buys the highest rated junk bonds. Many institutional investors can only hold investment-grade bonds as a matter of policy, and they are forced to liquidate bonds that get downgraded even when it makes no sense to do so. Vanguard lies in wait to take advantage of their mistake. This is a hedge fund strategy in a bond fund wrapper.

(I should add that this is after the author warns you about the high-yield bond asset class in general, and how if you adjust the higher yields to account for higher defaults, the net advantage can be small or even zero. He also adds that high-yield “junk” bonds are also quite volatile and should be treated like equities.)

But going back to the quote, DeMuth is saying that this fund tries to take advantage of a specific market inefficiency. I’ve never seen this strategy mentioned in either any Vanguard materials or financial media coverage. I went back and took a closer look at their prospectuses and other investor documents.

I was aware that VWEHX tends to invest in the higher-quality portion of the junk spectrum. From the Product Summary on their website:

Created in 1978, this fund seeks to purchase what the advisor considers higher-rated junk bonds. This approach aims to capture consistent income and minimize defaults and principal loss.

From the Fund Prospectus (dated 5/28/14):

The Fund invests primarily in a diversified group of high-yielding, higher-risk corporate bonds—commonly known as “junk bonds”—with medium- and lower-range credit- quality ratings. The Fund invests at least 80% of its assets in corporate bonds that are rated below Baa by Moody’s […] The Fund may not invest more than 20% of its assets in any of the following, taken as a whole: bonds with credit ratings lower than B or the equivalent, convertible securities, preferred stocks, and fixed and floating rate loans of medium- to lower-range credit quality.

Digging further into the Prospectus, we find the following under the “Security Selection” heading:

Wellington Management Company, LLP (Wellington Management), advisor to the Fund, seeks to minimize the substantial investment risk posed by junk bonds, primarily through its use of solid credit research and broad diversification among issuers. […]

The Fund will only invest in bonds and loans that, at the time of initial investment, are rated Caa or higher by Moody‘s; have an equivalent rating by any other independent bond-rating agency; or, if unrated, are determined to be of comparable quality by the advisor. […]

Wellington Management selects bonds on a company-by-company basis, emphasizing fundamental research and a long-term investment horizon. The analysis focuses on the nature of a company’s business, its strategy, and the quality of its management. Based on this analysis, the advisor looks for companies whose prospects are stable or improving and whose bonds offer an attractive yield. Companies with improving prospects are normally more attractive because they offer better assurance of debt repayment and greater potential for capital appreciation. […]

To minimize credit risk, the Fund normally diversifies its holdings among debt of at least 100 separate issuers, representing many industries. As of January 31, 2014, the Fund held debt of 172 corporate issuers. This diversification should lessen the negative impact to the Fund of a particular issuer’s failure to pay either principal or interest.

Here’s a quick summary of the Moody’s Credit Rating hierarchy, per Wikipedia:

Investment Grade

  • Aaa – Highest quality and lowest credit risk.
  • Aa – High quality and very low credit risk.
  • A – Upper-medium grade and low credit risk.
  • Baa – Medium grade, with some speculative elements and moderate credit risk.

Below-Investment Grade (“Junk”)

  • Ba – Speculative elements and a significant credit risk.
  • B – Speculative and a high credit risk.
  • Caa -Poor quality and very high credit risk.
  • Ca – Highly speculative and with likelihood of being near or in default, but some possibility of recovering principal and interest.
  • C – Lowest quality, usually in default and low likelihood of recovering principal or interest.

From the Annual Report (dated 1/31/15):

This is the first time we are reporting the performance of the High-Yield Corporate Fund against its new benchmark composite index, which consists of 95% Barclays U.S. High-Yield Ba/B 2% Issuer Capped Index and 5% Barclays U.S. 1–5 Year Treasury Bond Index. As we mentioned when we made the change in November, we believe that the composite index is a better yardstick for the portfolio. It more closely reflects the portfolio’s longtime strategy of investing in higher-rated securities in the below-investment-grade category while maintaining some exposure to very liquid assets.

From Wellington Management Advisor Letter (part of Annual Report, dated 1/31/15)

The decline in commodity prices sparked a significant widening of high-yield bond spreads, and although the problems now affecting high-yield energy credits are justifiable, they are relatively isolated
to that industry. We are looking to take advantage of recent dislocations created by the sell-off in non-energy companies, where wider spreads are attractive and the credits are well-supported by strong fundamentals.

The fund remains consistent in its investment objective and strategy and maintains a significant exposure to relatively higher-rated companies in the high-yield market. We believe that these issuers have more consistent businesses and more predictable cash flows than those at the lower end of the spectrum. We prefer higher-rated credits in order to minimize defaults and provide stable income. We continue to diversify the fund’s holdings by issuer and industry and to de-emphasize non-cash-paying securities, preferred stock, and equity- linked securities (such as convertibles) because of their potential for volatility.

Costs and Fees

The expense ratio of the High-Yield Corporate Fund Investor Shares at 0.23% and Admiral Shares at 0.13% are very low in comparison to the peer group average of 1.11% for High-Yield Funds (calculated by Lipper). The fact that Vanguard itself runs at-cost and the fund advisor Wellington agrees to only takes a fee of 0.03% are quite impressive:

Wellington Management Company LLP provides investment advisory services to the fund for a fee calculated at an annual percentage rate of average net assets. For the year ended January 31, 2015, the investment advisory fee represented an effective annual rate of 0.03% of the fund’s average net assets.

In comparison, sometimes the creator of an index (like the S&P 500) will want a few basis points just for allowing a fund to follow their computer-generated list of companies. Wellington is pruning through thousands of often-illiquid bonds.

Portfolio Credit Quality

Here is the breakdown of the Vanguard High-Yield Corporate Bond Fund portfolio by credit rating as of 1/31/15. Remember that Baa and above is investment grade, so the vast majority (87%) of their holdings are indeed the top two rungs of the non-investment-grade spectrum. I assume that the 5% allocation to US government bonds is in case of an increase in fund redemptions.

vghighyield

Recap
I am neither recommending nor discouraging investment in this fund. There are many types of risk involved: credit risk, interest rate risk, liquidity risk, poor security selection risk. I was just intrigued by a quote in a book and wanted to dig into it further.

I have read through the prospectus and annual reports and pointed out all of what I saw were pertinent mentions of their investment and bond selection criteria. I didn’t find anything particular in Vanguard’s materials about picking bonds that have recently fallen from investment-grade to just below investment-grade, but such a strategy would certainly align with their historical portfolio and stated goals of holding the “best of the junk”.

If this is indeed a significant market inefficiency, I wonder why it still exists. Perhaps you can only do it with a very low expense ratio? I don’t believe there is any other actively-managed bond fund consisting of high-yield bonds that has such a low expense ratio; 0.13-0.23% is nearly as low as many index funds.

The low costs alone create a relative performance advantage for this fund. I chose not to emphasize past performance as that can be fleeting, but this fund’s past performance numbers also beats their Lipper peer group average over the last 1, 5, and 10 years.

Now, I do own shares of the Vanguard High-Yield Tax-Exempt Fund, which has a different advisor; Vanguard Fixed Income Group. I wonder if they do a similar thing there?

Book Review: The New New Thing: A Silicon Valley Story by Michael Lewis

“The editorial content on this page is not provided by any of the companies mentioned, and has not been reviewed, approved or otherwise endorsed by any of these entities. Opinions expressed here are author's alone.”

newnewthing

Somehow I picked up a copy of The New New Thing: A Silicon Valley Story, which is a Michael Lewis bestseller published back in 1999 about the internet boom. The central character is Jim Clark, founder of Silicon Graphics (SGI), Netscape, and Healtheon/WebMD. That means Clark started three separate companies in three different industries that were all worth at least hundred of millions of dollars to over a billion dollars. Although Silicon Graphics has since filed for bankruptcy and younger folks probably don’t even know the same, for a while it was one of the most prestigious places for computer engineers to work.

It’s been over 15 years since the dot-com boom, and reading it actually felt nostalgic to this 36-year-old, but as with any Michael Lewis book it was at least a good story. It was light on practical finance-related material, but as always I like to record my notes.

  • The 1990s were a turning point where a young person with strong technology skills could get stupid rich. Before that, it seemed that you needed to work somewhere on Wall Street after showing off your Ivy League credentials. Even today, the smartest people want to be tech entrepreneurs. Geeks are cool and nerds can be treated like rock stars.
  • Clark grew up poor and had a chip on his shoulder. He grew up poor in a small town in Texas with an abusive father. Now on one of his rare returns “home”, he buzzes the town in his private jet, has lunch with his mom, and then jets off again the same day.
  • Jim Clark’s personality was perfect for this era. He had the smarts and street cred of a techie, but also the visionary skills and lack of self-doubt that made him a leader of other techies. Netscape was a web browser without a plan to make money (this was pre-Google!), yet it made Clark a billionaire. I liked this quote:

    Most people don’t enjoy making huge gambles on the future. They would just as soon have someone else tell them what to do. And that is what Jim Clark did. From the moment Netscape made him a billionaire […] half the engineers in the Valley wanted to work for whatever company he started

  • Rich men have a thing for big boats. Since Michael Lewis spent a lot of time following Jim Clark around and Clark was obsessed with his big-ass sailboat (which would barely fit under the Golden Gate Bridge), a lot of the book is somewhat boring stuff about trying to make a computerized sailboat called Hyperion. Then he commissioned an even bigger boat, Athena. Now go check out Steve Jobs’ super-yacht that cost over $100 million: Venus. Shrug.
  • “If money is how your measure yourself, you’ll never have enough” is a recent quote that I came across, source unknown. But that’s pretty much Clark (and probably a lot of other billionaires to be fair). Before founding his first big company SGI, he said he just wanted $10 million. After becoming a multimillionaire, he wanted $100 million. After his Netscape shares hit $600 million, he wanted a billion. After the Healtheon IPO made him an after-tax billionaire, he wanted more than Larry Ellison ($13B at the time).
  • The book ends with Jim Clark starting another business called myCFO, which was supposed to cater to all those new internet millionaires and help them manage their money without having to go with one of those stuffy, established institutions like Merrill Lynch or Goldman Sachs. myCFO ended up being sold off for “only” $30 million, but I think it was a precursor to modern non-traditional advisors like Wealthfront which also specifically targets Silicon Valley engineers.
  • Jim Clark’s more recent ventures since the publishing of this book have much been less exciting. The only one I hard heard of is Shutterfly, and he was really only involved with the funding. It appears that now he’s just enjoying life with his big boats and family.
https://viagraon.com

http://avtomaticheskij-poliv.kiev.ua/

читать дальше