Potential Replacement Value
High Yield Bonds May be a Compelling Option in a Low-rate Environment

April 2012

It's not necessarily difficult to replace nothing.

"Or almost nothing," says Richard Inzunza, manager of the Northern High Yield Fixed Income Fund, of the notoriously skimpy yields offered from U.S. Treasury and investment-grade corporate bonds. "If investors are seeking to replace the income they once got from top-quality issues, high yield may be a compelling way to do it."

Some investors won't have a choice. To fund retirements and meet actuarial obligations, individuals and institutions need bonds that have the potential to generate a meaningful yield. "You probably can't sit in cash or low-yielding bonds and meet your future obligations," Inzunza reminds. "Unless you win the lottery."

Appears to be in good shape
Though high yield bonds took a major hit during the financial crisis, default rates quickly receded. In fact, defaults among sub-investment grade credits are below the group's long-run average despite an anemic economic recovery and chronic geopolitical jitters.1

"That speaks well for how the businesses are being run," Inzunza says. "They've cut costs, reduced leverage and resisted the urge to get aggressive before economic conditions warrant. We believe there is real value in the high yield sector."

Literally. High yield bonds, as measured by the FINRA-Bloomberg Corporate Bond Index, have provided a roughly four percentage point cushion over the nation's 2.9% inflation rate.2 By contrast, the investment-grade component of the FINRA-Bloomberg Index has yielded only about one percentage point after inflation3 while real yields on 10-year Treasury securities are negative.4

Middle of the road
Inzunza generally positions the Fund near the center of the high yield credit spectrum. He moved heavily into BB-rated bonds last year and shifted into single B's and better quality CCC's to start the year now that the economy is gaining traction. Eventually, he expects demand to develop for lower quality CCC issuers, but the market is not there — yet.

"The central focus of this Fund is in-depth, proprietary credit research," he says. "We merge top-down analysis with bottom-up, fundamental due diligence."

The results are apparent in the Fund's default rate during Inzunza's five-year stewardship: Zero.

No promises, of course, but Inzunza aims to keep it that way.

"We don't strive to be the top-performing high yield fund in every environment," he says. "Our shareholders want yield, but not at the expense of getting paid back."

Because some things can't be replaced.

Past performance is no guarantee of future performance.

Bond Risk: Bond funds will tend to experience smaller fluctuations in value than stock funds. However, investors in any bond fund should anticipate fluctuations in price, especially for longer-term issues and in environments of rising interest rates.

High Yield Risk: Although a high yield fund's yield may be higher than that of fixed income funds that purchase higher-rated securities, the potentially higher yield is a function of the greater risk that a high yield fund's share price will decline.

Bond Ratings: Based on Standard and Poor's nomenclature, speculative grade bonds range from BB+ (considered highest speculative grade by market participants) to as low as D (currently in default), speculative grade bonds typically compensate for the additional risk with high yields. Bonds rated BBB- and higher (to AAA+) are considered investment grade. Ratings are relative and subjective and are not absolute standards of quality.

1 Standard & Poor's; March 2, 2012
2 The New York Times March 22, 2012; The Economist, March 24, 2012
3 The New York Times March 22, 2012; The Economist, March 24, 2012
4 The Economist, March 24, 2012

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