MW How to pursue high income with relative safety while diversifying your portfolio
By Philip van Doorn
These high-yield bond funds have high ratings for long-term returns
Some investors are taking more risk than they realize with stock-index funds. Others might need income now, or might be shifting their portfolio mix for the next phase of life when a stream of dividends will be more important than pursuing long-term growth in the stock market over a period of decades.
Brandywine Global - a unit of Franklin Templeton - manages two bond funds that select from within the high-yield space.
These are bonds or other corporate credits that are rated below investment grade or are unrated. They are commonly known as "junk bonds," and their combination of high interest payments and higher credit risk than investment-grade bonds, means they are probably best left to professional money managers. The two largest credit-rating firms are S&P Global and Moody's Ratings. At S&P, a bond is considered to be of investment grade if it is rated BBB- or higher. At Moody's, the minimum investment-grade rating is Baa3. You can review S&P's ratings hierarchy here and Moody's rating scale here.
Many bonds and other instruments issued by borrowers in the high-yield space are only available to institutional investors. But individual investors can participate in this market through mutual funds.
There is another reason to think about adding bond exposure to your portfolio. Pursuing high dividends in the stock market can come with a high price. In his Intelligent Investor column in the Wall Street Journal last week, Jason Zweig named several examples of stock-market approaches to high dividends, including exchange-traded funds, that had led to brutal declines in account values over the years. Yes, the income flowed, but investors paid for it with capital erosion.
Diversifying by asset class
The S&P 500 SPX has been performing very well over recent years, but its weighting by market capitalization means it is highly concentrated at the top, and this level of concentration has been growing. Combined, shares of Apple Inc. $(AAPL)$, Microsoft Corp. $(MSFT)$ and Nvidia Corp. $(NVDA)$ make up 19.1% of the portfolio of the $539 billion SPDR S&P 500 ETF Trust SPY.
We are nearly 18 years into the current wave of increasing concentration for the U.S. stock market, according to a recent analysis of 100 years of data by analysts at MFS Investment Management.
Here is a look at the research and stock indexing approaches that might fare best following the concentration peak.
And here is another indexing approach within the S&P 500 that reduces concentration risk.
But you can also diversify by moving some of your money completely out of the stock market while still pursuing decent returns. And if you want income, the BrandywineGlobal Corporate Credit Fund and the BrandywineGlobal High Yield Fund provide it monthly.
The two Brandywine Global high-yield bond funds
The BrandywineGlobal Corporate Credit Fund BCAAX and the BrandywineGlobal High Yield Fund BGHAX are co-managed by John D. McClain and William P. Zox. The following discussion of the funds is confined to their Class A shares, which are available to investors typically with a $1,000 minimum. Both funds have sales charges of 3.75% listed in their prospectuses, however, these charges are waived for investors who purchase shares through major brokerage platforms, such as Charles Schwab or Fidelity.
Both funds also have Class I shares available through investment advisers, which may have high minimums depending on the relationship between the adviser and Franklin Templeton. The Class I shares have lower expenses and therefore higher dividend yields, but, for simplicity, we will focus on the Class A shares here.
McClain described the funds' approaches to MarketWatch. Before getting into his comments, here is a summary of the two:
The $2 billion BrandywineGlobal Corporate Credit Fund quotes a 30-day SEC yield of 6.25%. Quoted yields and returns for bond funds are net of expenses, which are 0.86% of assets under management for this fund's Class A shares. The 30-day yield is best used for comparison with other funds and is meant to give an idea of the annualized yield over the near term. This fund was formerly known as the Diamond Hill Corporate Credit Fund, which was established in September 2002. When Franklin Templeton acquired the predecessor fund in 2021, its assets and liabilities were acquired by the present fund, with no changes made to investment policies or the portfolio-management team.
The $2.4 billion BrandywineGlobal High Yield Fund quotes a 30-day yield of 6.58% for its Class A shares, which have annual expenses of 0.92%. This fund was formerly known as the Diamond Hill High Yield Fund, which was launched in December 2015. The current fund acquired all assets and liabilities from the former fund when it was acquired by Franklin Templeton in 2021, with McLain and Zox remaining as its portfolio managers.
Both are rated five stars (the highest rating) within Morningstar's "High Yield Bond" fund category.
Here are one-year returns and average annual returns for longer periods through July 31 for the BrandywineGlobal Corporate Credit Fund's Class A shares and its predecessor fund's Investor Class shares, compared with those of its benchmark, the ICE BofA U.S. Corporate & High Yield Index. The fund's performance is net of expenses and excluding any sales charges, which are now waived, as explained above. All returns include reinvested dividends.
Fund or index 1 year 3 years 5 years 10 years Since inception (Sept. 30, 2002)
BrandywineGlobal Corporate Credit Fund - Class A 11.71% 3.18% 4.96% 5.52% 6.47%
ICE BofA U.S. Corporate & High Yield Index 7.59% -1.78% 1.56% 2.95% 5.07%
Sources: Franklin Templeton, FactSet
And here are average returns through July 31 for the BrandywineGlobal High Yield Fund's Class A shares and its predecessor fund's Investor Class shares, compared with those of its benchmark, the ICE BofA U.S. High Yield Index.
Fund or index 1 year 3 years 5 years Since inception (Dec. 4, 2014)
BrandywineGlobal High Yield Fund - Class A 12.50% 3.33% 6.14% 6.92%
ICE BofA U.S. High Yield Index 11.03% 2.19% 4.03% 4.83%
Sources: Franklin Templeton, FactSet
Both funds have beaten their benchmark indexes' returns by wide margins, which is even more impressive when you keep in mind that the indexes have no expenses.
Two different approaches to the high-yield space
BrandywineGlobal Corporate Credit Fund
When asked to explain the differences between the two funds, McLain said that the BrandywineGlobal Corporate Credit Fund could be considered "a high-quality high-yield" portfolio. This is the older of the two funds, with a lower credit-risk profile and a lower yield.
Zox has been a portfolio manager for the Corporate Credit Fund and its predecessor fund since 2008, after working with the previous managers since its inception in 2002. McClain became a portfolio manager for the fund in 2014. McClain said the Corporate Credit Fund's strategy had been created in the wake of the tech-stock bubble of the early 2000s, "when you had a lot of retirees or people near retirement who lost money at the wrong time."
"The goal was to create a somewhat safer way to generate income aligned with what a required minimum distribution [from a retirement account] would look like for a client," he said. He described "soft targets" for the fund of income generation amounting to 3 percentage points above the U.S. consumer-price index during periods of low inflation, and a yield of 7% when inflation is high.
So this fund is meant to take a lighter approach to the junk-bond space, McClain said. "The client gives us the ability to dial up or down the risk in the portfolio," he added. During a period of stress for the bond market, the fund will take advantage of market conditions, applying the managers' credit analysis to purchase heavily discounted securities to increase the portfolio yield and set up capital gains down the line. That type of move can actually increase the fund's allocation to investment-grade bonds. The portfolio was 70% investment-grade "coming out of the Great Financial Crisis" in 2009, he said. As of July 31, it has 181 investments and was 14.4% allocated to investment-grade securities, and about 79% of the portfolio is invested in securities issued by companies in the U.S.
Before looking at the other fund, let's look at Zweig's coverage of high-yielding stock-market investments and capital erosion. Zweig provided plenty of examples. Here is another: The $7.7 Global X Nasdaq Covered Call ETF QYLD quotes a dividend distribution yield of 12.68%. It invests in the Nasdaq-100 Index NDX, which itself is made up of the largest 100 nonfinancial companies in the full Nasdaq Composite Index COMP. QYLD generates income by writing covered call options on the entire index - a process described here.
QYLD has done an excellent job of providing double-digit annual dividend yields, but the cost has been significant capital erosion over the years. The fund's closing price on Sept. 6 was $17.18. That was down 32% from $25.34 on Friday, Sept. 5, 2014.
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BrandywineGlobal Corporate Credit Fund's net asset value (or NAV, which is a mutual fund's closing price determined daily after the market close) for the Class A shares was $10.66 on Sept. 5. Ten years earlier, the NAV for the preceding Diamond Hill Corporate Credit Fund's Investor shares (DSIAX) was $11.13. That is a 4% capital decline in 10 years. And that isn't bad when considering that bond yields now are much higher than they were 10 years ago (bond prices move in the opposite direction of interest rates).
BrandywineGlobal High Yield Fund
According to McClain, the High Yield Fund takes a "style pure" approach, with more credit risk and higher yields than the Corporate Credit Fund. The fund held 188 securities as of July 31 and was 80% invested in securities issued in the U.S., with less than 9% rated investment-grade. This fund and its predecessor have been managed by McLain and Zox since the preceding fund was established in 2015.
McLain stressed that both Corporate Credit and High Yield funds have relatively short durations, which limits volatility when interest rates rise and fall. This price volatility risk can be much higher than credit risk during periods of turmoil in financial markets, he said. He added that he, Zox and their families had significant assets invested in both funds, underscoring that their interests aligned with those of their clients.
He said that when analyzing companies for credit risks, it is important not only to consider the financial health of the issuer, but the structure of the bond. The bond structure can point to additional risks with the collateral securing the credit. There is also a pecking order for a company's various bond issues. In the event of a corporate bankruptcy, bondholders take control of an issuer. If the issuer is liquidated, there is a hierarchy among the bondholders. Holders of junior-lien debt might not recover any of their principal investments.
"We are trying to invest in companies and structures in which a number of things have to go wrong before we face impairment," McClain said.
He also emphasized the importance of recognizing risks when circumstances change and selling troubled bonds sooner rather than later. "What we lose sleep over is when we like a business and the market does not agree. We do not want to get caught off guard," he said.
"You have to sell when your investment thesis breaks. And when we cannot predict cash flows, we have to exit a business," McClain said. This emphasizes the importance of diversification and professional management within the high-yield space.
When discussing current market conditions and the path ahead, McClain said the Brandywine Global team had been observing "a meaningful shift of capital from overseas coming into high-yield U.S. assets," which bodes well for the health of the market. Shorter-term, savers and income-seekers who have enjoyed taking no risk with 5% bank CDs over the past year are seeing the good times end. The Federal Reserve is likely to begin a cycle of cuts for the federal-funds rate next week. That will accelerate the decline in CD rates.
"If you can get 7% to 8% lending to companies of reasonable quality for three years, that seems to be a good position to be in, compared with 5% for three months without risk," McClain said.
Don't miss: 10 'enhanced value' stocks of companies expected to grow quickly through 2026
-Philip van Doorn
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