An Interview With Kent Gasaway, Portfolio Manager, Buffalo High Yield Fund

    by Maria Crawford Scott


    CATEGORY: Corporate High-Yield Bond


      1Yr 3Yrs 5Yrs
    Fund 20.8 9.6 7.1
    Category 23.2 -2.7 2.9

    TOTAL ASSETS: (as of 9/30/03) $190 million

    CONTACT: Buffalo Funds (800) 492-8332

    Equities were not the only asset class aboard the sinking ship in 2000. High-yield ‘junk’ bonds went right down with them. And they have managed to resurface at about the same time—recent one-year returns have averaged 20%, tracking the stock market rebound.

    The recent ups and downs illustrate one of the main features of junk bonds—although they are fixed income, they offer much bumpier rides than other fixed-income sectors.

    On the other hand, they offer the potential for higher returns.

    One high-yield fund that has provided solid long-term returns with less risk than other high-yield funds is the Buffalo High Yield Fund.

    Last year, the fund was up 20.8%, compared to 23.2% for the category average. However, the fund has been among the top 25% of all high-yield funds over the last three- and five-year periods (through September 30).

    Currently, the fund has about $190 million in total assets.

    In September, portfolio manager Kent Gasaway, CFA, discussed the management of the fund with Maria Crawford Scott.

    What is the investment objective of the fund?

      The primary objective is to earn a high current income for shareholders. The secondary objective is capital appreciation over time.
    What would be a reason for investors to go into high-yield bonds?
      We have a large clientele who want a steady source of income for their retirement, and we invest in a combination of high-yield and high-quality and convertible bonds to generate that income. The fund was developed for those who don’t have enough assets to do a separately managed account.
    Are high-yield bonds a reliable source of income? And are high-yield bonds a substitute for owning other bonds, or are they used primarily for diversification within the fixed-income markets?
      Over time it’s proven to be a good diversification tool.

      For certain individuals, when they retire they expect to live on a set amount of income, but the only way they can get there is to take more risk—they can’t get there investing in Treasuries or Proctor & Gamble bonds. We try to make sure our shareholders understand this risk and are willing to take it. For these investors, the alternative is to go into equities for the capital appreciation, and then take out the gains to live on. The danger of that is, well . . . the last three years that we’ve gone through! High-yield bonds certainly have greater potential volatility than other bond classes, but they certainly have a lot less volatility than stocks.

      High-yield bonds are a legitimate vehicle when used prudently with good diversification to meet those goals.

    What area of the high-yield bond market do you invest in?
      Traditionally, single-B through triple-B rated bonds. Double-B is kind of our average rate.
    How do you structure the portfolio?
      The mix changes over time but it’s traditionally been three-quarters corporate bonds and one-quarter convertible securities.
    And those are all rated below investment grade? The convertibles as well?
      Most of them are, but we do buy triple-B bonds, as well, when the rates are there. We bought the bonds of the automakers when people were very nervous about their unfunded pension liabilities and the bonds were yielding close to 10%—they’re all triple-B.
    Why do you buy convertible securities?
      Convertibles are a natural extension of what we do in equities. We’re a large player in the small-cap stock market, where we’ve been very successful. Our long-term time horizon sits well with our strategy of being very patient and waiting for industries to turn around, because you get paid to wait in convertibles. When things do turn, you can often make 50% to 100% on your money.
    How do you decide which bonds you’re going to pick?
      Our core holdings in the fund, which make up two-thirds of the fund, are typically in the same industries where we do most of our equity investing. The basis there is that we want to be in industries that, in a three- to five-year timeframe, are going to grow faster than the overall economy.

      We’ve identified a number of long-term trends within different industries that we have a high degree of confidence will play out. When you can find both stocks and bonds in industries that are growing, typically good things happen not only to the stocks but to the credit profiles of the companies as well. However, some of the areas where we invest in the stock market aren’t populated by many leveraged companies. So we can’t always fill up a portfolio with the areas that we really like on the stock side.

      For instance, we happen to be a large holder of bonds in the cruise industry. There, we feel that the underlying long-term trend is related to demographics: The average person that takes a cruise is in their mid-fifties, and that age population is going to grow dramatically over the next five to 10 years—the front end of the baby boom. So we believe very strongly that the cruise industry has grown and will continue to grow much faster than the overall population. It also happens to be an oligopoly industry—it has very high barriers to entry. It goes through cyclical periods where too many ships are built and bad things happen in the world and people don’t want to travel. But long term it comes back into a more normal situation, which it’s doing right now. We bought those bonds after September 11, two years ago, when everybody thought that no one would ever travel again. It is an example of an instance where the trend had already been in place for a long period of time, but we had an opportunity to buy bonds at very, very attractive yields. Now it’s a core holding.

      The gaming industry would be another example. Actually, we have quite a long list—about 20 different trends that we invest in on the equity side, and we do our best to try to find bonds in those areas as well.

      We also do some contrarian investing in areas that are much more cyclical and lower growth. Typically we’re going to be buying those when no one else cares about them. It’s a very pick-the-best-company-in-a-crummy-industry approach, one that you think will survive regardless of it being in a bad industry. But you go into that with the realization that it’s going to be a cyclical holding, not a long-term core holding.

    How do you decide which specific bond issues you’re going to buy?
      We have a team of analysts that does all of the individual research. Once we’ve identified an industry that we think is going to have above-average growth, we go in and try to find the best companies. Of course, first we need to find companies that have bonds. And then we look for the ones that we think could be attractive. We’ll do very detailed fundamental analysis on those companies—if we’re going to take a large holding in it we’re going to get to know them very well.

      Our largest position right now is 2½%—Barnes & Noble convertibles. That’s a very high-quality company, really an investment-grade company. We bought the bonds when all retailing was in the dumps—the middle of last year, we loaded up on retailers across the board. We bought Best Buy convertibles, and we bought Barnes & Nobles convertibles—in fact, we bought a number of high-quality companies because, when you’re in a recession, everybody’s negative on everything.

    Is there any specific yield you look for at a specific point in time?
      Generally, we’re trying to buy bonds that will give us a certain amount of spread over the 10-year Treasury—I would say that would be a minimum of about 3% over wherever the 10-year Treasury is. There’s no magic to that other than that’s been sort of the long-term average for double-B bonds. If we can find companies that can give us that kind of yield but at the same time we think have much better long-term prospects than the overall market, we’ll be rewarded for that, and that spread will tighten over time.
    What about industry diversification?
      We have very broad industry diversification. Because we do have the two-pronged approach, it will get us into a whole lot of different industries. Even though, as an example, we’re not crazy about commodities, we’ll typically have some holdings in the oil area as a contrarian play. We had over 20% of the fund in energy in 1998 and 1999 when the price of oil was very low. Now that the price is very high we have extremely low weightings—the only energy area we now own any bonds in is refining.
    What features do you look for either within the issue itself or within the company?
      Typically we’re going to try to own the most senior bonds that we can in the capital structure. We’re going to try to own companies where there’s not a large amount of bank debt ahead of you, because banks are always in a bad situation and, because of the way they structure their financing with the companies, they’re always going to get the assets first. We typically like to see companies that have a fair amount of liquidity, either cash on the balance sheet or a long-term solid bank line that doesn’t have a ton of covenants that we think they could get in trouble with.

      We only buy public companies so we can watch their stocks trade every day—that’s very helpful, just watching what’s happening on a daily basis. You can sometimes get an early read on things by watching stocks. And the reporting is much better out of public companies than it is for private companies.

    What about maturities?
      We’re typically an intermediate-maturity buyer. The whole high-yield market in general is an intermediate-maturity market. You virtually don’t see any high-yield issuers issuing 30-year bonds—they’re typically always seven to 10 years because they don’t want that expensive money to be out there long term.

      The only places where we own some longer-rated bonds is where we really think we can get the bang for the buck on a turnaround. For example, when we bought the automaker bonds, we bought 10- to 30-year bonds because that’s where the spreads were widest, and that’s where you’re going to make your biggest money.

      We’re not interest rate forecasters per say—we’re not trying to buy long bonds when we think rates are going to go lower and shorten up when we think rates are going to go higher. Our strategy is really more security by security. That being said, we happen to have a pretty sizeable cash position right now because there are not very many bonds that we view as having any value.

      I guess it has something to do with rates at near 50-year lows. Spreads have tightened dramatically, and with the 10-year Treasury at 4.3%, you start to see a lot of high-yield issuers’ bonds going below 7%. Not many years ago, I was buying single-A bonds at 7%! I’m just not a person who buys into the notion that the bond market will no longer be cyclical. I think it is going to be. Rates have already risen quite a bit, and they’re probably going to rise quite a bit more.

    You don’t feel you’re being paid to take the risk right now?
      Correct. I don’t want to buy single-B rated bonds that yield less than 7%, that does not excite us. That’s a ‘me too’ strategy.

      We choose to leave the money in cash and preserve our shareholders’ principle, and then when bonds do become available, we’ve got a list of almost 20 names that we want to buy. We’ve already done all the research. But the yields aren’t there. We don’t feel the risk/reward trade-off is adequate.

      Of course, our large cash position is not helping our current yield right now. It’s suffering. But when rates hit their bottom, I view it as not much different than the Nasdaq at 5000. Looking back on that, I don’t think anybody would have argued with a manager having gone to cash when the Nasdaq went to 5000—they would have been heroes. Now, we get criticized for our cash position, but I frankly don’t care. I’m not going to invest the fund, of which I’m a large shareholder myself, in high-yield bonds at 6% or 7%. I’m not getting paid for that.

    What would prompt you to sell a specific bond?
      If it gets too expensive. We’ve sold every bond in the portfolio that yields less than 6%—we don’t believe that we’re getting paid to take any risk there.

      Also, we sell when we get any inkling on the credit that there might be a problem. It’s always better to sell something at 90 cents on the dollar even if you’re wrong and it goes back to 100 cents on the dollar. Those would be the two main things.

    How does the current environment and the current structure of your portfolio compare to a couple of years ago?
      It’s completely different. We were running fully invested up until almost a year ago, but certainly the beginning of this year we started getting a lot more defensive.

      In the past, we have always run this fund with less than 5% in cash. This year, for the first time ever, we bought high-yield stocks. When the 10-year Treasury hit 3½%, I was buying utility stocks that yielded 6% or 7%! I thought it was crazy—I couldn’t buy bonds that yielded that much, but yet I could buy stocks. Then the lower tax rate on dividends came through, the stocks went up and we sold them. I would never even have dreamed of doing that before. But you know what? You go to wherever you can find good value.

      Now that game’s played out. We still own a few stocks, but it’s less than 3% of the fund. It got as high as 10%—that’s as high as we can go.

      As for our cash position, it’s not like I aspire to hold a lot of cash for a long period of time—I really don’t. We’re itching to put this money to work, but we’re not going to do it foolishly. We’re going to take our time and let things come to us. And I think the way the economy’s playing out and everything’s working that some time in the next six to 12 months we’re going to have all kinds of opportunities presented.

→ Maria Crawford Scott