How to select bond funds based on your investing needs and time horizon

Investors who want income always face a balancing act of risk and rewards. Longer-term bonds tend to have higher yields than shorter-term bonds but will also experience greater price swings. Bonds with higher credit risk will also feature higher yields. These require more analytical work on the part of fund managers. But over long periods, portfolios of high-yield bonds have outperformed those of investment-grade bonds.

David Sherman, the chief investment officer of CrossingBridge Advisors, explained how his firm’s Low Duration High Income Fund could fit within investors’ portfolios. During an interview with MarketWatch, he also provided examples of bonds held within the firm’s portfolios to highlight his focus on downside-risk protection.

Sherman founded CrossingBridge in 2016. The firm is based in Pleasantville, N.Y. and had about $3.8 billion in assets under management as of March 31. In March, CrossingBridge was awarded LSEG Lipper’s annual award for the best fixed income small fund family group over the previous three years.

Most of the discussion centered on the CrossingBridge Low Duration High Income Fund, which Sherman described as “a hybrid between investment-grade and high-yield” approaches, typically with 65% or less of the portfolio invested in high-yield bonds.

High-yield bonds are those rated below-investment-grade by ratings firms such as S&P Global Ratings or Moody’s. S&P’s ratings hierarchy is explained here and you can read about the Moody’s rating scale here. For convenience, Fidelity has lined up the agencies’ ratings next to each other. The highest bond ratings are AAA at S&P and Aaa at Moody’s. The lowest investment-grade ratings for bonds at these firms are BBB- for S&P and Baa3 at Moody’s.

Bond issuers (corporate or government borrowers) pay the ratings firms to estimate the risk of default and assign ratings. Some issuers are comfortable within the high-yield space and choose not to pay to have their bonds rated. The high-yield space is specialized, with most new issues being in denominations that are too large for individual investors. That and the need for careful analysis of credit and pricing risk mean that this space is best left to professional money managers.

“High yield has always been more attractive for a long period of time for any period you chose,” Sherman said. “The net spread over time earns you a higher return,” he added, referring to how much higher yields are over those of U.S. Treasury securities of similar maturities.

“High yield is kind of a blend between equity and debt. You are lower down in the capital structure,” Sherman said. This comment was about credit risk. A company with a complex capital structure might have investment-grade bonds, whose investors would be first in line to be paid back if the company were to be liquidated as part of a bankruptcy process. Holders of such a company’s high-yield bonds would be lower in the pecking order, with common stockholders at the bottom.

For longer-term high-yield funds, a recent article featuring John Miller of First Eagle and that firm’s High Yield Municipal Fund showed how high-yield municipal bond indexes had outperformed investment-grade bond indexes by wide margins over various periods. That article also included a glossary of bond investing terminology.

And for taxable high-yield bonds, we saw similar outperformance against investment-grade indexes, in this article featuring an interview with John D. McClain of BrandywineGlobal.

The CrossingBridge Low Duration High Income Fund is rated five stars (the highest rating) within Morningstar’s “Multisector Bond” category. pays a monthly dividend. The fund has two share classes. The institutional share class CBLDX has annual expenses of 0.89% of assets and the retail share class CBLVX has an expense ratio of 1.14%. The institutional shares were first made available on Jan. 31, 2018. The retail shares were first made available on Oct. 31. If you are interested in this type of investment, the availability of the institutional shares may vary depending on your broker or adviser’s relationship with CrossingBridge. Your broker may charge a fee if you buy the institutional shares, which may be worth paying in return for lower annual expenses.

Based on the most recent monthly payout of 4.92 cents a share on May 31 and the closing price of $9.74 for the institutional shares on Friday, this share class’s annualized distribution rate is 6.06%. The monthly payout can vary considerably. The past 12 monthly distributions have totaled 61.77 cents a share, for a trailing distribution rate of 6.34%, again based on Friday’s closing price.

For the retail shares, the most recent monthly distribution was also 4.92 cents a share, making for a slightly lower distribution yield of 6.05%, based on this share class’s closing price of $9.76 on Friday.

The difference in the two classes’ expenses will be reflected in their total returns. From Oct. 31, when the retail shares were first made available, the total return through Friday was 3.57%. For the institutional shares, the return was 3.72%. All investment returns in this article include reinvested dividends or interest.

Here is a comparison of yield-to-worst durations as of April 30 (explained below) and returns through Friday for the CrossingBridge Low Duration High Income Fund’s institutional shares, with returns of three bond indexes through Friday:

The ICE BofA U.S. High Yield x Financial 0-3-year index and the ICE BofA U.S. Treasury 1-3-year indexes are appropriate benchmarks to the CrossingBridge Low Duration High Income Fund because the fund itself is a blend of high-yield and investment-grade securities.

Now we will need a few definitions for the duration column.

The durations in the table above are based on yield-to-worst calculations and show that the CrossingBridge Low Duration High Income Fund is positioned for low price volatility.

When asked why one of the fund’s benchmark indexes excluded bonds issued by financial companies, Sherman said he tended to avoid financials. “We are in the underwriting business and so are they. The difference is they are levered and we are not.”

The Bloomberg U.S. Aggregate Index is included in the table because it is an investment-grade index with a longer duration. It illustrates the type of volatility long-term bond investors had to endure when the Federal Open Market Committee increased its target range for the federal-funds rate to 4.25% to 4.50% at the end of 2022 from the range of zero to 0.25% at the end of 2021.

Here is how the CrossingBridge Low Duration High Income Fund and the three indexes performed during 2022:

Bond prices were hit so hard during 2022 that the first performance table above shows a negative average five-year return for the Bloomberg U.S. Aggregate through Friday.

When asked which type of investor would be best served by the CrossingBridge Low Duration High Income Fund, Sherman said it was appropriate “for people looking for income with a horizon of 12 to 36 months — a rolling holding period.”

For example, if you had set aside money to pay for a child’s higher education for four years, ”you should lock up only years 2, 3 and 4 in a fund like this,” he said.

“If a year goes by, during a bad period, we believe that within six months we can recover from peak to trough back to peak. That means in a 12-month period you will earn a good return. And that is not true about a long portfolio,” he said.

Money for the first year’s planned payments might be better kept in cash. For longer-term money (past that rolling 36-month horizon), it would be better to look at funds with longer durations and higher yields, Sherman said.

An advantage of active management for a bond fund, especially one that operates in the high-yield space, is pricing opportunities brought about by market disruptions or even problems (or perceived problems) tied to specific industries or companies. But this also means specialized credit underwriting and analysis expertise is required to limit the risk of default.

One example of a special situation cited by Sherman is Mangrove LuxCo III S.à rl., a private company based in Luxembourg that makes heating and cooling equipment for European and North American markets. CrossingBridge holds the company’s senior secured bonds that mature in 2029, and are yielding about 7%. Sherman said this issue was denominated in euros, but that it was normal for his firm to “hedge out the currency.”

CrossingBridge participated in the transaction when these bonds were issued by Mangrove. Sherman expects the company to be sold long before the bonds mature, which would mean the bonds would be called at 101. ”You’re earning 7% for six-month money,” he said.

Sherman cited another example — a senior secured term loan to Cox Media Group. Apollo Global Management Inc. APO is the majority owner of Cox Media Group, which operates radio and television stations. In March, Bloomberg reported that Apollo had hired an investment bank to explore the possible sale of Cox Media for about $4 billion, which “would more than cover the debt stack,” according to Sherman.

He added in an email exchange: ”CrossingBridge believed the Senior Secured Term Loan represented an attractive risk/reward with a [yield to maturity] in excess of 10% given strong broadcast cash flows, post-LME creditor protections, and the option on an event-driven total return from the sale of the business providing early repayment of our loan.”

LME stands for Liability Management Exercise, which, according to Sherman, resulted in Cox Media Group’s creditors “extending their maturities in exchange for tighter debt covenants, partial principal paydown, and increased spread economics.” That last term refers to the spreads between the bonds’ yields and those of benchmark bond indexes.

A “misunderstood” credit that Sherman mentioned was a $1.9 billion “broadly syndicated” loan to Bally’s Corp. BALY — the casino operator — due in 2028. The participated securities were heavily discounted “at mid-80s prices” for yields-to-maturity of roughly 12% when CrossingBridge began purchasing them.

Sherman said that Bally’s was “too easy to toss into the ‘too hard’ pile” because some professional investors shied away from “the complex corporate and guarantee structure.” But he also said: “Our work shows the debt is money-good, supported by the casinos and online gaming business. We can show the cash flow we are ringfenced by.”