High Yield Fund

Manager Commentary as of 06/30/10

The Buffalo High Yield Fund returned 0.27% during the quarter ending June 2010. The fund outperformed the Lipper High Yield Bond Fund Index by 110 basis points, and the Bank of America Merrill Lynch High Yield Index by 28 basis points.   The best-performing sectors of the overall high yield market were BB-rated (which returned 0.6%) and B-rated (which returned negative 0.1%), while CCC-rated names returned negative 1.4%.  CCC securities are an area of the market that we do not emphasize due to the high level of risk, and this was the primary reason for the fund's outperformance relative to the indices.

Data represented reflects past performance and is no guarantee of future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original value. Current performance may be lower or higher than the performance quoted. Performance current to the most recent quarter end may be obtained by clicking here. Performance current to the most recent month end may be obtained by clicking here.

During the quarter ending June 2010, the high yield market's positive momentum that had been evident in previous quarters began to wane as the quarter progressed.  The sector experienced increased volatility and periods of negative performance.  Investor sentiment early in the quarter remained fairly robust on improved prospects for an economic recovery.  The market tone turned negative on concerns regarding the potential for sovereign defaults (initially linked to Greece), though these concerns abated somewhat as European leaders developed a plan to deal with the financial crisis.  Compounding the negative sentiment were the oil spill in the Gulf of Mexico and a significant sell-off in the U.S. equity markets (S&P 500 declined 11.9% in the quarter).
 
Demand, as measured by high yield mutual fund flows, weakened as the investment class had $2.7 billion of outflows in the quarter relative to positive inflows of $2.4 billion in the first quarter of 2010.  Investor flows over the quarter closely tracked the performance of the market, as investors added funds in April on continued positive performance, withdrew funds in May as the market pulled back, and put money back to work in the sector as the market recovered late in the quarter.  New issuance in the quarter was fairly robust with $48 billion of high yield bonds priced.  However, this supply was front-end loaded with the bulk of issuance occurring in April.  As volatility increased, supply was curtailed.  Benefitting from record new issuance in the beginning of the calendar year, 2010 is still on pace to eclipse last year's record of $180 billion ($125 billion year to date).  Although the increased new bond volume has reduced liquidity risk for many bond issuers with near term maturities, buyers have shown limited appetite for low- quality deals, as the vast majority of the deals are rated single B or better.  The percentage of CCC-rated deals remained flat at 6% (down from the 16% peak).  The bulk of the proceeds have been earmarked for refinancing purposes, but there was a slightly increased proportion of deals for acquisition/LBO purposes (albeit still less than half of peak levels).

As a result of the increased market volatility the spread of the JP Morgan Global High Yield Index widened from 609 basis points at the beginning of the quarter, to 730 basis points over treasuries at the end of the quarter.
 
Market sentiment has turned less favorable.  Although companies are beginning to experience positive revenue and earnings growth, the job market remains less than robust, and there is increased skepticism about the pace of the recovery in the U.S. economy.  As noted above, the concerns with sovereign debt levels and the oil leak in Gulf of Mexico have also curtailed investor confidence.   Default rates continue to decline as the JP Morgan par-weighted default rate dropped from 8.80% six months ago to 2.71%.  Within this mixed environment, our strategy is to focus on the high-quality issuers that we believe are posed to outperform in a continued soft economy.
 
The composition of the Buffalo High Yield Fund at quarter end when compared to the previous quarter is as follows:
 

The decrease in the cash weighting reflects the allocation of cash toward attractive corporate bonds and convertible issues.  During the quarter we reduced/sold out of five names (all were called or had attractive tender offers), initiated/added positions in 22 credits, and took advantage of a favorable tender offer and converted one convertible bond holding to common stock.  The weighted average yield to worst of the fund now stands at 7.93%, and the current yield is 6.43%.  At quarter end, the portfolio was comprised of 83 issues reflecting 69 separate companies. The average position size is 1.2%, and the largest single position represents slightly less than 5% of the portfolio (across two separate issues). The portfolio companies are spread among a variety of industries; our largest sector weightings include Industrials (14 percent), Healthcare (11 percent) and Gaming (10 percent).

Some of the better-performing names in the portfolio during the quarter were American Medical Systems, Philip Van Heusen, Isle of Capri and The Greenbrier Cos.  Portfolio companies that underperformed in the quarter included; Janus Capital, Steel Dynamics, Hornbeck Offshore and Pinnacle Entertainment.

As bond spreads remain well above their cyclical lows, we believe there continue to be many investment opportunities in the high yield market that offer favorable risk/reward profiles. We are looking to add new names to our fund, and redeploy cash into the names that we believe have the best potential for outperformance.  We remain primarily focused on identifying companies that have the following credit characteristics: leading market positions in growth industries; high barriers to entry; sustainable margin structures; manageable balance sheet leverage; adequate liquidity; improving credit metrics; and with business models that will be relatively stable regardless of the state of the external economic environment.

We continue to stay away from emerging market bonds, collateralized debt obligations, and most bonds issued in connection with leveraged buyouts.

Click here for holdings.

Click here for definitions.

"Although companies are beginning to experience positive revenue and earnings growth, the job market remains less than robust, and there is increased skepticism about the pace of the recovery in the U.S. economy. Within this mixed environment, our strategy is to focus on the high-quality issuers that we believe are positioned to outperform in a continued soft economy."