High Yield Fund

(As of 9/30/18) — After producing positive returns in the 2nd quarter of 2018, the U.S. high yield sector stayed on course, generating positive performance in the 3rd quarter, with positive returns in all three months, although each month’s return was lower than the prior month. The market’s performance was driven by:
• continued, albeit modest, economic growth of U.S. Gross Domestic Product;
• a healthy labor market with additional jobs added and the unemployment rate remaining near cycle lows;
• the Federal Reserve maintaining a gradual pace of increasing interest rates and timing of plans to reduce their balance sheet; and
• a quiet new issue market which provided support for secondary pricing.

Headwinds in the quarter were:
• rising treasury rates;
• continued concerns regarding disruptions in international trade due to the Administration’s escalating trade wars with the North American Free Trade Agreement (NAFTA) countries and particularly with China;
• increasing oil prices; and
• an evolving geopolitical landscape and risks.

Despite uncertain market conditions, equity markets and high yield markets performed well during the quarter despite the level of short-term interest rates moving higher. The 3 Month Intercontinental Exchange London Interbank Offered Rate, LIBOR, increased 9 basis points (bps) to 2.42%, as investors continued to gravitate towards higher risk assets. The 10-Year Treasury Note returned -1.08% during the quarter while the JP Morgan Domestic High Yield Index generated 2.37% and the S&P 500 Index returned 7.71%.

During the quarter, the 10-year Treasury yield rose 20bps from 2.86% to 3.06%. Despite the increase in Treasury yields, demand for high yield caused spreads to tighten across the asset class.

Changing course from the last few quarters, higher-rated issues tightened more than lower-rated issues. Spreads on the CCC-rated segment tightened 30bps while the spreads on higher rated BB-rated bonds tightened 44bps. According to data from JP Morgan, the BB-rated segment returned 2.32%, slightly better than the B-rated segment return of 2.29%, but still less than CCC-rated segment, which returned 2.99%. The Buffalo High Yield Fund was underexposed to the CCC sector with a weighting of about 4.9% compared to the JP Morgan CCC weighting of 11.5%.

According to data from JP Morgan, the U.S. high yield market’s spread-to-worst for the period ended September 30th was 365bps, 50bps tighter than the preceding September quarter and 249 basis points below its 20-year historical average of 614bps. The yield-to-worst for the high yield market at quarter-end was 6.53%, below the 9.02% 20-year average, and below the yield of 6.72% at the end of the 2nd quarter.

Counterintuitively, high yield mutual funds continued to experience cash outflows during the September quarter of about $1.0 billion compared to outflows of $4.5 billion in the previous quarter, according to data from JP Morgan. High yield new issuance for the quarter was $42.1 billion, the lowest volume since the $38.2 billion in the 4th quarter of 2011, and well below the average quarterly volume of $83 billion during that seven-year span.

(As of 9/30/18) — The Buffalo High Yield Fund increased 1.80% in the 3rd quarter, underperforming the ICE BofAML U.S. High Yield Index by 64bps, which returned 2.44% during the same period. We ended the quarter with 131 positions compared to the previous quarter’s level of 140 positions (excluding cash).

The Fund’s cash balance at the end of the quarter decreased 33bps from the prior quarter’s level, as sales of existing positions were exceeded by new security purchases and investor withdrawals in the Fund. The Fund’s composition by asset class at quarter-end was as follows:

TOP CONTRIBUTORS
Specific securities that contributed most positively to performance include Live Nation 2.500% convertible notes, Greenbrier common stock, and Andeavor Logistics 6.875% perpetual notes. Live Nation advanced throughout the quarter on better-than-expected earnings and growing speculation that the company is becoming an acquisition target. Greenbrier improved on strong earnings and expectations for railcar orders to improve. The fixed-to-floating rate feature in the Andeavor notes attracted investors looking to gain more floating rate exposure as treasury yields were increasing.

TOP DETRACTORS
Specific securities that detracted most from performance include Medicines Company 2.750% convertible notes, Twitter 1.000% convertible notes, and PRA Group 3.500% convertible notes. The Medicines Company converts were down as the stock sold off in September, after a strong rally in the previous quarter. Twitter declined on disappointing earnings in July. PRA Group was hurt by disappointing earnings, and supply of defaulted consumer debt remains tighter than expected.

(As of 9/30/18) — A growing economy with modest inflation has created a favorable environment for risky assets. However, market participants are becoming increasingly concerned about potential trade wars with China and physical confrontations with North Korea and Russia/Syria.

The U.S. high yield default rate increased to 2.02%, up 74bps year-to-date, up 95bps from 1.07% as of September, 30 2017, but still well below the 3.0-3.5% long-term average.

On the positive side, the slowdown in new issuance activity has reduced the supply of bonds available for purchase, which has helped support bid levels. We continue to be concerned about the Federal Reserve taking a more aggressive tightening policy stance, inflation growth acceleration, geopolitical issues such as North Korea or tensions in the Middle East escalating, and increasing protectionism efforts from the White House.

Given that we are likely in the late stages of the economic cycle, we still find ourselves confronted with relatively-low spread and yield levels. We are managing the Fund cautiously, yet actively.

We continue to focus on higher-quality, non-investment grade issuers with defensive business models and manageable credit metrics. We will continue to deploy the Fund’s cash in opportunities that we believe offer the most appealing risk/reward tradeoff with a bias toward shorter durations and less levered credits. Additionally, we believe bank loans offer a compelling opportunity as they offer senior positioning in the capital structure and floating interest rates. Finally, we continue to look for opportunities in convertible bonds and preferreds.