High Yield Fund

The Buffalo High Yield Fund gained 1.68% for the quarter but underperformed the Bank of America Merrill Lynch High Yield Master II Index by 46 basis points (bps), which rose 2.14% during the period. After producing positive returns in the previous quarter, the U.S. high yield sector continued to generate favorable results in the period, but with returns decelerating on a sequential monthly basis throughout the quarter (April 1.13%, May 0.89%, and June 0.10%). The market’s performance was driven by: (i) continued, albeit modest, economic growth of the U.S. gross domestic product (GDP); (ii) a healthy labor market with additional jobs added and the unemployment rate near cycle lows; (iii) the Federal Reserve maintaining a gradual pace of increasing interest rates and timing of plans to reduce their balance sheet; (iv) the equity market indexes continue to reach record highs; and (v) expectations for fiscal stimulus. The favorable market conditions, resulted in investors buying risky assets. The 10-year Treasury bond produced a return 1.32% during the quarter while stocks, as measured by the S&P 500 Index, produced a return of 3.09%.

According to data from JP Morgan, high yield funds experienced outflows during the quarter of about $1.3 billion compared to outflows of $8.2 billion in the previous quarter. The high yield new issuance calendar in the second quarter fell sequentially to $77 billion from $99 billion in the March 2017 quarter and from $102 billion compared to the year-over-year period ending June 30, 2016.

During the quarter, the yield on the 10-year Treasury bond declined by 8 bps from 2.39% to 2.31%. The drop in Treasury yields aided the returns of investment grade and BBB crossover issues that are more sensitive to the movement in interest rates while weakness in energy pricing negatively impacted energy issues and lower credit quality CCC credits. This led to relative outperformance in higher-quality fixed income products during the period. According to data from JP Morgan, the BB-rated segment returned 2.53%, outpacing the B-rated segment and CCC-rated segments, which returned 1.69% and 1.44% respectively. The fund’s straight bond segment continues to be biased toward higher-quality, non-investment grade securities of relatively short duration which contributed to the fund’s underperformance during the quarter. On a positive note, the fund’s underweight to energy helped relative results as energy bonds declined by 1.45% in the quarter. The fund is underexposed to the energy sector with a weighting of about 6% compared to the Bank of America Merrill Lynch High Yield Master II Index at 13%.

According to data from JP Morgan, the U.S. high yield market’s spread to worst at the end of the June 30 period was 441bps, 15 bps lower than the preceding quarter and 172 bps below its 20-year historical average of 613 bps. The yield to worst for the high yield market at quarter-end was 6.12%, below the 20-year average of 9.22%, and below the yield of 6.27% at the end of the previous quarter.

The fund’s cash balance decreased during the period as new security purchases exceeded the holdings in the fund that were called away or sold outright. The fund’s composition by asset class at quarter-end was as follows:

The approximate rate and contribution of return from the various asset classes in the fund during the quarter is as follows. As shown in the table below, all of the fund’s asset classes (excluding cash) produced positive returns during the period. The fund’s straight corporates, convertible preferred, and common stock outperformed the index total return, while convertibles, preferred stock, and bank loans underperformed the index total return.

Specific securities that contributed most positively to performance include Insulet Corporation 2.000% convertible bonds, Spectranetics 2.625% convertible bonds, and Valeant Pharmaceuticals 5.375% straight corporates bonds. Insulet rallied on better underlying fundamentals. Spectranetics advanced on the announcement the company is being acquired by Koninklijke Philips NV. Valeant rose on continued progress on its restructuring.

Specific securities that detracted most from performance include The Medicines Co. 2.750% convertible bonds, Whiting Petroleum 1.250% convertible bonds, and Covanta Holding 5.875% straight corporate bonds. The Medicines Co. declined on reduced merger and acquisition expectations, Whiting Petroleum declined on the drop in oil prices, and Covanta Holding also traded lower due to weak energy prices.

The market for high yield securities remains well bid as yields and spreads bounce around cycle lows. A growing economy with modest inflation has created a favorable environment for risky assets. The slowdown in new issuance activity has reduced the supply of bonds available for purchase, while slowing default rates have reduced investor’s risk premium requirements. However, several risk factors could negatively influence the favorable environment. Our concerns include: the Federal Reserve taking a more aggressive tightening policy stance; fiscal stimulus policy not coming to fruition; continued energy price declines; geopolitical issues escalate such as with North Korea; and increasing protectionism.

Within this environment of low spreads and yields, we are managing the fund cautiously yet actively. During the quarter we initiated twenty-eight new positions and had 17 positions reduced due to sales, maturities, or calls. We ended the quarter with 130 holdings compared to the previous quarter’s level of 122 positions (excluding cash).

We are managing the fund with an emphasis 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 trade-off with a bias toward shorter durations and less levered credits. We believe bank loans offer a compelling opportunity as they offer senior positioning in the capital structure and floating interest rates, and we remain constructive in regards to convertible bonds and preferred issues.