Q: What is the history and mission of the fund?
Our approach to managing loans is to beat the index, and do it with less volatility. We want to offer a better return while taking less risk by way of active management and credit selection. The strategy mimics what we do for our global institutional investor base, investing primarily in U.S. non-investment grade corporate securities in the form of loans and high-yield bonds.
Our business evolved post-crisis, driven by market demand from not only CLO investors, but also institutional investors globally, such as pension funds, sovereign wealth funds and insurance companies. Loans emerged as a bit of an all-weather asset class, with continuing demand from institutional investors because it addressed concerns about potential rising rates and helped investors defensively position in terms of duration and any economic recession by moving up the capital structure. Investors got an attractive risk premium and consistent lower-volatility return without the duration risk.
Q: How do loans and high-yield bonds differ in your view?
Loans generally offer floating rates, while high-yield bonds typically have fixed rates. Loans are mainly senior secured, may come in a variety of flavors, and are usually senior to any subordinated debt like high yield bonds. This makes them structurally advantaged relative to bonds and less volatile.
Bonds potentially offer greater total return because there is some convexity around the fixed income instrument, whereas with a loan, if the company improves, the most it does is repay ahead of schedule.
Loans have a less volatile, arguably better, risk-adjusted return profile. But when the economy derails, we have a structural advantage in being a senior lender as opposed to high yield bonds, and have more fundamental protections against the downside.
The actual spread that investors are getting in high yield is about the same as in the loan market, yet, counterintuitively, they are being paid less of a risk premium in the high-yield market. On a relative value basis, we continue to believe loans offer the better risk adjusted return profile, particularly if we think rates will go up.
Q: How has the fund performed in volatile markets in the past?
Following the 2001–2002 recession, 2003 was a positive year for both the CS Leveraged Loan Index and for our platform. Our periods of material outperformance are generally those of higher volatility. While 2008 was a negative year for loans, we outperformed the index, and also outperformed in 2009, when the market markedly rose.
In 2015, the CS Leveraged Loan Index showed negative full year returns of 0.38%, but our fund outperformed by over 160bps net, producing a positive total return. Much of this outperformance was attributed to the differentiation around our investment process and our ideas about risk and what is appropriate.
Q: What are the underlying principles of your investment philosophy?
We try to beat the index, but with less volatility. We focus on loss avoidance versus default avoidance. While we prefer to avoid problem situations, a default in and of itself doesn’t necessarily mean a loss on our investment as a senior secured lender.
We do not maintain high concentration-type positions or disproportionate amounts of industry or issuer overweights/underweights in our portfolios. When investors purchase this fund, they are buying into our platform philosophy.
Q: What is your investment process?
At a high level all managers must do three things: source the opportunity, evaluate it, and then manage that position if added to the portfolio. We believe that the way in which we do that and the stability of the team doing it differentiates us from our peers.
The three senior members of our five-person credit committee have worked together for roughly 20 years. They have been in the market for a long time, managing through multiple credit cycles, like the Asian debt crisis, the Long-Term Capital Management implosion, the late ’90s Russian default, the dotcom bubble recession, and the global financial crisis. Ours is a stable engine.
Our investment team comprises 36 professionals, 17 of whom are credit analysts with an average tenure of 10 years. These are people who stay in their sectors and understand what drives the individual industries, which is a bit different in the loan market than the high-yield market. It’s not just the relationships with management teams but also sell-side counterparties, from capital markets to specific bankers who focus on industry sectors.
Roughly 50% of loan market issuance activity in any given year is going to be by existing issuers, whether that’s a tack-on acquisition, a dividend recap, or a simple refinancing. It’s not uncommon for bankers or even the company to call us directly and discuss the market and how a new transaction might be structured or offered.
Also, where in other markets somebody might say a smaller manager is nimbler, I think that in the loan market, bigger managers have a significant competitive advantage.
Q: Can you describe your research process with some examples?
First and foremost, we look for companies featuring sustainable business models that generate sufficient cash flow to service debt. That approach kept us out of a lot of what was going on in energy back in 2014, for example, when loans traded up and were priced to an unrealistic level.
It is also one of the reasons we have outperformed in 2017, by having a material underweight to retail, which stems from the high propensity for retail and restaurants to default, with historically lower recoveries.
We look at cash flow and try to deconstruct how that company’s profitability is derived. If the margins are remarkable, we look at the nature of the business and how vulnerable those margins are. If things look too good, that’s a red flag for us, just as when they look problematic. Management and competitive positioning are also critical. We like to see diversification among the client base, high switching costs in the product suite to make it difficult to go elsewhere, and limited ability by competitors to enter the space.
We don’t just analyze the loan, but look at all securities within an issuer’s capital structure, including the high yield bonds, preferred stocks, public equity, and utilize this analysis to determine a value on the equity to get a sense of the risk/return profile throughout the capital structure. It should be along the lines of a continuum, with the risk/return increasing as we go down further in the capital structure.
Q: How is your research team organized?
Our trading, portfolio management, and research functions sit together in a trading floor environment which provides greater immediacy of information and communication.
The analysts make recommendations to our five-person credit committee, which makes all fundamental issuer decisions. Given the team’s close physical proximity, when analysts make a recommendation and it is executed, the analysts hear it—they are very much a part of the process and see their ideas as actionable.
Q: What is your portfolio construction process?
Ours is a bottom-up fundamental credit research approach. We do not manage explicitly to a benchmark, although our benchmark is the Credit Suisse Leveraged Loan Index (not because it’s Credit Suisse per se, but because of its 25-year history). We buy the names we like as credits and then work with an independent risk team here to do monthly attribution analyses, so we add alpha primarily through security selection.
The portfolio’s overall complexion tends to range from weak BB rated loans to strong B rated loans in terms of the ratings composition from a diversification standpoint. In an asset class with this asymmetric risk profile, diversity is beneficial, and for the loan asset class we are big believers in diversification as a key way to mitigate risk. The asymmetric risk profile means that concentration doesn’t work as well with loans.
Across most of our funds, the top 10 individual names represent somewhere between 10% and 12% of our portfolio. This is a very granular portfolio, with approximately 350 individual issuers at the moment. From an industry standpoint, the top 10 industries would represent about 50% to 55% of this portfolio.
The top two positions are about 1%, the top 10 represent 9%, and the portfolio allocation is a minimum 80% in senior secured bank loans. That said, the other 20% really isn’t out of benchmark, as most other loan funds have cash and high yield.
We have about 8% in high yield bonds, and we manage those separately. We try to buy high-yield bonds with shorter duration and more loan-like characteristics in terms of being senior within that part of the capital structure, and to minimize interest rate risk.
Q: How do you define and manage risk?
Risk assessment goes back to our evaluation of a sustainable business model that can generate free cash flow sufficient to service the debt we assume. We can manage fundamental credit risk at more than just the issuer level, but by making those issuer-level decisions, we also make an industry-level decision in the aggregate.
We use diversification as a way to mitigate event risk in the portfolio, and pay attention to ratings and price volatility, working with a separate risk team.
The front line of our risk management is the portfolio management team working with the analysts on top of these portfolios every day, discussing attribution, looking at our performance volatility, and gauging how it ranks relative to peers.
We use risk metrics and look at the scenario analysis, remaining mindful of the risk around the portfolio in as many ways as possible, including reviewing each name in a macro context.
