Q: How has the fund evolved since its inception?
The TIAA-CREF Bond Fund, which was launched on March 31, 2006, is an actively managed core bond fund that is permeated at every level by a risk-management mindset. Over the past 30 years, a false sense of security in bond indices has developed, which can be concerning because they carry significant embedded risks.
The fund’s benchmark is the Bloomberg Barclays U.S. Aggregate Bond Index. Right now, the index has a heightened degree of rate and volatility risk because its duration is long and large components are highly sensitive to rising rates. Should the U.S. Federal Reserve increase rates or reduce its balance sheet, parts of the index could become much more volatile, as could credit spreads.
We acknowledge these risks, then contextualize them in a base environment as well in periods of market stress. Then, through asset allocation and fundamental security selection, we look for the elements that perform the best in both scenarios. Because there are points in the cycle where getting the largest absolute return is expensive, we are sometimes willing to accept lower returns in exchange for reduced volatility.
The fund’s risk profile falls between a core-plus fund and the index – though ultimately, we seek to beat the benchmark in the long term through an intense focus on return relative to risk. Further, by actively managing risks in the marketplace, we seek to reduce the potential worst-case scenarios. The goal is to offer investors the stability of a core bond fund while effectively managing risk during periods of great change in the markets, whether due to U.S. fiscal, tax and regulatory policy or geopolitical risks.
Around the time took over as manager in 2011, the fund began evolving to reflect a shift in its benchmark, which had become more conservative following the financial crisis with more treasuries and higher quality securities. Additional room in tracking error and duration was added, and our ability to invest both out of index and below investment grade was increased, although we remain within the norms of a core bond fund.
Q: How does the fund differ from its peers?
Our active management is evidenced by a higher turnover number versus many other core bond funds. Additionally, our risk-manager mindset manifests in a focus on information ratio.
The fund looks for diversified returns – not diversification for the sake of diversification, but diversification based upon directional views, relative value within asset classes, and in a specific asset class through security selection where we seek idiosyncratic fundamental outcomes. Our ideal is a 50/50 return, with 50% of return from asset allocation and 50% from security selection.
Security selection is not only important to diversifying sources of return, it also inherently dampens volatility. Regardless of the market beta, we are not solely reliant upon asset allocation. Instead, the outcomes of individual stories across structured products like corporate credit, emerging markets, or multinational debt securities tends to give us a higher level of return relative to risk over time or on a repetitive basis – as reflected in the information ratio.
Other unique elements in this fund include the active management of duration, curve, and market technical factors. Beyond credit selection or asset allocation, we attempt to exploit different technical elements in the market, and at all times have the ability to provide liquidity and to be paid for that relative to the associated risk.
The fund’s assets under management (AUM) are about $4 billion. TIAA Investments is an affiliate of Nuveen Investments, which has AUM approaching $1 trillion. As a result of the other funds and assets being managed, we benefit from the support of a significantly larger team in research, trading, derivatives, and quantitative analysis.
Q: What is the role of the portfolio manager in your strategies?
We do not have an oversight committee and there is no “portfolio manager” culture at the firm. Though every TIAA-CREF fund has a lead manager with direct responsibility for the funds’ performance, PM strategies will differ. Each PM is expected to provide an attractive information ratio over time – i.e., return relative to volatility – in whatever manner deemed most efficient.
PM’s do share the same sleeve structure across strategies. Sleeve PMs are industry veterans with expert views on how to maximize value through asset allocation within a particular space – say, non-agency residential mortgage-backed securities (RMBS), corporates, or sovereigns – and their expertise is available to all lead managers.
For example, the sleeve manager for agency RMBS will choose between being in 15-year or 30-year mortgages or high coupon versus low coupon, and after determining asset allocation, will also select individual securities. Sleeve managers make these decisions to maximize returns within their asset class in consultation with Lead PM goals/concerns.
Q: What is your investment process?
It’s largely qualitative and dynamic. While we have in-house strategists, the PM macro overlay, which provides important direction for asset allocation, comes exclusively from the PM.
Currently, the macro view calls for a continued exposure to credit, a moderate short to duration, and an emphasis on sectors that are less exposed to rising rates. This translates to asset allocation in areas like leveraged loans – mortgage and non-agency mortgage exposure – as opposed to more traditional agency RMBS or high-yield bonds, which have a convexity risk and higher risk of extension into rising rates.
Next, the sleeve PMs and I discuss where we see value in sectors. They, in turn, engage with the research analysts who support these areas – whether investment-grade bonds, high-yield bonds, or leveraged loans to find securities that fit sleeve and lead PM goals.
The idiosyncratic or return portion of our process is bottom-up. It harvests the best ideas from research, which are developed to provide alpha in any market scenario and serve as a critical damper on volatility. Although at times I may disagree with a sleeve PM about a particular profile or bond, typically they manage the bottom-up process of aggregating the best research ideas.
An empowered trading staff uses an in-house trading strategy to integrate our research ideas and recommendations advising research analysts about the trading and liquidity characteristics of bonds they are reviewing to help them make recommendations that are more valuable and meaningful though varying market conditions/cycles. A quant group assesses the efficacy of particular hedges and correlations when needed.
By and large, we communicate in person and through online platforms. This level of interaction leads to an iterative investment process and a healthy culture. For example, our agency RMBS manager recently suggested that we allocate more to the space because the technical factors were looking better; i.e. there had been a drop in new loan production and demand from overseas buyers had increased. After looking at different asset allocation opportunities and chatting with the other Sleeve PM’s, I decided against it. However, when he came back to explain how the situation had changed yet again, we made the allocation.
As top-down macro views shift, I speak to all the leads so they can understand it and help to adjust the bottom-up idiosyncratic security selection if necessary.
Q: How do you use credit spreads to your advantage?
We try to understand the spread today, but also how it relates to other opportunities in terms of potential volatility or how one spread moves vs. others in times of stress. This comes back to the notion of the bond fund manager as risk manager, and to information ratio as a long-term assessment of a risk manager’s efficacy – a notion which feeds through to every element of the firm’s culture and recommendations.
Spread as a notion of value is assessed contextually. Within an individual space, say corporate emerging-market (EM) spread, we evaluate whether it makes sense relative to the specific country being looked at – for example, sovereign Brazil risk. Once contextualized, we decide what the stress characteristics of that spread would be, and the research team will seek the most spread from the space, whether corporate or sovereign, local currency or USD that maximizes spread relative to volatility. .
Buying a bond merely because it has a wide spread is not the manner in which we operate; generally, recommendations should be spread compression stories relative to their peers. On rare occasions, we may add a bond that is more a spread story, though typically these have extremely short duration – one or one-and-a-half years to maturity such that their volatility component is low.
When something doesn’t work we try to understand what went wrong with the thesis, which is important to managing risk vs. return. These findings are shared publicly so everyone benefits, creating a safe and open environment. Culturally, the best trades are those where there was a thesis change which was caught early and acted upon.
Q: Would you describe your portfolio construction process?
The fund’s benchmark is large, with nearly 9,000 securities. Although our portfolio contains 1,400 to 1,500 names, it’s still considered quite large for a bond fund. Each of our holdings must tie in relative to other securities and have volatility characteristics that we expect to outperform in a market-stressed environment.
Position sizes can be large. By prospectus, the fund can go up to 2% of non-government or government-guaranteed sectors, although typical positions rarely exceed 1% in terms of non government bottom-up construction.
We want sector allocations that do not all move in tandem with the general credit beta of the market. At the close of our last quarter, for example, out-of-index municipal bonds represented approximately 4% of the fund. What we like about munis is that they tend to be longer duration and uncorrelated with the broad credit spreads of high-yield bonds, loans, and investment grade corporate bonds. By asset allocations to less correlated investment categories, the fund can behave in a more resilient manner.
At the core of portfolio construction is our belief that asset allocations must work together in order to maximize return relative to risk. For example, when oil prices recovered, the fund’s high-yield bond holdings represented approximately 3.5% out-of-index. They were partially sold off and moved into floating rate leveraged loans where there was a much lower exposure to oil. Doing so basically maximized the recovery in energy with a view that rates could rise and moving into floating leverage loan paper could help reduce price risks that were embedded in fixed rate high yield bonds. Currently, the fund’s exposure to leveraged loans is around 2%.
In emerging markets, we have a higher allocation than the average core bond fund. We generally find emerging market bonds to be an attractive out-of-index holding, even though the space can be underperforming for extended periods of time when the dollar is rising or in risk-off periods.
However, we’re willing to ride through that because of the lack of long-term correlation between emerging market sovereign and corporate bonds versus domestic high yield or investment grade bonds. At the close of the last quarter, emerging market bond allocation was around 7% or 8%.
