Q: What is the history of the fund?
Transamerica Flexible Income fund was launched in 1987 with an over-arching belief that quality managers, stable organizations, and a consistent investment philosophy and processes should outperform over multiple market cycles and create shareholder value.
Because we also believe that no single investment firm is the best at managing every asset class, Transamerica uses what we call our “Investor FirstSM Process” to select and monitor sub-advisers, tapping into the expertise of asset managers from across the spectrum of the investment management industry.
Brian Westhoff has been a manager for the fund since 2011, when he joined AEGON USA Investment Management, LLC (AUIM), which manages more than $121.5 billion as of September 30, 2016. His experience with the fund predates 2011, however; he was a member of the fixed income portfolio management team of another Aegon affiliate that managed the fund from 2004 through 2011. As the fund’s investment advisor, Transamerica Asset Management, Inc. uses an internal daily scoring system that measures risk-adjusted performance, portfolio diversification, process consistency, and organizational stability.
Approximately 60% of the fund is currently invested in corporate bonds, 14% in mortgage-backed securities (MBS), 10% in asset-backed securities, and 11% in agency MBS and government securities. The fund has a duration of approximately 3.5 years.
The fund is a relatively small portfolio managed by a large fixed-income firm. Often, the smaller deals we participate in result in allocations large enough to add meaningful alpha.
Q: What is your sub-adviser selection process?
Given the significance of sub-advisers at Transamerica, our focus is always on selecting the best manager for a particular strategy. We have a dedicated investment management team that selects and monitors more than 40 sub-advisers across retail, variable annuity, and retirement channels. The team will also replace a sub-adviser if necessary.
In our sub-advisers, we look for consistent, repeatable performance that will be durable throughout all market cycles. Once a sub-adviser is hired, we monitor not only their ongoing performance, but whether the fund is being managed in a way that remains consistent with our standards and expectations.
Q: How does AUIM implement the fund’s strategy?
AUIM, this fund’s sole sub-adviser, has devised a strategy based on its belief that bond markets deviate from fair value over credit cycles and business cycles. Along with its understanding of these market movements, AUIM utilizes bottom-up research to help identify opportunities.
Having a research team that stretches across multiple and different asset classes allows AUIM to pursue alpha without concentrating in one particular area. We couple this with our top-down knowledge to try to hit the market’s turning points, help the fund outperform, and mitigate ever-present risk – something quite important in a bond fund.
Q: How do you organize your research process?
Generally, two-thirds of our time is spent on bottom-up research ideas, working with our colleagues across the globe to make sure we get the right investment ideas in the portfolio. The remainder is spent on top down, which does not dictate immediate portfolio changes.
Although we spend less time on top down, it is no less important to our process. Understanding what is going on with the market, what is driving growth and returns, and what risks are bubbling up helps us determine when turning points may be coming and whether we need to mitigate exposure to certain sectors of the bond market.
The fund’s benchmark is the Bloomberg Barclays Aggregate, but the fund is not managed in lock-step with the index. The index, with a 5½-year duration at a 2% yield, is an almost $20 trillion representation of the U.S. investment-grade fixed-income space, and we use it to get an understanding of that particular universe.
Q: Where do you look for opportunities?
Within this universe, we find opportunities in government securities, corporate bonds, non-agency residential mortgage-backed securities, emerging markets, high yield, bank loans, convertibles, and equities. If an off-index investment will enhance the yield or the return profile for the fund, we will consider it.
Many people have made money in bonds in the last few years, both from an income point of view and a total return point of view. However, interest rate sensitivity has continued to pick up and the yield has come down, limiting opportunities in the lower-risk areas of the market.
Theoretically, capturing the returns from yield will help us mitigate the downside that can come from duration exposure or extra interest rate sensitivity. Given the market today, we prefer credit risk over duration risk, and use spread products where we are underweight Treasuries and agency mortgage-backed securities and overweight corporates and structured securities.
Q: Where do you seek alpha in the current low rate environment?
In this environment, there are three areas of the market which provide opportunities for alpha and yield without too much duration risk. The first is in investment-grade credits, typically the portfolio’s largest allocation, where we have an overweight in financials – banks, insurance companies, REITs, and other brokerage companies.
Though many of these companies have been downgraded, these credits are generally better today than they have been in the last 10 years. The banks have built capital and are in much better position, and regulation still drives the wind at their back.
Because they are generally more financially sound, we are willing to go further down in the capital structure. Instead of being in the senior unsecured or subordinated portion of the market, we now look to the hybrid part of the market.
Typically, these bonds have a fixed coupon and are callable at the issuer’s discretion in the next three to 10 years. Bonds that are not called turn into LIBOR plus 250 to more than 400 basis points, a back-end floating rate that offers a cushion in addition to the yield above the stated duration.
The second area where we pursue alpha is in high-yield securities. Not only do we look for yield, we also look for potential spread compression ideas in improving credits. The companies in this space are already levered; they have tried to fully exploit their capital structure. A number of them have good cash flows and are able to easily service their debt— potentially, they are rising stars transitioning from below investment-grade to investment grade.
The third source for potential alpha is found in the private-label structured product market, where we favor single-borrower commercial mortgage-backed securities. Many are floating rate in nature with attractive spreads over LIBOR—spreads which are comparable to those found in the senior loan space today. These are attractive positions that provide a bit of extra yield and asset coverage to the portfolio and help us to mitigate some duration risk.
Q: How do you construct the portfolio?
The core-plus strategy has a broad opportunity set, so we are not beholden to just Treasuries or agency mortgage-backed securities. Our research team seeks to identify good sources of return across the globe and across different sectors, finding opportunities mostly in the three areas I discussed.
To break down the strategy, roughly two-thirds is in credits, one-quarter in the private-label structured product market and the balance in what I consider low-risk investments like Treasuries and agency mortgage-backed securities that can be used for liquidity or to manage duration. Structured products include non-agency mortgage-backed securities, asset-backed securities, and commercial mortgage-backed securities.
We do favor emerging markets, but at 5%, they represent a small portion of our current holdings. Previously, we have utilized non-dollar investments, and they remain in our opportunity set.
As part of our regular monitoring process, our analysts look through the portfolio on a quarterly basis to discuss with portfolio managers future opportunities or risks with the underlying holdings. Portfolio managers meet weekly to discuss to what degree we still believe in the top-down themes and whether we need to move assets around to capitalize on other opportunities.
Q: How do you define and manage risk?
We consider many factors of risk, including duration positioning, curve positioning, sector, asset class, and security selection, and analyze each at different points. Some of this analysis comes from the strategy team and its understanding of where risks are in the market; some comes from the research team and its understanding of the inherent risks of individual securities; and some comes from understanding the downside and avoiding risk.
Our approach to managing risk is three-pronged. First, we try to make sure the right bonds get in the portfolio. Second, working with our portfolio risk management and control team, we stress-test the portfolio under different environments—for instance, to see how it might perform if oil were to run back to $100 or China slowed into a major recession. Third, an operational risk management team examines whether our processes are designed and function in a manner that protects clients’ interests.
On a more general note, fixed income has historically been used to provide income and mitigate risk in one’s portfolio, and at the moment, it is getting harder to say that is what bonds actually do, since interest rate sensitivity is up and they provide less income.
We try to be cognizant of this and craft the strategy to be more like what we believe a bond fund should be, with a focus on producing more income than the benchmark with lower volatility.
