Q: What is the history of the company and the fund?

Cincinnati Asset Management was founded in 1989, and over those 27 years has managed corporate credit across the credit spectrum, initially with a high-yield portfolio for institutional and retail investors, and shortly thereafter an investment-grade portfolio for the same client base.

In the mid-1990s it introduced its broad market strategy, combining two-thirds investment grade with one-third high yield, based on portfolio management theory, and optimizing its efficient frontier while maximizing its Sharpe ratio. This fund, which we initiated almost four years ago, uses this broad market strategy. 

We introduced the fund to enable those investors who lack the $300,000 investment necessary to qualify as a separate account to achieve the same kind of results our separate account clients enjoy, but through a mutual fund. 

There is no benchmark that truly defines what we do, but the benchmark that makes the most sense—what we have been using in our marketing materials and our filings—is the BBB performance of the Barclays Index. 

Q: How does the fund differ from its peers?

First, by staying as consistently as possible within that two-thirds/one-third blend, and not veering more toward one simply because it appears it might outperform. 

The portfolio’s average credit rating is BBB after incorporating our weightings to the high-yield space and the investment-grade space. 

Unlike many others, we do not manage an interest rate variable and are interest-rate agnostic. We focus on our core competency of credit research and on improving credit quality, or on those securities where we receive more than an adequate return with respect to credit quality. 

We predominantly buy in the 8-, 9-, and 10-year range, and as bonds roll down the yield curve, we typically sell in the 4- or 5-year range, depending on degree of slope of the yield curve, as well as when we believe credit metrics command us to sell, either in a deteriorating condition or if the bond price has appreciated far beyond what we believe its credit quality deserves.

We are always going to be in that sweet spot of the curve, typically a 6- to 8-year average maturity with very few positions beyond a 10-year final, something we do occasionally, but infrequently. We believe the reward for going beyond 10 years is insignificant relative to the volatility of a portfolio as, when, and if interest rates rise.

Another way we differ is in consistency—we do not buy government or agency securities, or high-dividend-yielding stocks. We stay 99.9% in North America versus looking for global opportunities, as there are enough companies here, with accounting we understand. 

Our consistency may belie calling this a strategic income fund, as that has come to equate, in other funds, to a go-anywhere, do-anything, “Trust me, I’m your manager, and I will do what I think is best” attitude. In contrast, we do everything consistently, and you always know that’s what you get. 

Q: What is your investment philosophy?

We are essentially a long-only corporate bond manager, looking to capitalize on the corporate bond market’s structural inefficiencies, which stem from its fragmentation. There is no central pricing source and a tendency for participants to overreact, which in turn creates more mispricing that can tip the risk/reward opportunities in our favor. 

We believe it is unlikely that anyone can successfully predict where interest rates will go and execute successfully on those predictions for clients over the long term. Tactical managers attempt to do that, but it’s not something we’re interested in doing. 

Our primary focus is to preserve our clients’ capital and not manage to a benchmark, which we think is a somewhat flawed way of doing things. There are plenty of other managers who copy benchmarks if clients want to go in that direction. 

Q: How would you describe your investment strategy and process?

Our strategy is the consistent two-thirds investment grade/one-third high yield allocation, which results in the investment grade rating we look to provide for clients. 

In addition to capital preservation, we look to uncover compelling relative value, to assemble a focused list of credits from which to add to the portfolio. 

We assemble that list by starting with the overall universe of credits. That universe comprises about 6,000 on the investment-grade side and 2,000 on the high-yield side, so, overall, a starting universe of about 8,000 different line items. We whittle that down by way of various screens and details, anything from too short or too long a maturity to too low quality or perhaps the historical relationship is not what we desire. 

At that point, our fundamental research comes into play, where we look for credits featuring asset strength and appropriate capital structure—those with a high probability to increase revenues and cash flow. We make judgments based on the value of those names relative to their peers, assessing the risk/reward relationship. Essentially, the goal is to increase the yield on the portfolio, increase the credit quality on the portfolio, and decrease the maturity on the portfolio, a tall order but one that we are determined to deliver. 

Q: What is your research process and how do you look for opportunities?

We take a bottom-up approach. While interest rates are probably a starting point for other managers, we stay in the 6- to 10-year average maturity and can extract value in the optionality of the calls that exist in high-yield securities and so there are some extension trades, as well as, some shorter term trades that make sense. 

While we are very much a bottom up research driven firm, we do take a macro economic view and consider what is happening in the world, and what is happening here, in North America, that might impact industries and even particular companies.

Back in the fourth quarter of 2008, essentially everybody in the world believed we were headed toward global death and destruction. On the investment-grade side of our business, our macro view was that a banking industry would remain. We wanted to own those securities with diversified sources of revenues, with the least chance of being blown apart for legal and criminal reasons. We successfully bought a number of credits at 60 cents on the dollar that recovered to par or better over the next couple of years. 

Another reason to look at macro is to determine what economic environment would lead us to be more aggressive or more defensive in certain security purchases. For example, the non-cyclical sector within the high-yield universe is typically one of the more defensive places to be. So if our worldview, our macro view, is that things are falling apart, that might be an area that would attract us. 

Q: What is your portfolio construction process?

Diversification is important, and part of that diversification is achieved via credit quality—that and the portfolio being a fairly fixed proportion of investment-grade and high-yield securities. 

The mutual fund generally has about 60 or so different issuers. Some issuers may have differing maturities and so there are 75 or so—sometimes more—different line items. Our buy and sell decisions stem from the relative value assessment we make, our judgment on what our compensation will be for the perceived level of risk we assume with a credit. Portfolio turnover is only about 25%. 

To give a somewhat extreme example, where there is an AAA-rated credit, the probability of default is extremely low, which equates to little or no credit risk. However, if there is no potential for compensation, we likely will not make that purchase. The opposite also holds true. We do not invest in CCC-rated securities, because they are the lowest quality and represent the greatest chance to lose money. We generally stay with A, BBB, BB, and B ratings. If those securities are downgraded to a lower credit quality, we assess what the compensation is for the risk in those names and act accordingly, both in the investment-grade and high-yield security arenas. 

If a security falls by 15% relative to the broader market, it will undergo investment committee review to decide whether we sell that security immediately, if we have not already done so, or hold it, although we do not make any new purchases of a name that has fallen like that relative to the broader market. If the decision is to hold that name because we spot a catalyst on the horizon, or for some other reason, it will nonetheless become a mandatory sell should the name fall further to –25% relative to the broader market, that sell discipline being part of our risk management process. 

Q: Does the process vary at all between the investment-grade and high-yield sleeves?

In terms of concentration, the investment grade sleeve will generally have no more than a 4% to 5% exposure to any one corporate name. That might consist of one or more individual securities but they are lumped together as we determine what our exposure is to that particular corporation. We do not take any outsized bets on any individual company. 

With the exception of financial institutions as a broad sector, which accounts for more than 30% of the Barclays corporate investment-grade universe, we limit our exposure to no more than 20% of any sector. Bank and finance typically runs to 25% to 28% in the investment grade sleeve of the portfolio and somewhat less than what the composition of the Barclays Corporate Index is. 

In terms of the high-yield sleeve we are even more restrictive in terms of diversification. An individual corporation will generally have no more than a 3% composition of the sleeve or a 1% weight to the overall fund. We won’t bet on any individual company hitting a grand slam. 

We also limit ourselves to approximately 125% of the sector composition of the Barclays high-yield universe. Within the sector there are industries that roll up into the sector, and we limit ourselves to approximately 12% or so exposure to any industry within the sector. 

There are two exceptions to this. Both consumer cyclical and consumer non-cyclical may go to 150% of their composition within the Barclay’s high-yield universe because with the large number of different industries within those two sectors, it is hard to limit oneself to a numerical number with regard to finding value among various names within a particular industry or sector. 

In high yield, all credits considered for purchase must first receive unanimous approval by the investment committee, whereas in the investment grade sleeve, two managing directors are required to approve a purchase. 

Committee approval to sell something is not required. If a particular event affects a particular credit, we don’t wait to muster the investment committee. We simply sell the credit. 

Q: How do you define and manage risk?

Looking at the big picture, risk is the concern of loss in the fund. As bond managers, we are cynical by nature, always looking at what could go wrong, to defend against a default. Equity managers, conversely, look toward what can go right because they benefit from optimism to the upside of earnings growth. 

Risk for clients is embedded in the process, so the things we do to manage that risk include diversification: the number of names in the portfolio, the different industries we analyze, the different places on the yield curve that our positions occupy. There are a lot of dynamics that go into managing risk, even in the vanilla portfolios we assemble. 

In any fixed income portfolio there are two sources of risk, interest rate risk and credit risk. We are interest rate agnostics, but we have also told you that we typically do not go beyond a 10-year final maturity because we believe that the reward for going beyond that is too insignificant. 

For an intermediate portfolio, as, when, and if interest rates go up, we tell clients we view it as a temporary impairment in their market value, and that over a reasonable period of time, as the bonds roll down the yield curve, most, if not all, of the market-priced appreciation will be recovered simply by holding the security for a reasonable period of time. 

If you have a 25- or 30-year average life portfolio, however, and interest rates go up one point, it feels like a permanent impairment when you have to wait 10 or 15 years to recover value. So we focus on the other element of fixed income risk—credit—and what we hope to achieve for the client is to manage a portfolio that preserves capital while providing them with a more than satisfactory return.