Q: Would you provide an overview of the fund?
We started the fund in 2011 to expand our fund offerings in the fixed-income space and to provide individual investors seeking exposure to corporate bonds access to our sector-specific strategies.
At the end of 2013, the mandate was changed to an intermediate corporate fund using the Barclays Capital Intermediate U.S. Corporate Index as its benchmark, which shifted the focus of the fund from bonds maturing in less than 30 years to bonds maturing in less than 10 years.
This change reflected the needs of our investors and, given our views on the market, it made sense to shorten the interest rate risk and credit risk of the portfolio.
Q: What is your investment philosophy?
The fund’s philosophy is a natural offshoot of what we do across all fixed-income strategies, where we utilize a multi-faceted approach to generate consistent positive excess return for our clients.
Being multi-faceted is important because different factors can drive performance and the primary driver of performance can change from year to year. For instance, in some years the key driver of performance may be duration, yield curve positioning, or sector allocation; whereas, in other years bottom-up security selection drives portfolio return.
By combining both top-down and bottom-up approaches while using both quantitative and qualitative analysis to assess fundamentals and relative value in the corporate market, we can take advantage of a number of different strategic levers. We assess the various risks in the market and allocate funds to those risks for which investors are being appropriately compensated. Importantly, the yield of an investment is always a secondary consideration in our process, since quantifying risk remains our primary consideration.
Q: What is your research process?
Using a team approach, we begin with a top-down view of the world but at the same time perform rigorous bottoms-up analysis.
Our fixed-income team creates a macroeconomic forecast that incorporates our projections for U.S. and global growth, the drivers of this growth, our outlook for inflation and interest rates, and the current stage of the business cycle. Our credit team then determines how this forecast will affect credit markets and creates portfolio strategies structured to outperform in our projected macro environment. These strategies, which we call our “credit themes,” serve as the foundation for portfolio construction.
For example, a consistent theme over the past few years for us has been the divergence in fundamentals between financials and industrials due to low interest rates and increasing regulation in the financial industry. As borrowing rates for corporations remained near historic lows due to low Treasury yields and tight credit spreads, non-financial corporate management teams were incented to borrow in the corporate bond market to buy back shares or pursue other shareholder-friendly (and bondholder unfriendly) activities, which pushed up balance sheet leverage. Meanwhile, Dodd-Frank and competitive pressures incented large banks and insurance companies to increase capital levels and refrain from such “re-leveraging” transactions. Therefore, we generally expected financials to outperform industrials and carried an overweight to financials.
Next, we utilize a number of proprietary quantitative models to objectively assess fundamental strength and relative value across sectors. We want to identify sectors in the corporate market that exhibit positive fundamental trends and offer attractive relative value. Overlaying our credit themes with the quantitative models allows us to fine-tune our targeted sector overweights and underweights.
Security selection begins with some screening tools that we use to narrow down the eligible universe of issuers and identify any issuers that might require an elevated level of scrutiny. Our quantitative tools screen the universe of issuers to identify those with higher potential for shareholder-friendly activity, while another model spots companies that are potential leveraged buyout candidates, which we want to avoid.
Once we have sector overweights, underweights, and issuers we want to avoid, our analysts scrutinize each individual credit within their sectors and recommend their top picks. If they wish to add a name to the portfolio, the analyst is required to create a full written credit report. The analyst then presents a written thesis to the rest of the credit team to make sure the analyst has identified all of the risks associated with the security.
Our internal research reports cover the detail an issuer’s business, its strengths and weaknesses, past financial performance and future outlook, and also information about relative value in relation to peers in their industry.
Importantly, with each security the investment thesis includes a set of sell triggers designed to maintain objectivity about the credit. Analysts spend a great deal of time understanding and analyzing a company that is recommended for inclusion into the portfolio. The sell triggers are designed to maintain objectivity since they are generated prior to making an investment. This is particularly important during periods of financial stress, when bad news can often be rationalized by the sponsoring analyst. Typical sell triggers may include changes in company management or strategy, deteriorating financial metrics, or something as simple as the relative value of an investment.
Q: How does your research team interact?
The depth of knowledge on our credit team is extensive, as each of our analysts has over 20 years of experience in fundamental research. This lengthy experience is invaluable in identifying trends in the credit cycle that objective metrics alone cannot capture. Furthermore, our analysts have developed extensive relationships with management teams and other industry analysts across their sectors of responsibility.
Our credit team, which consists of portfolio managers, credit analysts, and corporate bond traders, meets regularly to discuss macroeconomic events and industry trends to formulate our team’s credit outlook and identify opportunities within the corporate bond universe. During these regular meetings issues arising from the surveillance of our existing holdings are discussed as well as opportunities for investment in new securities. As previously mentioned, analysts will present their investment thesis for new companies they believe merit inclusion into our portfolios. While these meetings are held on a formal routine basis, during times of crisis ad hoc meetings are called more frequently particularly during periods of stress in financial markets.
Q: Are there any constraints in your portfolio construction?
The Fund invests primarily in investment grade corporate bonds with expected maturities of less than ten years. The maximum we can hold in below investment-grade securities is 20%. Likewise, by prospectus, we cannot invest in certain asset classes—for instance, the fund cannot purchase real estate directly. In addition to the restrictions expressly stated in the fund’s prospectus, which we would encourage every potential investor to read, we also have a number of internal procedures that we follow to further manage the risk of our portfolios.
Q: What is your due diligence process, and can you provide examples?
Bonds have an asymmetric risk profile. The upside return potential from investing in a bond is the interest earned over the life of the bond; whereas, the downside risk is that a bond falls into default and the investor recovers cents on the dollar from their original investment. Understanding this asymmetric risk profile of bond investing, we focus on companies with stable-to-improving fundamentals. We look for steady or improving trends in leverage and interest coverage, efficient capital deployment, and margin stability. Companies must have sufficient liquidity to service interest expense and maturities, be able to access the public debt markets during periods of volatility, and have a manageable debt burden. We prefer companies with moderate sales and high profitability to those with scale but lower margins.
Understanding a management team’s past attitudes and behavior around debt reduction is also a key part of our due diligence process. The goal is to determine how friendly a specific management team is to equity holders versus bondholders, and whether we can expect that to continue. We generally prefer management teams with a strong record of organic sales growth versus M&A driven expansion. Finally, we look for companies with a business model that acts as a strategic “moat” to lessen the risk of new competition or obsolescence.
The level of due diligence necessary varies depending on the company, the industry, and the amount of information available. For a huge global company like Bank of America, we wouldn’t need to visit one of the company’s branches to understand the business or learn about the management team; we can access an infinite amount of data and publicly available financial statements. However, smaller issuers often require greater due diligence, such as direct meetings with management and onsite visits, to fully assess the risk inherent that business.
NNN (National Retail Properties), a REIT, is a good example of our due diligence process. We believe that U.S consumer spending will drive the economy forward again this year and have sought to invest in companies that will benefit from the strength of the U.S. consumer. NNN fit well with this theme because higher consumer spending should benefit retail businesses and thereby improve the credit quality of tenants. Also the spreads within the triple “B” retail REIT subsector is attractive compared to other REIT property types. The majority of NNN tenants are major retail businesses located along commercial corridors with convenience stores making up almost 20% of base rent. Since all of NNN’s properties are located in the US, foreign market fluctuations are a non-issue. Occupancy exceeds 98% which adds further stability. All of NNN’s debt contains the standard REIT bond covenants that restrict total leverage, secured debt and maintain suitable interest coverage measures.
Q: How do you construct your portfolio?
Once we’ve determined our desired sector weightings, duration target and yield curve structure based on our qualitative and quantitative analysis, we fill each sector bucket with our analysts’ best ideas. Our minimum starting position size is usually 50 basis points; without that level of confidence in something it is likely not worth holding. However, we do follow internal issuer limits to control concentration risk and tracking error within our tolerances. Portfolio weights are based on our conviction level and our assessment of risk and excess return for an investment.
We select individual securities within a company’s capital structure by assessing relative value between the firm’s senior debt and subordinated debt, the size and expected liquidity of each issue, and its spread duration. Here we want to strike the proper balance between risk and return by investing where we are compensated properly for the level of risk we are taking.
Q: Do you have any maximum limit at the individual or sector level?
By prospectus, we are not allowed to invest more than 25% of the portfolio in any one industry. Aside from this rule, we use a sliding scale when it comes to sector weights based on the sector’s weighting in the benchmark. Each sector is limited to double the index weight or 15%, whichever is greater. We use a similar system when it comes to individual issuers. Right now the portfolio holds about 150 different positions and it typically will hold from 125 to 175 positions…
Q: What is your definition of risk? How do you measure and control risk?
We look at a number of different risk factors that contribute to the volatility of our corporate bond investments. Spread levels, spread duration, sector risk, interest rates and liquidity all contribute varying amounts of risk to the portfolio. We examine each of these factors, as well as the financial metrics of each company and its industry, when assessing the risk of an individual security.
We use an internally generated model to generate a forward looking measure of absolute and benchmark-relative portfolio return volatility. This helps us determine the contribution of various risk factors to overall portfolio risk. We can also measure the potential for spikes in volatility and the corresponding “fat tail” risk and capture the impact of correlations across both sector and interest rate factors. While we don’t believe in “black boxes,” quantitative tools like this are important inputs to our overall investment process because we believe that “if you can’t measure it, you can’t manage it.”
