Q: Can you tell us a bit about the history of the fund?
The fund began more than 40 years ago, in 1972, with its core mission being to generate income for fund holders and preserve principal. Back then there was no high-yield market so it focused on mortgages and other fixed income products, including corporate bonds. Nowadays, we also focus on corporate credit, the strength of companies. Thrivent, as an insurance company, has a corporate research staff, so having a corporate focus meshes well.
I began managing the fund in 2009, focusing more on the corporate bonds, particularly investment grade, and the BBB rated bonds in particular, but within high yield we do BB and B rated bonds to some extent, the upper part of that market.
We also hold high-yield leveraged loans and invest in secured-type assets like agency and non-agency mortgages.
Our current assets under management are just over $820 million.
Q: What is your investment philosophy?
Our goal is to generate above-average risk-adjusted returns with a heavy emphasis on risk management. We have a disciplined fundamental approach, and while we maintain a view on rates and the macro environment, our strength lies in proprietary credit research, both investment grade and in-house within secured, high-yield loans—taking credit risk is what we know and do best.
We take advantage of relative value opportunities, mispriced securities, and inefficiencies to generate excess returns. The upside of fixed income investing is limited, unlike equities, and the risks asymmetric, but the downside is complete, making it possible to lose the entire investment. So we place considerable emphasis on risk management as well as fundamental research.
We give our analysts ownership and hold them accountable for performance. Ultimately, we are investors and so their goal is to generate investment ideas. As a general rule, I follow their advice. After all, what’s the point in paying analysts if you aren’t going to follow them? If you don’t trust them, then you have to fix that.
Internally we have a collaborative culture, where it’s easy to sit down with the secured-side people and look for opportunities. Yes, we’re performance driven but not punitively—we want our people to be confident in expressing their views. We accept that if we take risks, we’re going to be wrong at times. We just need to be right more often than we’re wrong.
We believe in fostering an encouraging environment for ideas.
Q: How would you describe your investment process?
Our process is bottom up, analyst driven, and all about the fundamentals, but there is also a qualitative element to the process, e.g., management and incentives, such as whether management is credible, particularly in light of past distress situations.
The credit research process focuses on security selection and industry weightings. They dig into each company: the financial statements, capital structure, strengths, and weaknesses, with particular emphasis on cash flow, balance sheet, and liquidity because the key is getting paid back. Structure is very important too: how a security is structured, what are the covenants, the capital structure, the debt maturity profile, and whether we want to take, say, a 10- or 30-year risk.
In certain industries, companies can turn quickly, particularly in fixed income. Motorola was once huge, but not now. So, we assess on a security level too, industry analysis, structures, risk assessments, position in the value chain, and then relative value. Are we getting paid for the risk? Is it mispriced? Do we think it’s over- or undervalued? Is it a core holding? Maybe there are some issues, but can it compensate for that? Maybe it’s a short-term opportunity.
As the portfolio manager, I focus more on the top-down process, managing the overall risk of the fund, the liquidity, the duration, and the asset class weightings such as investment grade corporate bonds, high-yield, leveraged loans, Treasuries, securitized products, as they can be key drivers of performance. We have a team of asset class specialists here with whom we review attribution, value, risk/reward, whether high-yield is priced correctly, plus quantitative analysts looking to optimize risk-adjusted return.
So we compare across asset classes, such as a leveraged loan vs. a high yield bond. We also look at convertibles, as we manage a convertible portfolio in-house for the insurance company. And we examine non-agency mortgages, which have offered yields similar to high-yield bonds, but with less volatility at times.
We’ll look at valuation comps vs. the industry, vs. the market and vs. other asset classes, expected excess returns, the default probability, Z scores—factors like that. I look particularly at contribution to spread duration as a measure of a position’s risk.
It’s about balancing risk against potential reward. And the ability to move in and out of positions has diminished, making liquidity important, especially in corporate securities.
You can always chase yield, but the ability to avoid landmines is critical, as is staying disciplined, not being married to any position. It’s hard to admit you’re wrong, but you need to be able to cut your losses and move on. Conversely, you don’t want to hang on too long to a winning investment. It’s easy to rationalize bad news.
It’s okay to be wrong. You have to take risks. You just need to be disciplined.
Q: How would you outline your research process and how you look for opportunities?
For example, in terms of securitized investments, you have to know what you’re buying, as the dynamics of each deal vary. The securitized analysts dive into hundreds of deals, using software to parse the underlying quality of the mortgages, the deal cash flow, delinquencies, severity trends, level of subordinations, and different layers or tranches of the deal, and the ability to absorb losses.
We invested in non-agency mortgages across all of fixed income and generated very strong returns for several years, particularly 2012, 2013, and 2014. There were delinquencies in these structured deals, but the pricing reflected a much more severe outcome in some of the securities than we felt was likely to happen, and we were proven right.
Another area we have been overweight is bank corporate credit, where they had to be bailed out after the financial crisis as capital levels plunged. Banks used to trade inside, tighter on a spread basis than the market in general. That spread blew out during the crisis, and the European financial crisis that followed, but they eventually began trading tighter again.
Our bank analyst on the fixed income side is a former bank examiner and he dug into the industry, looked at capital levels, projections, balance sheets, profitability, credit quality of the respective portfolios, both U.S. and some European banks, and surmised that capital levels would rebound and losses would be manageable.
Capital levels have risen sharply, partly because regulators demanded they should, and a lot of risk has been regulated out of the industry. At the height of the financial crisis, you could buy Citicorp’s hybrids at 25 cents on the dollar. They were money good. So it’s worked out for us. We felt comfortable with other names, like JP Morgan, Morgan Stanley, and Bank of America, although BofA was to a certain extent more of a recovery story. We felt their underlying business was solid, their losses manageable. We were successful in the U.K. as well, particularly with Royal Bank of Scotland.
We’ve also been overweight Ford Motor Company, which had an improving fundamental story and investment grade metrics, and General Motors Company, which is split-rated right now. They’ve improved their balance sheet substantially.
Q: Was there anything about Ford that stood out for you across the various sectors?
They managed themselves well throughout—there was faith in management, their product, and their commitment to run a strong balance sheet. With Ford, we have always been confident in their strength and desire to be investment grade, with solid cash flow, a strong balance sheet, and a sound product line.
Sometimes you have to wait for an industry to rebound. There was a lot of pent-up demand after U.S. auto sales plunged during the financial crisis, but there has been steady growth since, and it’s probably peaking now. It is one area in which people felt comfortable taking on debt post-crisis.
Q: What drives your portfolio construction process?
I have a list of investment axioms posted in my office, including one on risk and one on greed. If you’re not worried, you’re not taking enough risk, and always take your profits sooner than you think necessary. I try to be disciplined in buying and selling and counteract the emotions of investing. I set spread targets within fixed income.
We consistently assess relative value on both a security level and asset classes. You need to watch relative value on new investments, particularly if it’s a trade where you stop-loss. If a particular investment thesis changes, we move on. There is a tendency to rationalize, to identify mitigating factors to explain it, but if the reason you got in no longer exists, you’ve got to move on, and that applies to winners as well as losers. It’s easy to overlook or rationalize risks when times are good. Being structured neutralizes this.
Diversification is important. There’s a lot of idiosyncratic risk now, whether it’s fraud, a financial meltdown, re-leveraging, etc. I don’t intend to blow up the portfolio on one position, so we tend to size positions relative to perceived risk, with a core position being maybe 2%. At the same time, I don’t like to over-diversify.
That said, taking risks drives income generation. We overweight what we like and invest outside our benchmark, Lipper’s BBB corporate peer group, in areas like non-agencies or leveraged loans. We also assess the whole portfolio with the quantitative analysts for optimal risk and return.
Q: Do you set limits on your holdings?
We look at it more on a risk basis vs. individual weightings, i.e., where the credit risk is. For example, we own multiple parts of Bank of America’s capital structure, with varying levels of risk, from senior debt to preferreds. So we manage the overall risk of a position using spread duration vs. just the position weighting. Our average position size for a core holding is probably not much above 2%, maybe 150 to 200 basis points, less for high-yield holdings as the risk is greater.
High-yield bonds comprise about 10% of the portfolio, but I still want diverse high-yield holdings, given the volatility in individual names. I model my high-yield positions off the higher-quality holdings of Thrivent’s high-yield mutual fund. . But I take smaller positions as I never intend to be more than 1% in a high-yield name because of the volatility.
Q: How do you define and manage risk?
We spend a lot of time looking at risk from a portfolio level: rate risk, curve, call-ability, credit risk, default, and regular mark-to-market risk. There’s also tracking risk vs. peer group or benchmark. There can be considerable structural risk. And there is liquidity risk.
Our risk-taking lies mainly in credit risk. While we do take interest rate risk, it’s not really what the portfolio is about. It is a true credit-driven portfolio. Ultimately, we’re concerned about volatility, seeing the downside risk and mitigating that volatility while achieving above-average returns. Our quantitative analysts run attribution and watch how the portfolio behaves. We watch volatility closely.
We’re not afraid to take risks, but we want those risks to play to our core strengths, in ways that won’t generate a large downside event. The goal is to consistently outperform while minimizing risk, optimizing risk-adjusted returns. We keep a core part of the portfolio liquid, more so in corporates. But we also use agency MBS’s—mortgage-backed securities—particularly TBA mortgages (“to be announced”), which often offer yields similar to the higher part of investment grade corporate, as that section of the MBS market is as, if not more, liquid than Treasuries. You can do hundreds of millions in a trade.
Also, we will hedge some, using CDX indices, and use Treasury futures to manage our duration and offset credit risk. Particularly with high-yield credit, duration can be negatively correlated.
Overall, it boils down to solid fundamental research and quantitative analysis in assessing the risk metrics of the portfolio.
Q: What lessons did you take away from the global financial crisis?
I took over in 2009, right in the heart of it. That market and the ensuing panic created a wealth of opportunities. You had to be willing to take chances and take the long view. Also, you need to question consensus and act early. Additionally, you have to understand what you own, particularly in structured products. A lot of people didn’t understand what they owned heading into that, and there was a lot of pain as a result.
Another lesson learned is that you need be careful reaching for yield late in a credit cycle when spreads are tight. It’s not about picking up pennies in front of a steamroller. And you need to position the portfolio ahead of a downturn, because liquidity can evaporate quickly. Liquidity is important. At the margin, for the management of liquidity risk we’ve started to use CDX (credit derivative index) or even ETFs (exchange-traded fund) to express a tactical view. When the market is heading down, everyone wants to sell, and when it’s going up, everyone’s a buyer. These tools give us the ability to adjust, at least on a margin, our exposure more quickly to an asset class.
