Q: What is the history of the fund?
The fund has been around for 36 years, making it one of the longest-running government bond funds in the country. The goal from day one has been to deliver government-only, that is, non-credit bond market exposure to investors. Government bond funds need only contain 80% government securities, and so many of our peers include corporate securities. However, we have always maintained 100% government securities in this fund, so those who buy into this portfolio get government securities and nothing else.
This was one of the original Benham Group funds, which had a rich history in bond portfolios, starting on the government side. Back in 1995, Twentieth Century Mutual Funds, known for its stock-picking prowess, bought Mountain View, Calif.-based Benham Management International, a mutual fund company specializing in fixed income, and subsequently renamed itself American Century Investments.
Q: How long have you been with the fund and how has the fund evolved since inception?
I have been with the firm for 33 years, 21 of which I’ve worked on this portfolio. I have led the mortgage and interest rate teams for 15 years.
The portfolio strategy has not changed over the years. It is a portfolio of intermediate bonds, as evidenced by the duration statistics. Our benchmark is the Barclays Capital U.S. MBS (mortgage-backed securities) Index, which comprises 54% Treasuries, 42% MBS, and 4% agency debentures.
Q: What is your investment philosophy?
Our investment philosophy is to exploit the mean-reverting tendencies of what is an inefficient bond market, and to use an active management style that focuses on allocation and security selection, and emphasizing diversified sources of return. We want to avoid having all our eggs in one basket. We believe that fundamentals drive performance over time, and we strive for strong risk-adjusted returns.
Q: How would you describe your investment strategy?
We strive to add value using allocation and selection. Also, we actively manage out-of-index sectors. Examples of that would be CMOs, collateralized mortgage obligations—we own agency-backed commercial mortgage-backed securities (CMBS) and inflation-linked debt. We have a significant weighting in mortgage-backed securities, and including ARMS, adjustable rate mortgage securities, which protects us if rates move higher. We also have exposure to the inflation-linked debt market.
We think inflation-linked debt is attractive—commercial mortgaged-backed securities, mostly multi-family, and some CMOs. We do not make large interest rate bets. In terms of excess return, duration yield curve management should be roughly 25% of excess return, security selection 25%, and allocation 50%. That is where using out-of-index sectors comes into play.
We stay close to our benchmark’s duration and generate about 75% of the excess return by way of allocation and security selection.
Q: How is your research team organized?
We have a very seasoned team that averages 21 years of industry experience and 13 years average tenure at American Century. Within the fixed income team, we’re divided into sectors, such as domestic rates and securitized, as well as corporate credit, non-dollar, municipals, and emerging markets. Also, we have a dedicated risk management team.
The macro team sets the broad investment themes for the department—duration yield curve, allocation, and risk management—while the individual sector teams manage security selection across all fixed income portfolios. For example, the rates and securitized team manages government bonds and mortgages, and the credit team manages all the corporate bonds across all fixed income portfolios.
While we employ a team approach, there is a primary portfolio manager. Ultimately, it is the sector team leader’s responsibility to ensure the portfolio adheres to the overall themes of duration yield curve, allocation, and risk level.
The macro team, which is responsible for duration yield curve, applies two primary models we developed in-house to help us develop our duration and rate calls. One is an economic and interest rate score card that gives us a sense of how the economy is performing. It looks at roughly 40 economic variables—consumer, business, inflation, levels and trends in employment, etc.—and scores them on a scale of 1 to 5, with 5 being the strongest, which gives us a sense of how the economy is performing.
Q: What is your research focus?
Right now, employment has a solid score because it is trending positively, with levels reaching pre-Great Recession. The same holds true for housing. All this rolls up into an overall economic score.
The second model is a consumer trend indicator that identifies turning points in the economy.
In the Global Macro team, we go through a GDP and rate forecast exercise, offering opinions and calculating probabilities. One is whether the economy is going below, at, or above trend. Our most-likely scenario is that the economy will remain at trend growth between 2 – 3%.
In terms of where the rate markets will go, again, our most likely scenario is that rates will be marginally higher than they are today with the 10-year Treasury roughly around 2.25.
These probability-weighted outlooks roll into allocation and are given to the sector teams, like the corporate, mortgage, and non-dollar teams, to put an excess return target on their sectors and then we rank those. This is one of our primary allocation drivers.
For example, right now we believe we will remain at trend in terms of growth and that the Fed will gradually raise rates, which should be generally supportive for spreads, so we want to be overweight risk. So, we rank the different spread markets according to the excess return that our sector team is given. Emerging markets and European investment grade are at the top of our list, although they do not apply to this particular portfolio. TIPS, Treasury Inflation-Protected Securities, on the other hand, do apply, so we are overweight inflation in our government bond portfolio. Also on the list are non-agency CMBS, so we are overweight there. That’s our allocation process.
Q: What drives your portfolio construction?
The construction process is where our sector team approach plays a valuable role. Our success lies in how we stay true to our models and tools, whether it be our interest rate model or our sector allocation model, and combine that with the expertise of our teams. The mortgage team, for example, focuses solely on mortgages. They don’t have to worry about the interest rate call, the yield curve call, or the allocation call. They are given an allocation and their job is to work solely on security selection.
Our sector team likes the commercial mortgage market, so we are somewhat overweight CMBS in this portfolio because unlike many mortgage securities, it does have a roll-down. A mortgage’s average lifespan can change, given fluctuations in interest rates, but agency CMBS have positive roll down the curve and this gives the portfolio the convexity we seek when rates fall. We have some floating rate product in the portfolio that also serves as a hedge.
Right now, we have a significant position in mortgages and are slightly overweight hybrids, or ARMs, because the thesis at the security selection level is to be underweight lower coupons. We want intermediate coupons, which are low loan balance and less prepayable, because it gives us a good option-adjusted spread (OAS).
We like low loan balance because these pools are less prepayable. Consumers whose mortgage balance is $50,000 or so are less likely to bother refinancing. This is particularly attractive with a higher coupon mortgage, as we want to retain that extra yield.
Geographics is a factor, particularly when assessing low loan balance. A $100,000 balance on a mortgage might be low in proportion to purchase prices on the west or east coast, but not everywhere. This is especially true for us with CMBS. For example, we like multi-family housing in California. One particular security we own comes to mind, concentrated in southern California, where supply is low and rental prices high. We want to own multi-family housing where demand is strong and supply short.
We also buy TBA, or forward, mortgages. Because we do not have to pay for them until the next month, we have a temporary pool of cash that we can invest in: short Treasuries, agencies, and/or collateralized mortgage obligations—to gain additional yield.
Risk management is an integral part of our construction process. We operate within a risk budget that overlays and controls the construction process. It is up to the individual members of the managing team to stay within the risk levels and allocate it in the way we feel best maximizes performance over time.
Q: How do you define and manage risk?
We have three measures of risk: market value, contribution to duration, and tracking error volatility.
For example, while currently at the global macro level we want our risk to be below our long-run tracking error target, which for this portfolio is 70 basis points. At the moment, we’re at roughly 42 basis points, which is 60% of our long-run target. Tracking error comes from inflation, CMOs and CMBS.
Unlike some funds, the global financial crisis did not change our process per se. However, as one example, in analyzing our interest rate scorecard, we expected the Fed to begin raising rates quite some time ago. We have been in this roughly 2% GDP range for quite some time, and spreads have been tight, but these current circumstances are unprecedented, and the technicals of Fed policy trumped what the fundamentals told us. So, we will adjust our risk management and thinking on portfolio construction as needed.
Currently, we appear to be at an inflection point. The Fed is in a precarious position where it has now started the normalization process. It wants to continue it, but it is data-dependent, which increases volatility in the market. To combat that, we have nice hedges in our floating rate product, our floating rate CMOs and ARMS. We have fixed rate product in the CMBS that roll down, but also, importantly, will not extend if rates back up.
We also have an alpha source in that we think the inflation markets got badly beaten up with fears of deflation, and so we have an inflation hedge. We appreciate the market fundamentals, but what has become apparent over these last few years is that fundamentals don’t always drive the process in the short term.
One must also consider the technicals of the market. For example, in the mortgage market, the Fed is still buying mortgages. Until we see, or get an inkling, that they intend to stop reinvesting their mortgage holdings, we will continue to feel pretty good about the mortgage market.
