Q: What is the history of the fund?
The fund began in 2012 as an extension of what Pacific Asset Management had been doing in the corporate credit space since the group was founded in 2007. Pacific Asset Management’s investment group was born out of members of its parent company’s (Pacific Life Insurance Company) credit research and portfolio management staff that had been together since 2002. Pacific Asset Management’s corporate credit expertise, which draws from a deep research bench and Pacific Life’s extensive heritage in the sector, is utilized in implementing the investment strategy for the fund.
One of our fundamental beliefs about the corporate-credit space is that additional spread income provides more flexibility. This flexibility allows duration to move up and down versus the benchmark, while maintaining attractive income. Although the fund will invest, under normal circumstances, at least 70% of its assets in investment grade, the fund’s investment strategy enables us to take advantage of opportunities in the upper end of the high yield space. Credit quality ranges from AAA down to B. The fund also allows us to use our senior floating rate loan expertise—something many of our competitors have not done.
At a very high level this is a flexible short-duration credit strategy; weighted average duration is generally expected to be less than three years. The portfolio also has a unique cornerstone of corporate credit—it has not employed a multi-sector strategy. Our research staff is industry focused. When looking across the credit quality spectrum, our analysts are able to see the relative value between investment grade bonds, high yield bonds, and floating rate loans. Those views are articulated in the portfolio.
Offering our strategy in a mutual fund provides investors with a high level of transparency and understandability, an important factor especially after the 2008 financial crisis. As a result, they can view the portfolio and know exactly what they own—it doesn’t have much in derivatives, structured products, and the portfolio is 100% USD denominated.
Q: How do you define your investment philosophy?
We believe corporate bonds offer the best risk/reward opportunities in the investment-grade universe. The additional spread embedded in corporates, particularly in the BBB space, means we do not need to reach aggressively for yield. The research team’s experience helps us avoid downgrades so we can capitalize on that additional spread, with the goal of providing higher income and better returns for investors over the long term. To complement investment-grade holdings, the fund includes higher quality, below-investment grade holdings as well as floating-rate loans. Compared to most short-duration peers, it typically holds more corporate credit and senior floating rate loans.
Because we are able to see where short-term investments lie within the maturity spectrum and understand cash flows, even in stressed environments, a clear pathway to payback for investments is visible. This gives us comfort, knowing companies will have the ability to pay us back.
Q: What is your investment strategy and process?
We look at investments across three main asset classes: investment-grade corporates, senior floating rate loans, and high yield bonds. Although based on bottom-up fundamental research, our process starts with a macro framework that takes into account overall corporate fundamentals, global macro-economic drivers, and relative value across the credit spectrum. This framework determines our view of spread and yield targets. From there, the portfolio is constructed from a bottom-up standpoint.
If the investment team sees momentum in an industry, we may articulate this view within the fund across credit quality of its holdings. When considering a specific name, we first analyze the industry and then the company’s entire capital structure to see whether there is a relative value trade-off between a company’s bond and/or bank loan it may have outstanding.
Q: Would you tell us about your research process and how you look for opportunities?
Especially in a short-duration portfolio, there must be an identifiable path towards repayment for an individual issuer and investment. The keys to this are cash-flow analysis and the quality of cash flows. A quality asset base is also important, because during stressed periods a company can potentially use them as security or lever them up to ensure repayment of debt.
Additionally, a company’s management must be committed to a strong balance sheet; this is paramount, particularly in the investment-grade space at this time in the credit cycle. It has become increasingly tempting for management teams to utilize the low-cost funding environment to benefit equity shareholders. As a result, we have seen less of a commitment across a few industries towards maintaining strong balances and retaining investment-grade ratings.
Within high yield and bank loans, the enterprise value is foremost. We want to see a loan-to-enterprise value that has a lot of cushion for a potential downtrend in the cycle and that the investment value is covered. In senior floating rate loans, the quality of asset bases becomes even more important. Assets or brands should not be cyclical in terms of value, and we desire ones with staying power and predictable values where the loan-to-value can be relied on.
Our research process begins with basic fundamental analysis. Ten analysts, five of whom are also portfolio managers, share these duties. To narrow the investable universe, we focus on larger issuers across the credit quality spectrum; this eliminates about half the names but still gives approximately 80% coverage on the indices.
The research team is organized by industry, giving them the ability to look up and down the spectrum of credit quality within an industry and evaluate capital structures within a company. Analysts also dig into a company’s management, its board, and the sponsors behind the group to get a historical feel for how they have treated bondholders and their balance sheet in the past.
We are a small, focused, and experienced team. We draw on this experience before making investments. Ideas can come from either analysts or portfolio managers, but it is important to gather together as a team when talking about a credit. As the portfolio manager for the fund, I determine whether an investment will have a role in its portfolio—does it have a steady carry-play story, offer diversification, or provide a catalyst that will benefit the yield or return?
Q: Can you discuss some examples of investment opportunities?
Over the years, we have liked investment-grade corporate debt at publicly traded REITs. This asset class is not widely known in the investment-grade universe, and it is appealing because the companies within it have strong asset bases and controls around what they can do with those assets. Covenants determine whether they can sell off assets and whether they can secure debt against them. It is one of the few investment-grade areas where covenants can be found.
Another attractive area is found in Enhanced Equipment Trust Certificates (EETCs), where corporate debt is secured by aircraft. Even though the industry is more cyclical, it has been consolidating with favorable fundamentals and the issues have the benefit of security offered by those aircrafts.
To add nice, stable spread and yield into the portfolio, we seek BBB floaters that are not widely issued. But given our size and concentration on corporate credit, we are able to find attractive opportunities
Q: What is your portfolio construction process?
On December 31, 2015, there were 155 issues in the portfolio, which is just a little higher than the 125 to 150 credits we have normally held in the strategy. Also know that we will hold multiple issues of particular issuers. The majority of the fund’s investments are currently on the credit side with the balance being largely government exposure. From a firm level, we realize there is a heavy bias to credit, so we look essentially at underlying credit performance with a little risk premium to incorporate high yield and loans.
Exposure in a name is generally 50 to 200 basis points. When constructing the portfolio, higher weightings are obviously given to investment-grade issuers, which are more stable and predictable. On average, these higher weights have 1% positions in the portfolio; a high yield or bank loan may be just 25 to 50 basis points.
The fund’s benchmark is the Barclays 1–3 Year U.S. Government/Credit Bond Index. The benchmark is primarily a guidepost for yield and duration, not for sectors or credits. Though small variations in duration are allowed, we try to find most of our alpha outside of duration, primarily from sector and security selection.
Q: How do you define and manage risk?
Many of the standard risk factors that larger shops face do not affect our strategy or the fund. We invest in U.S. dollar denominated holdings, with limited-to-no securitized debt, and do not really have derivatives. Our risk management centers on duration, credit quality, sector concentration, security limits, and liquidity. There are firm rules around each of these factors.
We start with overall portfolio risk, the OAS and yield relative to our longer-term targets. Typically there is a higher overall spread in yield than the stated benchmark’s—but from both duration and industry standpoints the benchmark remains a guidepost.
The fund’s portfolio has a lot of spread duration versus pure interest-rate duration, and is the core behind why we believe in corporate credit, especially investment grade. If the belief is that rates are going to either stay low or move up, that belief makes the argument for corporate credit or spread instruments.
Especially in this volatile period, there is a benefit from having BBB floaters and bank loans as a part of the portfolio. The flexibility to do so allows us to maintain an attractive yield while at the same time limiting duration and its impacts.
Diversification plays an important role in managing risk and is built into the portfolio in several ways. We create dispersion across sectors and industries as well across underlying business catalysts.
