Q:  What is your investment philosophy? A : We are trying to generate reasonable riskadjusted returns for our shareholders over a period of time. We are a bond fund managed by an equity-oriented fund management company, which we believe gives us added resources to leverage our expertise in the equity market while managing a bond fund. In equity selection we take a business owner’s view of cash flow that a business can generate over a number of years and buy it at what we think today represents a meaningful discount to the present value of that cash flow. We combine a business we can understand with management whose interest are aligned with shareholders with a price in today’s marketplace based on the cash flow that that business generates. Now, it’s a little harder to do that in fixed income when those kind of disconnects aren’t quite as prevalent. And so, our investment philosophy, when it comes specifically to fixed income investing, is to try to generate reasonable returns over a long period of time. We strive to be mindful of where we are in an interest rate cycle and manage in a way that tries to minimize interest rate and credit risk. We try to not guess interest rate moves, but try to take advantage of what might be periodic anomalies in the marketplace. These opportunities to buy assets for less than they are worth are not as frequent as we might be able to identify in equity investing, but do periodically occur. They can take the form of wide credit spreads in corporate bonds (incremental return above U.S. Treasuries) that adequately compensates for the risk assumed. Or inflation protected securities may periodically provide attractive real plus inflation-adjusted returns when compared to nominal alternatives. And so our approach is to generate reasonable returns but not try to guess which way the economy or interest rates are going to move in the next six months to a year. Q:  With that kind of thinking in mind, generally, where do you look for opportunities for the short, medium and long term? A : Our strategy is U.S. centric. At the firm level we are trying to uncover equity opportunities. As we are exploring those opportunities, we are mindful of the leverage of the capital structure of those businesses which can often present an attractive opportunity for us in our bond fund. As we’re working on trying to ascertain whether or not the business is a sound investment for our equity portfolios, it often provides a very fertile opportunity to determine whether or not that higher up in the capital structure, the fixed income portion of their capital structure might represent attractive investments for a bond fund as well. We incorporate that approach along with paying attention to what’s happening more broadly in the marketplace and comparing each particular asset relative to what we could earn on a risk-free asset (i.e. U.S. Treasuries). Is the spread sufficient to compensate us for the risk that we’re taking? And so, what we are doing every day is comparing the returns that are available in the marketplace relative to Treasuries across a broad spectrum of assets in the U.S. from corporate bonds to agency-issued bonds and not targeting a return in any way. We also do not try to create a portfolio that in any way mimics an index. Ultimately, we’re trying to build a portfolio that represents the best risk-adjusted returns available. A year ago, for example, our portfolio had very low credit (or corporate bond) exposure as we felt that we were not being paid for the incremental risks we would assume. Our portfolio was therefore weighted to U.S. Treasuries, U.S. agency bonds and agency mortgages. Today, as spreads have widened dramatically from a year ago, we are finding more opportunities to deploy shareholder capital at reasonable-to-attractive risk adjusted returns. Q:  Do you see opportunity in the current weakness in the agency bonds issued by Fannie Mae and Freddie Mac or do you think it is more of a value trap? A : We believe it represents more of an opportunity than a trap. The way we have managed the fund recently, though, is to not have a very large exposure in the senior debt of fannie mae or freddie mac. Where we have found value, however, is in the mortgage securities issued by fannie mae and freddie mac as spreads on these assets have widened meaningfully in the past year. By focusing on the cash flows (that is, where the ultimate mortgage payment is coming from), as we do with our equity investments, we believe we can minimize our investment risk. And while agency – fannie and freddie in this case – mortgages certainly have the companies guarantee, their primary source of repayment is from the many mortgage payments made every month by homeowners across the country. One way we have chosen to take advantage of the dramatic widening of spreads while at the same time mitigating the company-specific risks has been to buy seasoned mortgage bonds (i.e. older mortgages, those that have been issued years earlier). Our portfolio currently is predominately comprised of seasoned agency mortgage backed securities, typically those issued in 2004 and prior. Consequently there has likely been a fair amount of equity built up in those mortgages to the extent that any of them might be experiencing payment challenges. In addition, we have historically concentrated our investments in 20-year, but more specifically, 15-year amortizing mortgages which build equity for the owner of the home much faster. And so, fannie and freddie’s guaranty is insurance that we don’t think we’ll necessarily need, but that is there. One of the more positive variables that enhance a bond investor’s view of mortgages today is that we’re in a low prepayment rate environment. Given the slowdown in housing and reduced liquidity, prepayment speeds of mortgages have declined quite a bit. Five years ago, it wasn’t uncommon for cpr (constant pre-payment rate), prepayment speed of mortgages expressed as a compound annual rate, to be well in excess of 20% to 30%, a very rapid clip. Today, that has come back to much more of a long-term historical norm where turnover of housing is somewhere in the order of maybe once every 5-to-7 years. That’s approximately the prepayment rate that we’re increasingly moving towards. And despite a low prepayment rate, spreads are equally as wide as they were five years ago if not higher as people are not simply worrying about, “Will fannie and freddie honor their obligations?” but that liquidity has really been an issue in the marketplace generally. As an example of this lack of liquidity, ginnie mae mortgage-backed securities, which are backed by the full faith and credit of the U.S. government, have been available in the marketplace at similarly wide spreads to comparable fannie and freddie securities. Credit concerns are a factor in today’s wider spreads but we believe this highlights how a lack of liquidity has helped to create some of these wide spreads lately. Q:  How do you incorporate inflation expectations in your portfolio construction and securities selection? A : That is a challenge and can cause a portfolio manager to potentially be even shorter in terms of an average life or portfolio duration. By doing so, assets under management would recycle (mature) at a faster rate and guard against either rising headline inflation or inflation expectations. Outside of inflation protected bonds like TIPS (Treasury Inflation Protected Securities), one could also mitigate against rising inflation by investing in a portfolio of shorter term bonds. This would help to lower any exposure to the vicissitudes of rising long term interest rates and keep inflation from eating away at an investor’s purchasing power. Q:  What is your portfolio construction approach and what kind of diversification do you use in the fund? A : In building the portfolio we don’t typically use a laddered approach, but we want to have the ability to have assets that would mature on a periodic basis so that we’re able to take advantage of the environment that presents itself. In terms of constructing the portfolio, there is no particular target whereby we would have so much weighted in corporate bonds or in mortgages. We stay within our prospectus limits in terms of having the percentages in fixed income securities and are mindful to not have too large an exposure to any one security outside of U.S. Treasuries. Beyond that, in terms of portfolio construction, we want to take advantage of the opportunities that are presented to us (from Treasuries to mortgages to corporate and taxable municipal bonds) and construct the portfolio one asset at a time that takes advantage of the current interest rate and credit environment. Our portfolio has at times been very U.S. Treasury bondweighted and other times, like now, more mortgage-backed security weighted. And it’s very plausible that we’re heading into an environment now, given the widening of spreads across just about every opportunity set in the last year, for other credit sensitive areas like corporate bonds to present favorable investment opportunities. Q:  What research approach do you take in deciding where the opportunity is? A : Our credit research approach works in a complimentary way with the work we do to identify equity investment opportunities. Our research is very ‘primary’ document driven. In other words, the research for our corporate bond exposure would be based on the bottoms up work that we would do in terms of understanding the economics of the business and paying attention to the related documents that they report and file on a periodic basis. Our equity-oriented perspective can help identify fixedincome opportunities when, for example, a key driver of equity value creation for a company might be de-leveraging its balance sheet. When coupled with our credit-driven approach, investment opportunities like this can be appropriate for our fixed income assets. Beyond that, when it comes to U.S. Treasury or other mortgage related investments, just spending time daily, weekly, perusing the readily available data from the marketplace as to where those assets are currently trading, and where there might there be anomalies, while being mindful of the changes that are happening on a day-to-day basis in the marketplace and how the spreads to the extent we are looking beyond U.S. Treasury investments, how those spreads are changing, what’s impacting them, and how we might be able to take advantage. Q:  What are your views on risk and how do you manage it? A : Risk, for us, is probably best defined as permanent loss of capital. Ultimately, for us, we want to be sure that, in the case of fixed income investing, a dollar lent is a dollar paid back. Initial due diligence on the investments you make and ongoing maintenance is critical to success. To the extent mistakes are made, then it’s important to reevaluate at each step along the way to try to determine whether or not your risk of impairment in this case is a temporary one or one that might be permanent, and then make the decision as to hold it or not. Given the makeup of this portfolio, there is less that would transpire because it has historically been a rather higher quality asset mix portfolio, but that ultimately is what I would think is our best definition of risk. Try and understand the risks you’re taking (credit or interest rate, for example), but most importantly for us, we think of risk as permanent loss of capital. When it comes to purchasing power risks, one way we do minimize that, as we’ve talked about, is to construct the portfolio that, by and large, is shorter term so we’re recycling maturing bonds and interest payments on a regular basis into new assets. What is often misunderstood and misapplied is that, for a bond investor, the returns over a long period of time isn’t really capital gains, rather it is reinvestment or interest on interest. Given our equity culture we have enhanced our returns over time by investing a small portion of our portfolio in convertible preferred, straight preferred or common stocks that paid a meaningful dividend. This is another way to mitigate some of those inflation risks we talked about since owning the equity of a company that can grow over time and whose dividend cash flow can increase unlike a bond which, as a contract, does not. We think, given the nature of the firm, that it allows us opportunities to include in an appropriate way a very fixed income centric portfolio, but enhance it with some of the work we’re already doing on our equity portfolios by including certain assets that would fit well within a fixed income environment.