Q: What is the history and mission of the fund?

A: Thornburg Limited Term Income Fund was established in 1992 and was Thornburg’s second fund in the taxable fixed income space. The idea was to extend our capabilities from strategies focused on municipal bonds to funds that invest in corporate bonds, government structured products and mortgages. Over time, we have also developed capabilities in asset-backed securities and include those in some of our strategies. As markets have grown, we began to include international securities.

The mandate of the fund hasn’t changed since inception. Our core mission is to provide investors with a fixed income product, which focuses on safety of the principal. We aim to minimize the components that could sustain permanent losses. We also focus on the stability of net asset value, while maintaining a stable income level that’s consistent with safety of the principal.

Today, I manage the fund alongside President and CEO Jason Brady and Co-Head of Investments, Jeff Klingelhofer. We apply the Thornburg philosophy for our investors, which is to go where value is and to take on risks within the universe of high-quality, fixed income investments only when we are appropriately compensated.

Q: How is your fund different from its peers in the marketplace?

A: We are truly looking for the best relative value across different asset classes and we position the portfolio where the value is. Fixed income is a large and diverse universe with many different issuers and structures. That aspect makes the fixed income market a bit inefficient. Many traditional investment shops have siloed themselves which means certain team members only look at corporate bonds, mortgages or asset-backed securities. They don’t tend to talk to each other, so the market becomes inefficient in the overall risk/reward evaluation.

Because of our flexible structure, we are able to look across the investment grade market to find pockets of inefficiency and make judgments on individual securities without regard to the benchmark or asset class siloes.

A key differentiator is that we are an active, benchmark-agnostic manager, and we let the relative value process drive our investment decisions. We don’t start with a benchmark for asset allocation and security selection. Rather, we consider it a place to think about how much risk we are willing to take in order to deliver the investment solution for which the fund is designed. Still, we understand that investors use the benchmark to measure our performance so we monitor relative performance.

Q: What core beliefs drive your investment philosophy?

A: We believe that fixed income markets tend to be more inefficient than stock markets because of the breadth and diversity of structures and issuers. Moreover, due to the siloed nature of many traditional managers, there is inefficiency in the evaluation of risk/reward in the space. That is our starting mindset.

We look for securities that stand out in terms of value for a unit of risk across sectors. We don’t care whether these are asset-backed or corporate-backed securities, because that’s just the wrapper that contains the cash flows of an investment. We aim to evaluate the probability, the quantity, and the timing of these cash flows. For example, we would compare an automobile ABS with an automobile corporate bond to see which one is fundamentally better. We add the market valuation to see which one has the best relative value and which one we want to own at the time.

Our Limited Term Income Fund is a zero- to ten-year laddered product. It is an active ladder and we always have cash, because the securities roll down the curve and mature regularly. And then, we use that cash and our cash reserves to reinvest in the best value along that maturity ladder.

Q: Can you explain the critical steps of your investment process?

A: We have a fundamental, bottom-up process. We pick each security, conduct individual analysis and see how the market is compensating us for that particular risk. Then we have a comprehensive relative value discussion across the entire fixed income team to achieve the best portfolio outcome.

Each portfolio is built security by security, while trying to achieve diversification and to control the overall risk exposure. Despite the fact that Limited Term Income is a bottom-up fund, we evaluate the price, quantity and timing of cash flows keeping in mind the economic reality. From that bottom-up work, we develop a macro view, which helps to inform our decisions. But we wouldn’t buy utilities or ABS just because they look particularly cheap without regard for the fundamentals behind individual securities. We know what we own, and we control the risk through that process.

The fundamental analysis is a key element, because it starts the overall investment and risk management processes. Of course, we consider duration in terms of the Fed’s policies and that helps us to position the portfolio in the zero- to ten-year curve. Since a significant portion of the portfolio tends to be in credit products, we believe that we can control the default probability by doing individual analysis. The process relies on identifying securities with good value for the default probability, not on positioning the portfolio on a macro basis.

We still want to control the credit duration for some investments as that can create portfolio volatility. For example, we need to be cognizant of the speed of innovation in our technology company investments. The fortunes of these companies can reverse pretty quickly, while utility companies with large, monopolistic-like positions are more stable. So, we are more comfortable with ten-year securities in utilities, while we may only take two- or three-year investments in cutting-edge technology companies.

The bottom line is that our clients seek a risk/reward outcome, stable NAV and interest income, which corresponds to the safety of principal philosophy. We have a flexible mandate, so every day we look at a variety of securities to fit the overall solution that we try to provide.

Q: Could you illustrate your credit selection process with some examples?

A: The retail space, for example, requires a lot of analysis of a particular name. Among many components, we look at the concept, the main competitors, and the dynamics of the particular market. An everyday essentials retailer like Home Depot is quite different from a specialty retailer with a mall-based teenage clientele, where trends change quickly, and the probability of default is higher. Generally, Home Depot’s bonds will have lower volatility and lower probability of default and, as a result, a lower compensation for investors.

As bond investors, we only get back the promised coupon and our principal. The risk/reward in fixed income is very asymmetric. In some cases, it may be a better idea to invest in the equity, but companies like Home Depot have a place in high-quality credit portfolios, because they are robust, with a lot of cash flow and many levers to pull in a recessionary environment.

In the retail space many companies tend to be too volatile for high-quality fixed income investing, while an essential industry like utilities represents a good bond business. Of course, there are changes related to clean energy and shutting down coal plants, but because it is a regulated, essential industry, it is able to pass some of the costs to customers. That business tends to be particularly stable and pay back even when things go awry. Obviously, Pacific Gas and Electric Company in California is the exception that proves the rule but, in general, companies that own the equipment, power lines, and the distribution system tend to be good businesses. In the fixed income world, the stability of the cash flow is paramount.

Q: How do you generate investment ideas? Do you use external ratings or do you have an internal rating system?

A: We are all responsible for idea generation, individual name selection and existing portfolio holdings. Ideas in fixed income typically come from two places. First, companies look for money and come to the new issue market every day, so we make sure that we analyze these names.

And of course, there is the secondary market which has a lot of potential investments. Ongoing analysis of our portfolio holdings is also a source of secondary ideas. There are many competitors, suppliers and end-users that may become potential investments. We look at them closely and pair them with market valuation to make individual decisions. Ultimately, it is up to us, the portfolio managers, to make sure the universe is covered.

Our process involves writing up investment notes, sending them to the team and having team discussions in real time. As portfolio managers, we have the final word, but we try to come up with a consensus from the group. Everything happens in real time on the desk, so we have the flexibility to respond to situations quickly and to ensure everyone’s participation. Diversity of thought within the group makes decision making robust and sustainable.

We don’t necessarily assign a specific score to each security, but we make qualitative assessments of the rating agencies’ scores. These assessments are important, because the market uses the ratings to position portfolios. Often managers have limitations based on those ratings. So, we pay attention to the ratings, but we don’t rely on them as the final arbitrator of the quality of a security.

Q: How do you approach your investments in global issuers?

A: We look at every eligible investment grade opportunity, regardless of where it is domiciled. We are agnostic to where the cash flow is generated. The only limitation is that it has to be denominated in US dollars. For example, we have some exposure to Barclays Bank and we recently added a couple of South Korean issuers, such as Hyundai Motor Co. These are all US dollar-denominated investments.

Q: What is the role of diversification in your portfolio construction process?

A: This is an investment grade fund and, by the prospectus, 65% of the portfolio has to be A-rated or higher at the time of purchase. That rule limits the amount of BBBs that we can buy. This prospectus limitation is just one broad and fairly crude rule that helps diversify the portfolio. Diversification is a core principle of our portfolio construction process, and we look to diversify the portfolio across many different dimensions.

Because the fixed income market is asymmetric in terms of risk/reward, investors will either get their principal and promised coupon, or something much less. There are very few high-quality opportunities to earn multiples of your money like you can in stocks. As such, diversification is a great way to mitigate the negative impact that risk asymmetry can have on the portfolio. We diversify by individual sectors such as corporates versus asset-backed versus mortgage-backed securities. Then we look more granularly, such as our exposure to auto loans in ABS, banks in corporate, or even different types of government mortgage-backed securities. With mortgages, we are mindful of our diversification by different convexity profiles. In the international space, we are currently controlling our exposure to the U.K. banks, because of Brexit, as one example of a special risk case.

Q: What is your buy-and-sell discipline?

A: It is related to evaluating individual situations to find the best relative value opportunities in a given market environment. Right now, we believe that consumer asset-backed securities have a better risk profile than many corporate bonds, which have levered up. So, we have been moving towards asset-backed securities and selling down some of our corporate bond exposure.

When making a sell decision, we evaluate the developments in the fundamental story. If it is still intact and the valuation is still reasonable, we will continue to hold. If it has become too expensive, we sell. We don’t have a high turnover because we favor the ‘buy and hold’ approach. But if the fundamental story is falling apart, that’s a primary reason to sell because the security no longer represents the quality and the safety we look for.

Q: What is the fund’s benchmark? Do you have limits on your position sizes?

A: Our benchmark is the Bloomberg Barclays Intermediate Government/Credit Index. We don’t consider it for deciding our exposure to individual names or sectors, but it is important in terms of the risks we are willing to take for our clients.

In terms of guardrails, we understand the need for diversification, and we achieve it in different ways. But we haven’t set limits on our exposure to corporate bonds, asset-backed securities or Treasuries. Instead, we think about how much risk we want to take relative to the benchmark and what absolute type of volatility we are willing to take.

Q: How do you define and manage risk?

A: The first step, particularly in a high-quality portfolio, is the safety of the principal. Our thinking is definitely skewed towards situations in which we believe that capital preservation of an individual security is highly likely. That’s a key aspect. Certainly, there is a risk of capital loss as we invest in corporate bonds, non-government mortgage-backed or asset-backed securities with credit exposure. We minimize that risk through fundamental, bottom-up analysis, which is a key aspect of our risk management process. Knowing what you own, what risk that individual security contributes to the portfolio and the aggregate risk exposure is paramount for us and for our clients.

Second, we consider the portfolio volatility on absolute basis and relative to the benchmark. The benchmark sets the base for how much risk our investors might be willing to take in this portion of their portfolio. Since this is a high-quality bond portfolio, the volatility is lower than the volatility in high-yield bonds or stocks.

When we discuss our investments, the first question is whether they pass the fundamental test. Then comes the relative value of pairing the risk and reward and finding securities with compelling relative value to the marketplace and to the portfolio. Last, we ask ourselves how this investment helps with diversification and risk control.

We may be willing to accept increasing risk in a given area if we are being compensated appropriately. That said, we need to consider how it increases or reduces the volatility/risk of the portfolio. It is also important to consider if we already have enough of a given exposure and how that security compares to the names we already own.

Ultimately, our risk management is a qualitative process with many quantitative inputs that inform our decision making process.

Q: How has the experience with past crises affected your process?

A: As a specific example, after the 2015-2016 drop in oil price, we evaluated how to approach our exposure going forward in the energy sector. We moved more towards the midstream or pipeline sector as opposed to the E&P sector, given the potential volatility of oil and natural gas price movements. Midstream companies aren’t completely isolated but are better protected via contractual provisions.

We believe that it is important to maintain a database of individual decisions which can be reviewed regularly to improve the decision-making process, so we write up the actual decisions.  Over time, with learnings, the write-ups have become more robust and comprehensive. It is particularly helpful at the portfolio level because we have different databases that record the specific moves that were made and the reasons why. For example, we can look back and see what the portfolio did in 2011 when the US was downgraded, what credit sectors we were invested in, how were we positioned and why, and how the portfolio components moved.

The continuity of our investment team is also beneficial as we have managed the fund for ten years.  We have developed and refined the process together. And this continuity has led to consistent execution and a relatively seamless ability to grow and train the team as needed.