Q: What is the investment style and approach of the fund?
We manage a global fixed-income fund that invests in all classes of bonds. Our goal has been to create a high quality, liquid bond fund, and to do that we cap our holdings of high-yield corporate credit and emerging market debt at 20% (although we usually don’t exceed 15% in either).
Our benchmark is the Barclays Global Aggregate Index, hedged to the U.S. dollar to limit currency risk. We take active views against the benchmark including sector rotation and country selection.
In some cases we might be overweight credit or underweight other sectors, but the majority of the fund, between 40% and 70%, is in developed market sovereign bonds. It is probably best described as an 85% to 95% investment-grade-rated and developed market fund.
The fund was launched on January 1, 1994, and the style and approach have not materially changed since that time.
Q: How do you search for and identify opportunities?
We have 130 investment professionals located in the U.S., London, U.K., and Singapore, who focus exclusively on fixed income analysis.
We start with a macro approach, where our team of sovereign research analysts develops views on central banks, countries’ inflation, GDP (gross domestic product), and other economic statistics and compares them to expectations to screen some of the more top-down trades, e.g., decisions on currency, yield curve, duration, and country selection.
Then we delve deeper across the subcomponents of fixed income—securitization, corporate credits, sovereign bonds, developed and emerging markets, etc. Security selection is also important in the investment process. Because we don’t run a mega fund, there are a lot of bonds we can tap at the security level to help add performance as well as actively trading them. And if the thesis or valuation changes, we can sell a bond fairly easily.
In addition to top-down and macro, there is considerable input from a lot of people, including our chief investment officer. As the analysts uncover their best opportunities in each of the subclasses, Brendan Murphy and I, two of the fund’s co-primary portfolio managers, decide how big any particular strategy or bond should be in the portfolio.
Q: What are the underlying principles of your investment philosophy?
We believe the more opportunities there are, the better investors have to achieve higher, risk-adjusted returns. We feel that investing in global fixed-income (hedged) can increase this likelihood.
We do not maintain a structural bias toward any one sector, such as corporate credits, emerging markets, or currencies. This fund has held up well in periods of stress, like 2008, 2011, 2013, and 2015, partly because we don’t foster such structural biases.
While value and opportunities exist in those kinds of trades, e.g., duration, position yield, yield curve, and currency, opportunities may also exist in security selection. That is where we seek to add value. We feel our size permits us to maintain a competitive edge. We do not run huge amounts of assets, and there is a limited supply in some bond markets.
Q: How would you describe your investment process?
The process evaluates three criteria before we make investment decisions: value, existing fundamentals, and market sentiment.
In terms of value, there is a quantitative or qualitative evaluation as to whether the strategy or bonds are cheap. Grasping the fundamentals includes understanding an issuer within corporate credit; understanding a pool of collateral in the securitized bonds, or a sovereign balance sheet; or identifying the political risk within a country. We also look at external ratings, but we do our own research.
.
Emerging markets in 2014 is a good example of the importance of gauging market sentiment. Emerging markets sold off, countries began to look cheap on a pure valuation basis and, in some cases, there were signs of improvement in a country’s fundamentals. So one may have been tempted to invest, however, where sentiment and technicals around a particular country or bonds are negative, we might avoid investing.
We start with top-down development. Every month we have two important meetings. A global macro committee comprising all of our sovereign analysts in the CIO team meets to parse views on growth, inflation, bank policy, and how our views compare to consensus when they differ. We follow that with a bond strategy forum meeting, where we take views from the first meeting and do two things.
First, we feed this range of views into a set of models and view the historical relationships, calculating what is and isn’t attractive. It ranks various subsectors, like investment grade credits, mortgage pass-throughs, U.S. rates, etc., to illustrate where the most value exists in the various market sectors, giving us a set of broad-based investment themes. For example, the models may indicate a preference for high-yield corporate credit versus investment grade credit.
The next step is idea generation. Our analysts take these base case economic forecasts and begin evaluating opportunities in the various sectors. So, when comparing different commercial mortgage-backed securities, we would look at a range of potential outcomes on the underlying loans. If the U.S. growth range is predicted to be 0.5% to 3%, we examine how loans would perform throughout this range. The same is done in the other sectors, forming the basis for our security selection. My analyst team and I then review this in monthly meetings at the subsector level.
We also hold a daily morning investment team meeting to discuss events the previous night: duration or interest rate changes, economic releases, critical events—whatever may have occurred.
Those two things—macro and idea generation—help to identify value, fundamentals, and sentiment. But at the end of the day portfolio construction comes down to the portfolio managers. We rely on a lot of tools, risk, portfolio management sizing, and stress-testing, to best determine how to invest across all the potential opportunities identified by the analysts. We do not sleeve out any sectors of the portfolio to other teams.”
Q: Can you give an example of what drives your research process?
Let’s look at trades around Europe. I am simplifying this considerably, as there are a lot of details that go into such decisions, but coming in to the end of last year, we had a broad consensus view on European inflation. We suspected inflation would be lower than the market was predicting and that the European Central Bank would be forced to act. We wanted to transition the portfolio to benefit.
That meant deciding which sovereign bonds to buy. We had the opportunity to buy Greece, as a new issue. But although it was one of the higher-yielding European bonds, our sovereign review identified considerable political risk. Instead, we bought positions in Portugal, where we were much more comfortable with the political risk, reform process, etc. As value was realized, we later sold them.
Another example is emerging markets, which we have avoided for much of the last two years because the sentiment and technical surrounding them are worrying. We have a low consensus view of growth in China, for example, which keeps us from taking significant exposure to some of the more volatile emerging market countries that are heavily tied to China regarding commodities.
However, emerging markets is a broad term—we would qualify some of them as developed markets. Morocco is a bond market most firms ignore because it’s relatively small and trades tightly with emerging markets, but it features a strong growth profile, low inflation, stability in its political situation and the banking sector, and also benefits from drops in commodity prices and oil, which makes it attractive to us.
Q: Can you provide an example based on security selection vs. macro?
Commercial mortgage-backed securities comprise about 10% of our portfolio. We manage the fund against the benchmark, the Barclays Global Aggregate Index, hedged to the U.S. dollar, without being closely tied to it. So, we looked at older bonds, issued five to 10 years ago, and stress-tested various outcomes.
All securities performed strongly with relatively short maturities, and with only two or three years left in the cash flows, many are still yielding 4% to 5%. That is an example of a bond we are comfortable with—no losses when we stress test underlying loans.
Q: How do you construct your portfolio?
There are over 15,000 securities in the global aggregate index and only roughly 150 to 250 issuers in the portfolio. We hedge a lot of currency risk back to the U.S. dollar. And while we might have two or three bonds from the same issuer, we do not have hundreds or thousands of positions because while we want to be diversified, we do not want to be so diversified that it negates the value we achieve through security selection. We size bonds—investment grade bonds are typically are between 25 basis points and 1%. And we don’t sleeve sectors out to other teams to manage.
We consider account liquidity, valuation and correlations, and whether perhaps the sovereign is a better way to express a country’s view vs. a mortgage or credit bond. There is no one tool we use to evaluate securities. We also gauge how they might correlate across sectors.
In terms of position size, at the security level, sovereign bonds can go higher, so we might hold 5% to 10% in, say, a German bond or a U.S. Treasury. If it is a corporate, mortgage, or emerging market bond, something with a default risk, we’ll size those positions smaller, typically between 25 basis points and 1%, but in certain cases we might extend it as high as 2%.
Q: Isn’t 5% to 10% an unusually broad range to target?
While admittedly unusual, we permit it. For example, if we believe the Reserve Bank of Australia will decrease interest rates, we might buy 3% of an Australia 3-year bond. Our thesis is that even if interest rates moved by 15 basis points, it would add only 1 or 2 basis points to the performance, which wouldn’t impact the portfolio. We could have 6% or 7% in a 2- or 3-year Australia bond in order to drive value, but that’s rare. For us to have 6%, it’s usually in high-quality developed market government bonds with shorter maturities.
Q: Do you try to be sector- or duration-neutral?
We vary our exposure over time, avoiding downturns and rotating into areas where bonds have fallen in price and promise value. For example, in 2008 the portfolio did well in our view because it avoided parts of the mortgage and corporate credit markets that were under extreme pressure, and also we feel did well in 2009 when we rotated back into some of those distressed market areas. We are quite active with both security selection and sector and country selection.
Q: How do you define and manage risk?
Risk is unquestionably multidimensional, meaning there are different ways to define risk. One is in volatility of the return stream. We use many risk tools to evaluate this on a daily, weekly, and monthly basis. We use quantitative tools to budget positions based not just on what the exposure is, because a 1% position in a triple-C bond is different to that of a single-A bond, but also to determine how many basis points of risk we have to counter daily volatility.
We also consider risk-adjusted returns and have historically maintained a high Sharpe ratio.
Another risk control concerns loss of capital, notably an issue in fixed income where there is asymmetry in these positions. We need to be cognizant of the skew to asymmetrical return profile. We target avoiding loss of capital, either as a default or a broad negative return over some period, viewing it both quantitatively and qualitatively.
Quantitative risk measures on their own are insufficient. We include scenario analysis, stress-testing specific scenarios we define, and look at past stress periods, all to see how the portfolio will hold up.
The qualitative approach is that if the thesis changes or there is uncertainty around a position, we are quick to sell it, even if it means sacrificing some of the upside in exchange for avoiding big drawdowns or losses.
We view risk management as a complex undertaking.
