Q: What is the history of the fund?
The fund was launched October 31, 1995. At inception, the fund held any corporate security that had income related to it, including stocks with dividends. However, the fund moved away from that and has focused on bonds since I took over as portfolio manager in 2003.
Previously, the fund’s benchmark was the Barclays Capital U.S. Credit Baa Index but we switched it to the Barclays U.S. Dollar Corporate Index because current holders wanted more of an investment-grade corporate focus.
Q: What are the benefits of investing in investment-grade corporate bonds?
For investors looking to earn yield over time rather than focusing solely on total return, investment-grade corporate bonds can do that with relatively low risk. Currently the average spread over Treasuries in investment-grade corporate bonds is 165 basis points, so 1.65% on top of a 10-year Treasury of 2.2% is good extra yield.
To get this extra yield involves slightly more credit risk. But the historical default rate in investment-grade companies is less than 1%—more like 30 to 40 basis points annualized over a long period.
High yield is a competing asset class, and it is a great place to be when the economy is growing and companies are improving, going from high yield to investment grade either through improving credit metrics or through acquisition.
Now, though, at the top of the economic cycle, investment-grade bonds can add extra yield over Treasuries. Although yields aren’t as high as those on high yield bonds, the credit risk is much lower. We expect defaults in the high yield market to be around 4-5% over the next year or two.
Q: Would you describe your investment philosophy and strategy?
Overall, our philosophy is to find securities with good risk-return profiles that out-yield and out-spread the index. We do that through fundamental bottom-up security selection with a team of 12 analysts focused on investment-grade corporates. Collaboration here is important; many times our emerging markets or high yield analysts have followed companies as their businesses have grown or their ratings improved; in addition, because our equity counterparts often have more access to executives as owners of the firm than we do as lenders to the firm, we partner with them frequently.
For the portfolio to consider a particular company there must be a fundamental credit reason behind it, so every one of our securities is rated and recommended by an analyst. We might add a company if it has a stable to improving credit profile and will either lower the overall risk in the portfolio, increase the yield, or, ideally, do both.
A main focus is to reduce risks we don’t want to bet on, like the Treasury yield curve and the portfolio’s overall duration relative to our index, and maximize risk we do want to take, like credit risk as a whole and idiosyncratic risk—specifically a particular company’s credit risk.
Q: What types of companies or issues do you generally focus on?
Each analyst covers 40–60 investment-grade corporate credits, so we can cover approximately 600–700 different companies.
However, the fund has the ability to invest in non-investment grade corporate bonds, so up to 15% of the portfolio can be high yield. Currently this makes up 6% to 6.5%.
In high yield, our focus is on security selection, not adding beta. Exposure is limited to securities that are either stable BB credit quality with good risk-return profiles or those likely to be upgraded to investment grade. This area of the credit spectrum often gets overlooked but it has good value.
Q: How do you conduct your research process?
It starts with fundamental credit research aided by a repeatable proprietary process. We use a quantitative risk and relative value model to figure out whether bonds in the market are trading at attractive levels relative to their peers. The research for a particular day is summarized, shared in multiple databases online, and distributed via e-mail so it is accessible anywhere.
The team meets regularly. Monday through Thursday we get together for 15–20 minutes in the morning for bullet points and headlines on what happened in the last 24 hours or over a weekend, or discuss what is expected to occur that day. These meetings prepare us for the trading day. On Wednesdays, we dive deep in a particular company or sector for 90 minutes.
The portfolio focuses on buy-and-hold, long-term investments. We try to minimize turnover because of transaction costs, and because our research process results in us taking a long-term view on a company’s credit quality.
While our analysts always dig into a company’s financial statements, a key part of our research consists of credit analysts, along with their equity counterparts, visiting companies at their headquarters, at conferences, or hosting them here at T. Rowe Price.
During management question-and-answer sessions, we pay closer attention to the balance sheet, which shows us how a company has been run in the past, while the equity analysts remain more focused on growth and earnings. This gives us a holistic view of a company, and we gain an understanding of the shareholder pressures management faces.
Understanding these pressures is the reason our analysts stay in close contact with both company management and equity analysts. They need to be able to anticipate if an otherwise attractive company—one with a strong balance sheet, cash flow, interest coverage, or strong debt-to-equity metrics—might make an overnight decision to acquire a high-risk company, announce a share buyback, or increase its dividend.
Though our corporate bond portfolio is not top-down driven, macro variables help identify areas with the potential for relative value. Most recently the energy and commodity sectors were flagged; our expectation is that commodity prices will remain lower for longer. We have asked analysts to stress their companies to decide whether exposure to these sectors should be reduced or whether there are companies that have been unfairly punished we should add.
Q: Can you cite a couple of examples to illustrate your research process?
General Motors Company was one of our biggest successes last year, and still remains our number-one exposure with about 3.5% of the portfolio.
Because of the financing operations General Motors does, it needs an investment-grade rating. It had that but was downgraded to high yield and went through issues associated with its restructuring. When it was still rated BB, we started to build a position because our high-yield team and our investment-grade analyst saw the company was solely focused on regaining its investment-grade rating, and management was following through on improving the balance sheet.
We liked General Motors for other reasons as well. To reduce debt on the balance sheet it turned secured debt into unsecured debt and issued it at attractive yields. It also used company cash flows to continue to pay down debt rather than paying dividends or buying back stock. Moreover, it started focusing on where it succeeded—in the U.S. and Europe—and dialed back where it was not as successful.
Another example that illustrates our research process is within banks. The regulatory environment supports the balance sheets of large, diversified banks, so we began to build up our exposure particularly in companies like The Goldman Sachs Group, Inc., the investment banking firm.
Goldman Sachs is an excellent operator in its field and was issuing subordinated debt securities at attractive levels. We liked its balance sheet and believed its credit ratings were stable to improving. In banks like it and Morgan Stanley we were able to pick up extra yield at an attractive risk profile.
Q: What kind of due diligence goes into covenant analysis?
It differs depending on the particular sector—banks, for instance, will be considerably different from industrial companies. Usually, though, in investment-grade there aren’t a whole lot of covenants: unsecured debt is truly unsecured, with a company’s cash flow mainly providing security.
Something we look for, especially in the current environment with a lot of mergers and acquisitions, is a change of control covenant. So if a change of control gets a downgrade from the credit rating agencies, we generally have a put or mandatory call built in.
Q: What sector-specific factors do you look for in industrial, telecom, banking, or financial services companies?
AT&T Inc. and Verizon Communications Inc. are the two big U.S. telecom companies, but they manage cash flows very differently. AT&T has a fairly large dividend that it has supported in the past through acquisitions, whereas Verizon has been relatively more conservative in its dividend payout. But both companies have a significant amount of debt outstanding.
In a sector like this we seek exposure to companies with better cash flows, even if they have a more levered balance sheet. So we have invested in tower companies like Crown Castle International Corp and American Tower Corp, which have been in the portfolio for five-plus years. Though the companies themselves were below investment-grade years ago, they issued investment-grade securities by securing them with the towers themselves and the mortgages on the towers.
One of our analysts uncovered the opportunity and we built a pretty large exposure—it was just the type of investment we like. It was a bit off-the-run, so there was a liquidity premium because not many firms were looking at these companies. And the companies had stable cash flows and were looking to improve their credit ratings from high yield to investment grade.
Q: How does your rating process work?
Every company in the portfolio has an internal rating. We also follow the national rating agencies and have researched how ours are different from theirs.
Historically, 45% to 55% of internal ratings differed from the agencies’. We found this varied through time. During positive sides of the economic cycle 60% to 65% of internal ratings were more conservative, but when the economy slowed, 70% to 75% of internal ratings were more conservative—meaning we were downgrading faster than the rating agencies. When our ratings were higher we found opportunities the market had not discovered yet, like the tower companies.
Finally, if the rating agencies move toward our internal ratings we call that a win. If our ratings move toward theirs we call that a loss. When we examined those changes historically, we found we won more than we lost—so not only are our internal ratings different, generally they were leading those of the agencies. This adds value to the portfolio.
Q: How do you construct your portfolio?
The portfolio is built security-by-security based on credit worthiness, risk-reward ratios, and total return merits, rather than on risk factors like high yield beta or energy sector beta. Currently, the portfolio has 165 different companies, so it is relatively diversified.
Our top 10 holdings comprise about 25% of the portfolio, and we hold approximately 15% of the portfolio in non-U.S. companies.
The index we follow has 900 to 1,000 companies that often issue more than one bond, so that provides a large opportunity set. Though it is a U.S. Dollar index, the companies are global. We have issuance in Asia, South America, Europe, and Australia, but only look at dollar-denominated bonds. When investing in companies outside the U.S. we determine whether they are taking on currency risk to borrow in the U.S. market, or whether they are matching revenues with their debt. Taking on currency risk by buying a bond denominated in something other than dollars is something we avoid. Also, we are wary of a company earning revenues in pesos but with significant debt in dollars.
Q: Are you duration neutral to the index?
Duration exposure relative to the index doesn’t figure much in total performance or tracking error but in the current environment, we do run the portfolio slightly long duration—within a quarter of a year from the index’s. The portfolio’s slightly longer duration hedges against spread risk, so the overall volatility of performance will decline. In addition, we have a very steep yield curve so adding a quarter year can add a few basis points to overall yield in the portfolio. In an environment earning very low return, we feel this makes sense.
Q: What is your definition of risk? How do you manage and control it?
We define risk as tracking error relative to whatever benchmark the client is expecting us to manage against, so we are somewhat more benchmark focused when we think about risk.
Because our focus is on taking credit risk, we think our biggest risk management tool is our fundamentally driven, bottom-up credit research, which is enhanced by a lot of quantitative tools that ensure the top-down credit risk is within our guidelines. The quantitative tools show us which factors are driving performance relative to the index and help assure the bets we take are related to credit risk or company-specific risk.
An analyst’s surveillance of a company in the portfolio gives us a long-term focus on the credit view. If that view changes based on expectations of what management might do or how the business is progressing, then we consider selling.
For example, Avon Products, Inc., the beauty products manufacturer was in the portfolio. The company had operational issues and an accounting scandal, but was a very large business that had been relatively successful in the past. We thought it had good managers who could turn the business around.
But the Brazilian real devalued, which put up another big hurdle because a significant portion of Avon’s business is in that country. We had bought Avon based on a plan we believed management could execute and we expected a turnaround. But this devaluation had a large impact on Avon’s revenues that made the plan very difficult to achieve, so we eliminated it from the portfolio.
