Q:  Would you give an overview of the fund and its investment philosophy? A : The Principal Income Fund was started on December 15, 1975. Edge Asset Management, Inc., located in Seattle, is the sub-advisor for the Fund. By taking a value approach with a contrarian bias, we seek to identify companies that we believe have a strong history of managing through current as well as multiple business cycles. So, we see sell-offs in the market as buying opportunities in most cases as opposed to following the crowd in selling our portfolios. We employ our strong fundamental research to ensure that as long as the underlying fundamentals remain the same, our portfolios will succeed in weathering most storms and, in this case, in generating cash flow that can be used in a prudent manner. Q:  What is your investment process? A : We drive alpha primarily through our fundamental research with strong security selection and sector allocation decisions. Since this is a core plus strategy, 65% of the portfolio must be in investment grade corporate bonds, which allows us to do up to 35% in high yield. Yet, the main driver of return for this strategy has been our allocation to corporate bonds, which we generally have in a 70% to 80% range for the overall strategy, with the balance of the 20% invested in U.S. government agency mortgages and Treasuries. Next, from a process and screen standpoint, we sit down in formal discussions to establish our macro outlook for the next 18 months. We have a four-step process with the first step being idea generation. From that we identify the asset classes, industries and sectors that we believe will perform best under our economic outlook. Then, once we have identified the areas expected to perform best, we apply some quantitative screens to identify the areas that appear to show the best relative value. We do that on an asset class to see today’s value based on a trailing 12-quarter period. We want to see how it compares relative to other sectors and if it is a tight or wide relative value comparison. Moving on, within the corporate sectors we are investigating the subsectors, and more specifically the ones that appear to be offering better value. That two-level matrix of where we think the good performers lie as well as where relative value appears to be helps us narrow down our investment universe and pinpoint the areas where we want to conduct more research. We regularly do in-depth industry reports to build a good company list, as well as one-off research studies on companies not in our targeted industries. Our grading system for those companies enables us to compare the characteristics and competitive advantages of both companies and industries in light of our economic outlook. Then we look at the management team to assess if they are a good steward of capital and have been able to execute on strategies that they have laid out in the past and will they continue to do that. The third step of the process involves screening for event risks that are identifiable and manageable. In certain industries, management teams have little control over regulatory bodies, whereas in other industries, management teams can really drive the ship. Those theses all play into how we eventually conclude what makes a good company. Lastly, we are always scrutinizing the fundamentals of the industries and companies as part of an iterative process. Given the different roles and responsibilities of the team, it is the analyst’s job to unearth enough information in order to have a certain level of confidence in a company. It is then the portfolio team’s job to question that thesis before the lead portfolio manager determines what securities to actually have in the portfolio. Q:  How do you execute your research process? Would you illustrate with a few examples? A : Once we identify companies and sectors for investment, we patiently wait for a good entry point. Many of the companies that we invest in are global players. The top-down approach weighs out the macro outlook, but at the end of the day it comes down to security selection and what bonds actually end up in the portfolio. Oil and gas exploration and production continues to be one of our favorite sectors, and the real estate investment trust industry comes next. Having said that, we do not have any big sector positions today given where valuations are. Having a positive view on the oil and gas industry, we are waiting for opportunities from our contrarian bias to present themselves. We will then carry out another level of research to make sure that we are not missing something. This rationale led us to taking a position in British Petroleum Plc after the spill in the Gulf Coast. We did not buy Transocean Ltd or Anadarko Petroleum Corp because we were too concerned if their business was going to hold up to this unknown risk that was developing on the spill. At that moment we felt that British Petroleum would be able to weather the storm. Despite the scale of the ecological disaster in the Gulf, our long-term research and experience suggested that management would do the right thing and that the company had adequate reserves and assets throughout the world that they could use to cover the cost of overcoming this catastrophe. We will probably not know for a little while exactly what the final cost will be, but at this point it is well under control. In 2008, there was a mass exodus from a large number of sectors. One of them was the real estate investment trust sector, partly because of fears in the market that those companies would not be able to refinance their debt, or that if they managed to do so, it would be at exorbitant rates that would be unsustainable for managing the business. It was a sector that we had been following closely but we did not have much exposure to it at the time. And as companies were coming to the market to refinance debt, the bond covenants that they were putting in place were not necessarily secured by particular assets, yet they were close to being secured. That gave us a lot more confidence that the sector was successfully refinancing itself. Consequently, we have been able to build a good exposure to the REIT sector through multiple names with a couple of underlying themes such as the health services space and storage facilities. In a period of aging demographics, we have a preference for healthcare-related companies. These are areas where companies own medical offices, senior care housing, or space used by biotech firms for research and development. As a whole, we think of this as a sector with a steady flow of income that is not directly tied to healthcare reform bills. As far as storage is concerned, companies in that space do not have many bonds outstanding because they do a lot of their financing in the equity market. This is a fairly fragmented industry with substantial cash flows and with many companies consolidating smaller or family-owned businesses. Q:  How do you build your portfolio? A : Our objective is to build a diverse portfolio comprised of issues and issuers that are likely to deliver the best risk-adjusted return. Our mandate allows us to have up to a 5% concentration in an issuer, but in effect our positions will rarely exceed 1.5%. Because we are identifying sectors, we like to own a few names in a sector if we think of it as an attractive investment idea. From a sector standpoint, we are capped at 25% of the overall portfolio, but in reality we are at 15% at most in any one sector. We try to keep our portfolio around 150 to 180 positions, which would be somewhere around 80 to 100 issuers giving us adequate diversity. About 80% of our alpha comes from security selection and sector allocation. As part of our process, we do not try to forecast where the rates are likely to be. We stay relatively close to the duration of our benchmark, which is the Barclays Capital Aggregate Bond Index. As a general rule, we avoid sectors that require a lot of ongoing capital expenditure for maintenance of their business that is not necessarily defendable against disruptive technologies. For instance, the high yield wireless segment is a space that we have tended to stay away from. Q:  What is your asset allocation process? A : We tend to have between 70% and 80% of the portfolio in corporate bonds, which speaks to our core competency of corporate research. The balance is usually in agency mortgages or Treasuries, and within that corporate piece we will generally have between 55% and 65% in investment grade corporate bonds, with, at most, high yield bond exposure in the low twenties. We put the incremental dollar in agencies or Treasuries, but most of the time we allocate to agencies because of the incremental yield we can get over Treasuries. Once the market adjusts, we start shifting dollars back into the corporate bonds, be it to investment grade or high yield depending on where we truly see the appropriate relative value. Q:  Do you consider rerating opportunities an important factor in your investment process? A : At the end of the day, the most important thing for us is how much free cash flow is being generated, whether it is improving, and how management is using it. In this market environment, given the low level of rates and corresponding spreads, I do not know if rerating is necessarily something that is driving a lot of management teams today. In fact, the cost of capital does not change that much, based on where rates are. There is enough money looking to be invested in the fixed income market, so the good companies do not necessarily have any problem raising capital regardless of their rating. We like to look at businesses with defendable positions. We want companies with a good moat and we want to see a good management team that can execute on the strategy laid out in front of the company. Those are the key components of our selection. Q:  What kinds of risk do you primarily focus on? How do you mitigate risk in the portfolio? A : For this strategy, there are two types of risk primarily associated with fixed income investing. The first type is interest rate risk. We run our strategy relatively close to the benchmark duration-wise, so we are not trying to generate alpha there. Then, the second and most critical risk based upon the structure of the portfolio is credit risk, which plays to our strength, fundamental credit research. Some of our risk control measures are maximum issue size and sector allocation, as well as the limit on the amount of high yield that we can buy. Our risk management and performance evaluation involves monitoring the performance return, the sources of alpha, and the risk direction of the portfolio as it relates to different factors that can cause the downside risk we are trying to mitigate.