Q:  What core beliefs drive your investment philosophy? A : We believe most attractive opportunities lie outside the index, and that particular fixed income sectors continue to offer yields higher than their historical norms. On a risk-adjusted basis, these out-of-index sectors may offer the most compelling investment opportunities. Q:  How does this philosophy translate into an investment strategy? A : We begin with a bottom-up approach and ask sector specialists to identify each sector’s potential from a standalone investment. Each specialist is asked to quantify their return expectations and the volatility of those expectations based on scenarios presented. Then we compare that with a historic view of the risk levels in the portfolio. We think scenario analysis is an extremely important tool in the portfolio construction process and a highly appropriate way to supplement traditional risk model estimates of volatility. Derived by our macro team, the scenarios themselves are views regarding potential points of consideration, both from an economic and a financial market perspective. We pose those scenarios to our sector specialists, who give us what would be a prospective view on the environment. We try to find ways through a risk lens to create return diversity. Given the investment universe for traditional core bond funds is largely high quality assets, the risk dimensionality for the portfolio is dominated by duration. Using the sector teams and our risk model, we begin the process to identify ways to diversify by sector away from the dominant risk. Based on history, we try to figure out which period is most similar to today because the risk model itself is highly dynamic, and the expected volatility that we experience can change based on the period we choose. An important consideration is the state of liquidity in the market which we have various internal ways to quantify. We try to match the environment today to something similar historically, which enables us to have a better forecasted tracking error before positioning the fund. By employing our liquidity tools and risk models, we try to identify where in the risk and return process we should be from a portfolio construction standpoint. Q:  What distinguishes your fund among its peers? A : Through our fund investors gain access to an active style of management that is based on a bottom-up team approach to investing. Since we view a lot of indices as inefficient, we try to create a more diversified risk process with the help of our sector specialists along all elements of the fixed income investment process as we shift our focus. Today, duration is out of favor and we are shifting into the sector style that we think is most in favor in terms of where risk model and our investor input would direct us. Naturally, if those styles come out of favor, then we will certainly reallocate to something else. As part of our team approach, we do not have any corporate, mortgage, sovereign or sector bias. Q:  How does your risk model work? A : We have built our own risk model completely in-house. This is necessary as we focus on less traditional fixed income sectors. We make sure that we maintain real information from the same traded sector that we are participating in for our risk model, which gives us a lens as to how these assets have performed in different environments. When we get perspective views from the sector specialists, we compare them with our risk model to begin the formation of our portfolio. Q:  What kinds of analytical steps does your research process involve? A : In our view, the best way to merge all sector ideas into a portfolio is by splitting the whole fixed income framework into four core risks – duration, credit, volatility (mortgage prepayments fall into this bucket) and liquidity. These core risks are further broken into more granular components – but from a 20,000 foot perspective, the four core risks are instructive in splitting the investment process for diversity sake. We have a senior team of investors who each lead a team of sector specialists. Each member of the team is assigned a particular sector to contribute to our investment process that we think is unique. For instance, in the mortgage process, a lot of the focus is on the valuation framework. With regards to the mortgage market and the mortgage credit process, we find pitfalls in the assumptions that history brings into a model. We carry out extensive research to find out why those errors exist and what makes a model behave in a certain way. We spend a lot of time on studying the nature of those differences as we try to create positions that capitalize on differences yet to be identified by the market. From a credit process point of view, we have 30 analysts dedicated to following the area. Their reports and views on companies filter in through an investment thesis that we put together. As a whole, it is our fundamental research that drives a lot of the investment decisions within the team. On the sovereign side, we have to come up with our own metric for valuation and risk by looking holistically at a sovereign balance sheet as if it were a corporation. And, by taking into account the legal framework, capital markets and even demographics, we develop our view with relative value and opinions on the sovereign debt. We have a unique process of bringing in young people who learn our investment philosophy and who, once they have fully assimilated our principles, are the life blood for new ideas that we should be considering in our process. Q:  How do you build your portfolio? A : The main objective of our portfolio construction is to create a level of risk diversity beyond that of a broad index. This team-based process starts from a bottom-up approach in that we have around 50 investment professionals dedicated to different sectors within the fixed income space. We have two stages to our portfolio construction process. The first stage (we term it ‘local’) drills deeply into 3 of our 4 core risks: duration, credit, and volatility. Our other core risk, liquidity, is left out of the process until the final stage. In this ‘local’ stage, senior members of investment teams meet to discuss a core risk. Given the 3 risks, there are 3 separate groups. Each of the portfolio construction local teams meets once or twice a week for internal discussions. In the final stage (we term it ‘global’), a representative from each of the 3 local meetings gathers to begin the process of parceling out the risk budget. The sector specialist’s view and the input from portfolio construction local is where we actually arrive at the portfolio construction global input. Despite the highly collaborative process, as portfolio leader for the Putnam Income Fund, I’m ultimately responsible for all allocations to the fund. The benchmark of the fund is the Barclays Capital U.S. Aggregate Bond Index and we seek to produce excess income of between 100 and 200 basis points over the index. Given that the assets under the benchmark are high quality assets, 88% of the fund’s return can be associated with duration. Our portfolio can hold anywhere between 300 and 900 securities depending on the universe and the amount of new flows we get in, as well as on the opportunities that are created by a particular environment. While there is no formal concentration limit on positions, by our investment process we tend to have a lot of individual securities. However, on the corporate side we target exposure no greater than 50 basis points of the fund assets and rarely exceed it. Q:  What is your buy-and-sell discipline? A : We take the input from the sector specialist to the portfolio construction local about expected return and return volatility quite seriously. Transparency and accountability are key characteristics of the process. Daily return attribution provides enough information to keep track of current developments as we are trying to determine whether we are deviating beyond the distribution that was used in the assumptions for portfolio construction. The most difficult part of the process is questioning if we get any deviation from those assumptions that were fed into the model but do not seem to be working out. Because the portfolio construction process is highly inclusive from sector specialists recommendations through risk budgeting, we can adjust our positioning quickly when we deviate from expectations. Q:  Did the period prior to the financial crisis have any impact on your portfolio? A : Going back to that period, we happened to have a very good bottom-up view. We tried to reduce our portfolio risk posture prior to June 2007, when things really started to fall apart, and we continued to do so through August 2007. A persistent scenario used in our portfolio construction is the worst cast scenario. In our opinion, every asset class before 2008 had a worst case scenario that was defined by some event in the past. At some point in 2008, each sector began to approach our estimate of the historical worst case. As we began re-investing, the liquidity environment changed quite dramatically and we had to decide which sectors we wanted to ride out in this storm. At that moment we chose mortgages. We felt that the modeling in mortgages was extraordinarily bad because history could not anticipate how the credit process had fundamentally changed. All those trends in mortgages had allowed the mortgage asset bubble to go to such a point that we knew those models would be not only wrong, but wrong in a very significant way. We shied away from the corporate balance sheet because we felt that they would be challenged for cyclical reasons. While our fundamental view was sound, we sorely underestimated the liquidity environment. As a result, the portfolio experienced a significant bout of return volatility. The subsequent strong performance was a validation of our fundamental view as well as a recognition that these are very safe assets. Capitalizing on the view was a great call but one that was volatile too. Had we known in advance that the distribution in terms of where spreads could go prior to it would eventually go there, we would have moderated the portfolio’s view of the allocation but the strategy would have remained unchanged. We had a very strong view that the best value trade in 2008 was following how the mortgage valuation framework based on history was going to be wrong. So, by investing appropriately at the time we managed to take advantage of the situation. Q:  What risks do you focus on and how do you manage them? A : We bucket risk into four forms – interest rate risk, credit risk, prepayment risk into the volatility risk, and liquidity risk. Our risk management is essentially focused on balancing among those four buckets. We have a separate risk team that monitors risk in the portfolio to help us ensure that the investment team is not going off the primary objective of the fund. We have established risk guardrails for each fund. Any time the portfolio measured by our risk system touches a guardrail, the chief investment officer of fixed income, the investment team and the risk manager will initiate a discussion. At that stage our professionals would like to determine why the investment team may want to breach what everybody sees as the normal conditions for any portfolio. Throughout these discussions the risk and investment teams try to match the current environment because any change in correlation has a nasty change in terms of forecasted tracking error. Liquidity itself is a factor that changes correlations dramatically and all asset classes are subject to liquidity change, hence identifying the liquidity environment helps in terms of creating a more robust version of tracking error forecast. We like to think that having our own risk system that is so granular is a major competitive advantage.