Q: What is the history of the company and the fund?
The fund began in 1994 with a focus on socially responsible investing. Our parent organization, Everence Financial, was formerly known as Mennonite Mutual Aid and is part of Mennonite Church USA. Delmar King has been the fund manager since its inception and with the company for 44 years. Benjamin Bailey has been a co-manager since 2005 and has been with the company since 2000.
It has always brought its values to investing by screening out specific companies. We have always used negative screens to build in important values that our investors care deeply about, but about eight years ago we saw an opportunity to push this out in an active way by buying positive impact bonds.
We began to see unique opportunities in positive impact areas of the fixed-income world. Through these positive impact bonds we were able to actively look for investments that have a positive impact on the climate and the community. We screened our investments, we bought positive impact bonds and we still outperformed our benchmark on a net basis. This combination allowed investors to be able to invest with their values and still get the returns they desired.
Q: What is your investment philosophy?
The fund’s investment style is core plus which means we invest most of the holdings to a core style of the index, but we also add high yield securities which aren’t in the Barclays U.S. Aggregate Index. Over time we add value through top-down management of credit and bottom-up corporate selection as well.
One important aspect to understand about fixed-income investments is that during good times, returns and outperformance are in basis points, but when economic downturns occur, the underperformance can be in percentage points. That is where we try to be a bit more conservative than other funds that try to push the edge on credit. Sometimes managers are astute enough to make adjustments before downturns come, as they inevitably do, but many times they are not.
Everence is a diversified company with mutual funds, a trust company, a foundation and more. As a result we bring an asset allocation perspective to our management of the bond fund because we know that many advisors and asset allocators want us to a consistent fixed income fund. When stock markets are down a manager wants to be able to reallocate out of bonds and into stocks. A very risky bond mutual fund may not allow that to happen as easily because it may have negative returns also. Our fund generally invests in a conservative manner that will hold up well during times of stress.
Q: How do you transform your philosophy into an investment strategy?
At the beginning of each year, we work on our annual strategic plan. The planning process includes running scenarios that model a worst case, base case and best case scenario because we never believe that we know just what will happen. We want to test to see how the fund does when rates go up or down and how it performs in good and bad times for the corporate markets.
Out of the planning process, we set targets for duration, expectations for yield curve moves, how to allocate across the curve, and what kind of allocations to make among the various market sectors that make up the index.
These top/down allocation factors, along with drivers of the bottom-up side, are important when looking for investment ideas. Historically, and particularly when things are more difficult and spreads start to widen, we like to be in a position to add risk to the portfolio, and make decisions based on that opportunity set. This begins by looking at sectors that might have struggled recently. Then using a bottom-up selection process, we search for individual securities that can be used to implement our strategy.
Our process includes negative screening to eliminate investments that do not reflect Everence’s values. We avoid anything associated with alcohol, tobacco, gambling and other areas. Also, because the Mennonite Church is a peace church, the fund minimizes investments in military-related areas—including U.S. Treasuries, because some view Treasury debt as having funded past wars. Instead, we have used agencies (such as FNMA and FHLMC), which have generally been a successful alternative.
Along with socially responsible investing, we also research the Environmental, Social, and Governance (ESG) factors of the companies we own. These factors help us to understand the long term risks of a company.
As we mentioned before, positive impact bonds now make up 22% of the portfolio and these generally benefit the climate and community.
Climate allocations relate to low-carbon and other green investments, while community investments include things like medical research and low-income housing. We have been a leader in green bonds, working along with the broker-dealers who developed this space and who contact us about almost any deal that comes to the marketplace. Of the 22% of positive investments, about half are heavily oriented toward green bonds and environmental investments.
Q: What is your research process and how do you look for opportunities?
We generally view our expertise as credit oriented. To get a perception of credit quality, we listen to providers like Moody’s, S&P, CreditSights, street research, and look through regulatory filings like 10-Ks as well.
This credit analysis is combined with top-down management, which is another important part of the research process. We do our own correlation studies to assess how effective various indicators might be, and we use these to help determine allocation.
Macroeconomic trends and data are constantly assessed in terms of the broader market environment. At the same time we bring a lot of risk management to our portfolio. Our approach to duration management tends to take a longer-term view. We build a model to structure our tactical duration decisions in a disciplined way. Historically this has been an additive process to returns.
The fund and management team within fixed income are very benchmark driven, and we focus on outperforming it. This drives the portfolio allocation as we assess the environment and where value may be. As an example, in the past few years the Federal Reserve’s quantitative easing program took out any value that was in mortgage-backed securities (MBS). While they had other interesting attributes, we felt that there was little value present. So we consistently underweighted MBS.
Another example of our approach, particularly with corporate credit, is we have been disciplined at watching indicators of market valuation. As spreads widened in 2007–2008 we were strong buyers, and as they began to tighten in the beginning of 2012 we lowered exposure to corporate credit. We try to be buyers when spreads widen and reduce our risky asset exposure when the market is richly priced.
A specific name we liked from an ESG standpoint, Southern Power Company, was recently added to the portfolio. They issued their first green bond in the fourth quarter last year. Southern Power is owned by Southern Company and is an independent power-producing contractor. Unlike many independent power producers that will sell things on shorter contracts, Southern Power manages its business conservatively and does so only with long-term contracts with investment-grade counterparties on the other side.
While Southern Company itself would not have been a top choice because of its nuclear power exposure and the risks it has taken with heavy coal concentration, the Southern Power side of its business is more attractive and the fact that they issued a green bond was especially appealing. Southern Power has a lot of natural gas generation and is now starting to branch out into alternative areas like solar and wind. The bond was sufficiently wide that it priced in some of the risk that could spill over from the nuclear plants.
Q: How do you construct the portfolio?
As I mentioned earlier, our benchmark is the Barclays U.S. Aggregate Bond Index, which is the closest equivalent to the Russell 3000 Index in the equity world. It includes Treasuries, agencies, MBS, credit, and other securitized investments such as asset-backed securities (ABS) and commercial mortgaged-backed securities (CMBS).
Our portfolio is always underweight Treasuries, but they are a large part of the Barclays Aggregate. So our allocation begins with agencies because they give us the liquidity needed to adjust duration. Deciding the degree to be overweight credit is a key decision, because credit is where we believe we can add value and enhance our return over time. This is always viewed relative to the benchmark and relative to the current opportunity set.
Position sizes always depend on credit quality because we find this to be a very effective risk-management tool. If something is risk-free from a default perspective—like a government mortgage or an agency—the size of an individual holding is not a great concern. But wherever there is a credit exposure, we have fairly hard limits. We position our duration between 80% and 120% of the Barclays Aggregate duration. We also monitor sectors relative to the benchmark to limit exposures there.
Right now the fund has about 400 holdings from hundreds of issuers. We have an overweight to agency securities versus the index. Our corporate exposure is higher than the index and a bit above the middle of our historical range. We have a relatively large allocation to multilateral agencies like the World Bank, Inter-American Development Bank, and African Development Bank because they have been prolific issuers of positive impact bonds, plus they are generally liquid AAA rated securities. We are underweight MBS versus the index and our ABS and CMBS holdings are modest because we have not found great opportunities just recently. The fund also has a small weight in municipal bonds.
Uniquely, 1% of the fund goes into what we call community development investing and this is the one area where the rate could be at a concessionary level. This 1% goes to the Calvert Foundation, which channels capital to high-impact community development initiatives in the U.S. and around the world.
Q: How do you define and manage risk?
One definition of risk is loss of principal, which we control through credit exposure limits, by lowering credit exposures during times when it gets expensive, and by managing sector risks.
Liquidity risk is an important risk to monitor in a fixed-income fund. Under conditions of stress, like in 2008, liquidity becomes very important to bond funds because investors usually put these funds in a diversified portfolio and they may want to rebalance out of bonds and into stocks during these times. They expect withdraw money on very short notice, so we try to keep a significant weight in agencies and the mortgage-backed space, where we can liquidate things to generate cash quickly. We do not want to have to sell riskier assets when the equity market declines.
This really paid off for us in 2008 and also after 9/11 happened, when the markets shut down for about a week. You needed liquid assets to handle withdrawals as soon as the Federal Reserve allowed the banking system to function.
