Q: Could you give us a brief overview of the fund’s history?

The fund was launched on April 15, 1988. The current team managing the fund, including OppenheimerFunds’ Chief Investment Officer Krishna Memani and myself, has been in place since March 31, 2009, so we are coming up on ten years at the firm. We have built an experienced and tenured team with a proven history of risk-adjusted outperformance with benchmark-like volatility.

Q: What core beliefs drive your investment philosophy?

The investment philosophy of the fund is to generate consistent risk-adjusted outperformance, but also act as ballast or a risk diversifier for an overall portfolio. In times of stress, when there are negative drawdowns in the U.S. equity markets, our main goal is negative correlation with the equity markets. We manage the portfolios with the idea that we don’t hide any equity-like risk in exchange for yield, nor do we target specific yield levels. Since this is a core domestic fixed income fund, our primary goal is to protect the value of capital for investors.

We are rate agnostic, credit-centric risk managers and anything outside that philosophy is not acceptable for us.

Q: Which parts of the bond market do you focus on?

Before allocating across our investment universe, we look at the Sharpe Ratio and the expected Information Ratio of each sector. Currently about 50% of the portfolio is invested in U.S. corporate bonds, and 35% is in government agency mortgages. We also have an allocation to asset-backed securities, primarily auto paper.

Consistent with serving as portfolio ballast, we don’t invest in bank loans or emerging market credit, even if it’s dollar denominated. We don’t buy any deep high yield (anything B-rated or below), but do have some ‘implied BBB’ credit, which is in fact BB or BB+ credit. We have found, historically, BB-rated credit has the best Sharpe Ratio of any credit rating sector.

That is not a fixed allocation, but a tactical allocation, where we add when we see value.

We may buy subordinated debt, but we don’t buy any European debt. While we include European banks, they have to be banks with dollar-denominated debt issued in the U.S., because we don’t take any currency risk in the portfolio. The Fund is meant to be very specific and to have negative correlation towards equities. Therefore, we are not looking to include investments that are riskier and have higher beta.

Q: How would you describe your investment process?

We look at the macro picture with the belief that it is the credit cycle driving the economy, not the economy driving the credit cycle. There are two components to the credit cycle – the price of credit, which is affected by the Fed, and its availability. To build our macro and risk view, one data point we focus on is the monthly loan officer survey, which examines lending standards and the loan demand.

We structure the portfolio with a six to 12 month timeframe in mind. It is that short, because we do not buy any securities with hidden intrinsic value that would require two to three years for that value to be realized. As a matter of fact, if any corporate bond has a story attached to it, we do not want to own it. We focus on getting compensated for taking systemic risk in the credit market and we try to avoid idiosyncratic credit risk as much as possible.

When I invest, what I really want to own is exposure to the sector, so we limit our individual positions to 50 basis points for investment grade and 25 basis points for sub-investment grade. Overall, the goal is a steady influx of alpha to the portfolio with minimal risks.

We manage duration at the portfolio level nightly. The overnight duration management delta hedges our negative convexity and maintains our target duration – which is typically neutral versus the benchmark. If rates are falling and mortgage durations are becoming shorter, we have to make sure that we are up to the benchmark on a daily basis. Likewise, when rates are rising and mortgage durations are extending, the negative convexity gives more duration and we have to manage that. That process has been in place for 10 years and has worked out well. It may cost us 10 or 20 basis points per year, but it is well compensated by the excess return or alpha that we receive from being able to be in and out of the mortgage market.

One of the features that differentiate the fund is the stop-outs at the portfolio, sector, and individual security level. A stop out is an automatic predetermined investment action that occurs at a specified level to neutralize a position that is trending away from an expected view. When I see the security price movements at the individual level, I want to know what’s going on, why that particular security is not performing and that goes on a watchlist. Yes, spreads move up and down, but we aim to prevent putting our own egos within the process, and establishing stop outs is a risk management tool that can help in that regard.

Overall, the only thing we can control is the risk we take. We don’t control what happens in the markets, but we can definitely control how we react to it and that’s what we focus on.

Q: How is your team structured? What is the strategy in terms of the decision-making process?

The team consists of seasoned investors with 22 years of experience on average, so I ask for opinions and consensus. We are very fluid and we have the ability to change our allocations weekly and sometimes we do. We are active managers and our turnover is about 80% per year, but we go up and down the risk scale.

The analysts are responsible for different sectors. On the corporate side, the team is organized based on industry sectors, so each analyst has three to four sectors with the exception of the finance sector, where we invest up and down the structure and we buy preferred securities, perpetual bonds, etc. We also have an analyst who focuses on agency mortgages and another analyst who specializes in ABS, CMBS, and mortgage credit.

Because of our risk-controlled framework, our analysts can act as sector portfolio managers. After determining sector allocations, the analysts don’t need permission to include a particular bond. They operate within a specified framework, which is also watched by an independent risk team, which reports to the CEO. I ask them to deliver basis points per month over the benchmark, if they can. They are able to add value by participating in the new issue market and by looking at value along the credit curves within a particular sector or company.

I believe that the analysts should be able to make their own decisions within sectors because ten brains are definitely better than just one of the portfolio manager. I also believe that people perform at a higher level when they have a sense of ownership and decision-making power. And if I cannot trust someone on the team to make a decision, he or she really shouldn’t be on the team. I need top performers around me.

Q: How do you select the sectors for the portfolio?

The sectors with the highest expected Sharpe and Information Ratio, or IR, receive the highest allocation. That is not a set allocation, because when certain securities outperform and the forward-looking Sharpe Ratio and IR are not attractive, we will reduce the exposure.

While we are not married to any allocation, most of the time we do have an overweight to the U.S. mortgage market. We examine where we are in the credit cycle, at what price loans are being made, and what the availability of credit is. When I say loans I mean U.S. corporate bonds. To me fixed income is just lending, where the investor is a third-party lender, not primary.

The other questions we ask ourselves are the ability to repay loans, the coming maturities over the next two 12 or 24 months, can they roll the debt over, what is the environment like, can people get mortgage loans, what are credit cards doing. When credit cards are used for buying groceries, that’s usually not a good sign. All that information is available nowadays and these are the main factors we track.

Q: Do you rely on your own internal rating system or on third-party rating agencies?

We use the ratings of Standard & Poor's, Moody's and Fitch Group as a base. Then we do re-underwriting of the credit on our own. Each analyst is capable of following between 50 to 60 securities, actually knowing them, getting on their earnings calls and meeting with the management during conferences. Basically, they have to re-underwrite every security that we buy.

Q: Could you illustrate your research process with some specific examples?

I would use the example of the subprime auto asset-backed securities. We like the asset class because, in our view, the trusts in which the assets reside are well built and protected. The sector offers great value, but also has high beta and so we’re conscious of limiting exposure to high beta sectors in the event of equity sell-offs. We often buy BBBs in this space.

One of the reasons for investing in subprime auto is that issuers typically retain the riskiest portion that would be subject to the first losses, so they continue to hold that risk and are required to build additional protection. That usually means that by the end of the first year, that portion is about 22% of the overall trust. So if 22% of the customers defaulted and the severities were 100%, we would still be insulated from those losses.

At the same time, senior debt gets amortized, so the amount of assets versus the amount of liabilities in a trust shifts, with less liabilities and the same amount of assets, which decreases the leverage ratio. When leverage comes down, we normally get an upgrade at about 12 months, where the BBB bond becomes an A bond, representing about 1 point of price appreciation. So we have an investment-grade short-term bond, which in many cases is better protected than a corporate BB or BBB, that will return Treasuries plus 250 to 300.

Nevertheless, in 2011, 2013, and 2015, during times when high yield was selling off, these BBBs exhibited a little higher beta than the U.S. corporate BBBs. So with this in mind, we limit our exposure in this area to 5% of the portfolio.

Q: How do you construct the portfolio?

Portfolio construction is driven by our risk management mentality. The primary metric that I look at is Conditional Value at Risk, or CVaR, which measures potential loss in a “worst-case” scenario, akin to the Global Financial Crisis. The most important factor in constructing a portfolio designed to provide ballast is understanding how a period of negative drawdown, especially a big one, could affect the portfolio. In these types of periods, investors count on this portfolio to be inversely correlated, so actively managing to that is crucial.

We have a dedicated risk analyst who is present at all our meetings, monitoring the portfolio versus the security and sector limits and the risk in terms of duration and sector allocation that we have established as acceptable for this portfolio.

Our maximum position sizes at individual security and the sector level are based on weight, spread duration, value at risk, tracking error and CVaR. Risks are ever changing and the portfolio has around 800 line items. The turnover ranges between 70% and 80% and that does not include rolling mortgages, credit and asset-backed securities, and cash securities.

Q: How do you define and manage risk?

Our benchmark is the Bloomberg Barclays U.S. Aggregate Bond Index and we have a fixed risk budget of about 350 basis points of tracking error to the index. In the fixed income market, you are not compensated for specific securities. You have to keep the position sizes as small as possible and you are compensated for the systemic risk at the sector level. Therefore, position sizes are very important. They have to be small to avoid any particular defaulting security to drive the portfolio returns.

We not only diversify, but we also have hard stops. When something is not working, we sell it and move on. The stop-outs are an important mechanism to control risk. Over the last two years, when the Fed was in the tightening cycle, we had a strategic short via two-year futures, because we knew that the two-year note would be the most affected. That was a duration call, which we normally do not make, but we had stop-outs in place to take any emotionality out of the process. Fixed income portfolios are plagued by unbounded risks, and the stop-outs provide a mechanism to bound that risk.

Risk management imbues our investment process and drives portfolio construction. If you look at the portfolio IR over the past 10 years, we are in the top percentile not because of what we did, but because of what we didn’t do. And what we didn’t do is bad performance in bad times.