Q:  Would you provide a brief overview of the Morgan Stanley Global Fixed Income Opportunities Fund? A : The Morgan Stanley Investment Management Global Fixed Income Group has worldwide focus, and our investment expertise ranges from sovereign bonds and emerging markets, to government agency bonds, asset-backed and convertible securities, and corporate bonds. Our investment teams in Tokyo, London and New York search and evaluate various investment opportunities, and we invest in diverse products, including interest rate and currency products, credit products, derivatives and commodities-related securities. As Chief Investment Officer of the Global Fixed Income Group, I oversee all fixed income strategies. Q:  What investment beliefs drive your philosophy? A : We have built the investment philosophy for the Morgan Stanley Global Fixed Income Opportunities Fund around several fundamental points of view. First, we strongly believe in mean reversion and that undervalued fixed income securities appreciate to their fair value. We consider ourselves value investors, meaning that we seek to maintain a diversified portfolio of bonds trading below their intrinsic value. Second, we have a disciplined sell process. When bonds become fully valued we undertake a rigorous review of the fundamentals. If fundamentals have not changed, we will likely sell the bond. As part of this philosophy, asset allocation is just as important as picking the right security and following a disciplined approach to investing. Divergences in returns between sectors can be dramatic. Applying a top-down macro approach to sector selection complements quite nicely our bottom-up process of attempting to find the most attractive bonds within a sector. For example, we have identified certain investment environments that typically benefit corporate debt. We use this analysis to decide our total credit exposure, and then our credit team will work to try to find the best bonds to meet our asset allocation targets. In addition, we are convinced that generating positive returns over a medium-term horizon in our funds is more important than just beating the benchmarks. The philosophy behind this fund – rather than to think solely in benchmark terms – is to be opportunistic and give higher priority to absolute return investing and bonds that have attractive returns. Our viewpoint drives us to seek out better investments among various bonds while managing downside risk. Since the onset of the financial crisis in 2008, yields have fallen to very low levels. This has created an investment dilemma for clients who want to earn a certain income from their fixed income portfolio but are getting less now than they were several years ago. We want to help investors sort out this problem. Q:  What is your investment process? A : In many ways it is quite simple: buy undervalued bonds and sell overvalued ones. The challenge is doing the analysis to identify in which camp a bond falls. We have investment teams of specialists who focus on government, emerging market and corporate bonds. Analyzing bonds in their individual areas, the members of the different teams develop domain knowledge that helps them select bonds they believe offer a better risk reward profile. For example, the mortgage research team analyzes agency and non-agency mortgage securities, asset-backed securities and commercial mortgage-backed securities among many other varieties. They have a deep understanding of historic behaviors of the asset class, and their analysis includes both top-down and bottom-up views to find sectors, asset classes and individual bonds that meet our investment criteria. Another example is our emerging market team that analyzes specific countries and the global economic and demographic trends driving these economies. The team reviews bonds using a subjective analysis of the individual country and of its prospects on the economic and political front. The team also employs a strong set of proprietary quantitative models that consider inflation, growth and other variables that go into measuring and identifying fair value for government bonds. Their expertise helps the entire group in understanding the relative merits of different regions across the world. Additionally, we have a team of professionals who focus on macroeconomic developments to guide us in our thinking on whether and how much interest rate risk we should take. What is more, their analysis seeks to identify which part of the yield curve, country or currencies to invest in or which currencies to avoid. Each individual research team analyzes specific sectors and securities, and our investment process relies on the research ideas generated by this analysis. That said, our investment strategy is highly dependent on buying into multiple sectors of the fixed income universe – from mortgages to corporate credit and interest rates – so our ability to put this all together is critical in determining our final success. To that end, we have a highly structured approach that facilitates continuous interaction between the teams and relies on a collective decision making process. We have a formal asset allocation meeting regularly to discuss cross sector opportunities as well as to decide on aggregate risk targets for the entire portfolio. All investment team leaders participate in this discussion. Throughout, the fund relies on proprietary models to analyze yield curves and movements in currencies. We also have credit models that provide assistance with fair value spreads. A very important aspect of our investment process is that we have a strict discipline and we adhere to it. Q:  Could you give a couple of examples to better illustrate your research process? A : One of our specialist teams focuses on corporate credit. Our belief is that there should be one single credit research effort. We think that individual analysts that cover both investment grade and non-investment grade companies are best positioned to understand the dynamics of that particular sector. They need to know the competitive positions of all companies in their sector – investment grade and non-investment grade. A good example of this is our team’s coverage of financials, where we tend to be overweight in bonds issued by banks. The reason is straightforward. We looked at the valuation of these companies and came to the conclusion that they were further away from fair value than our models suggested, especially relative to risk, and more undervalued than other corporate securities. Our analysts work hard to understand company dynamics – profitability, levels of risk, management intentions, and prospects for banks going forward in the current competitive universe – before they come up with an assessment if a particular company is going to succeed or fail. Our overweight focuses on banks that we view are national champions. Every country needs a banking sector, at least any capitalist economy needs a well functioning banking sector to take deposits, make loans and manage the payment system. We tend to like such banks because they are viewed as indispensable. They are systematically important institutions that we believe are priced at a discount to intrinsic value. We will buy the senior debt of those banks, because they are attractively priced relative to the set of fundamentals, even though banks have been under a lot of stress in the past couple of years due to all the dislocations in the economy and financial markets. Despite seeing that profitability has been hurt in many institutions, we know that, in many cases, a large number of these banks have very good business models in their respective countries and, as national champions, they will likely be supported by their respective governments, come what may. Moreover, due to the financial crisis and a strong desire on the part of regulators to reduce systemic risk emanating from the banking sector, governments require (and will continue to require) banks to hold more capital over time. As a result, banks could become less risky entities. Consequently, we have more confidence that we will get repaid. Q:  How do you build your portfolio? A : We have a diversified portfolio not only across sectors in the fixed income market but across currencies as well. It is a combination of government bonds in both the developed and emerging market world and high yielding corporate bonds and non-agency mortgages. The majority of assets are in U.S. dollars, but there are assets in other currencies too. Bonds are looked at both from a relative yield and absolute yield perspective. What this means is that just because a non-government bond has a high (by historical terms) spread does not mean it will be included in the portfolio. Its actual yield is just as important as its risk-intensifying or risk-reducing properties. Although we use the Barclays Capital Global Aggregate Index as the benchmark for this fund, we are not focused on the index as much as we are focused on generating attractive returns over an economic cycle. The index reflects our desire to look globally for investment opportunities and not to constrain ourselves to a particular geography. If a particular security no longer has attractive features and we struggle to find alternatives, we have no problem going to cash and waiting for an opportunity with an attractive return profile to come along. Q:  How do you do your asset allocation? A : Our fund aims to achieve attractive medium-term returns by being in what we believe to be the best sectors of the fixed income market and avoiding overvalued, low yielding sectors. The way we do that is by coming up with expected returns for each sector. For instance, while government interest rates tend to have very quick mean reversion properties, currencies tend to have very long mean reversion properties. In this way, just because a currency is undervalued does not mean that we will be eager to invest, because it could take three years or more for that valuation gap to close. For this reason the process by which valuation gaps are closed is incorporated into the expected return of a security, let us say, for the next 12 months. Each specialist team has several sector leaders, and these individuals will come up with their expectations and analysis of how attractive each sector is in terms of expected return. Then, the investment team as a whole will have a debate where each team will talk about the pros and cons of their particular sector or how far their sector is deviating from fair value. Again, we may impose certain diversification limits because we do not want to stick to one sector just because it is cheaper than the rest. We have a normal range for each sector and we will purchase each sector away from that average depending upon how cheap it is. Our absolute return focus also puts an emphasis on medium-term fundamentals and on avoiding expensive bonds like U.S. Treasuries. We seek to make a targeted rate of return through good security, sector, and country selection and by sticking with the selections as long as we think the fundamentals justify those positions. Our robust decision making is an integral part of our investment process, and that helps us in refining the fund’s expected returns and the risks being taken. Furthermore, the strict sell discipline behind our investment process dictates when we should sell. Each sector leader is expected to come up with sell ideas whenever their sector has done well so that the fund can take profits. Q:  Which risks do you focus on and how do you contain them in the portfolio? A : The future remains difficult to predict. Our belief is that if some unforeseen event is likely to happen, the best defense is diversification. Additionally, we conscientiously avoid most structured products as these tend to be excessively complicated and can lead to unpredictable results. Generally, we feel the only way to protect against the possible outcome of complicated interactions is to avoid investing in those kinds of securities. That said, the one complicated sector we do invest in is mortgage-backed securities. We feel we can analyze the fundamental risks in both agency and non-agency MBS, and the potential rewards merit the added complexity. We manage risk by trying to understand the security and how it is going to behave in different scenarios. We seek to establish a high degree of clarity in terms of what these risks are. We believe in constant stress testing and in remaining open to all kinds of eventual outcomes without taking anything for granted. Moreover, we also apply scenario analysis and stress tests to the entire portfolio to make sure we know where our risks are coming from and how diversified they are. In recent years, there has been a lot of noise coming from global macro risks, whether it is from policy, sovereign debt issues or natural disasters. We keep close tabs on whether or not markets are in a “risk on” or “risk off” mode. This helps us mitigate risk as well as helping us take advantage of when we feel bonds have been unfairly penalized or boosted by events outside of the normal risk parameters for that bond Finally, the core of our investment philosophy – our strong belief in mean reversion and our inclination to buy undervalued assets and get out of overvalued assets – is a good risk control measure.