Q: How has the fund evolved in recent years?
The fund was launched in 1992 to extend investments into corporate bonds, government-structured products, and mortgages. The firm had begun around municipal bond funds and established a limited-term government fund in 1987. Today, the fund is team managed by Jason Brady, Jeff Klingelhofer, and me.
Over time, we have adhered to the general operating methods, processes, and philosophy of the company which for high quality fixed income includes following a laddered maturity approach. The only real change during the last five years is the addition of more international exposure. However, we buy all U.S. dollar debt for this fund.
Q: What core principles guide your investment philosophy?
Fundamental bottom-up analysis helps identify favorable risk-reward and income-generating opportunities, but we do not ignore the macro view. In the corporate bond market it is particularly important to pay attention to what’s going on with the economy, interest rates here and abroad, and even exchange rates because companies obviously buy and sell across borders.
Overall, our philosophy is to be flexible, to go where value is within the confines of our mandate, and to take risk when paid appropriately.
Q: How do you implement your investment strategy?
In our space many funds are defined as core or core plus. This typically means they follow a benchmark, quite often the Barclays Capital Aggregate Bond Index, plus or minus a percentage relative to that. We are benchmark agnostic.
The fund’s investment universe is anything within the U.S. dollar investment-grade bond universe. Security selection and ultimate exposures change over time based on where the best value can be found. Providing shareholders with an income stream is important, but the portfolio is not managed to a given yield number.
For instance, when investing in corporate bonds, agency-mortgage backed, or asset-backed securities we decide where the best relative value is, then dial up or dial down asset allocation. Our focus lies within the intermediate portion of the yield curve (0-10 years) as we have found that straying longer than this introduces excess volatility without the necessary incremental return. Additionally, we generally tend to find a more attractive opportunity set within credit products—both corporate bonds and asset-backed—that are more credit oriented than the typical governments and agencies.
In 2014 and 2015, we stepped back risk because there was not a lot of value in investment-grade corporate bonds. As some of the markets sold off, we began redeploying money into riskier situations (though still high quality) because the rewards were worth it.
In 2015, when the 10-year U.S. Treasury bond yield curve crossed 2.3-2.35%, it became a more attractive purchase. But when yield dropped to around 2%, the risk no longer made sense, so we exited.
Q: What is your investment process?
It begins with the core belief that good fundamental analysis uncovers good value propositions. Also, because the returns and structure in fixed income are very asymmetric, it is necessary to avoid big mistakes, and fundamental analysis is key to doing this.
Every situation is approached bottom-up. Obviously in corporate bonds there are specific metrics we compare when looking at individual names and different industries and geographies.
A primary goal is to manage the volatility of our net asset value (NAV) and shareholder experience. There is only so much risk—credit or otherwise—that we want to accept, so we stay in the investment grade space and utilize a 10-yr maturity ladder
We can’t buy high yield, thus at the time of purchase everything must be investment grade. The fund is also limited in the amount of sub A-rated debt it can take on; with only 35% in BBBs and rated below allowed. If something falls below investment grade it does not trigger an immediate sell. Instead we can hold and make a more thoughtful decision.
Q: Would you describe the critical steps of your research process?
The eight-person research team is flexible, generalist in nature, and not just working in isolation in single areas of the market.
There is some specialization, with several people who focus on corporate bonds, others on asset backed. At the same time, everyone tries to understand all the stories; the asset-backed folks look at corporate bonds and vice versa. The underlying assets are often the same, but the way they are packaged may be different. By having this cross-fertilization of ideas and robust discussions, the team ultimately identifies and selects the best risk-reward outcomes.
Some important metrics in evaluating a company include how levered it is, cash flow relative to debt service cost, the inherent nature of the business, market position, and how well it can withstand changes in the marketplace. Is the business highly cyclical? Will the metrics change significantly as the economy gets weak, or is it counter-cyclical?
Though it is hard to judge whether management is good or bad we do look at past actions that affect bondholders. Have they balanced the needs of shareholders, whether private equity owners, public or private with debt holders, or banks?
Searching for ideas takes up lot of our day. We see where things are trading, where pockets of value are, and may focus on a specific bond or group of bonds. Also, new issues are monitored daily and there are times when participating in them represents better value than secondary issues. Sometimes ideas come from external sources such as reports by sell-side brokers/analysts or from talking to people on the buy side. But buy and sell decisions are never based on somebody else’s work, and every analyst is encouraged to think about how his or her ideas can be put together in the overall portfolio.
Q: Could you cite examples that illustrate your research process?
The energy sector has been pretty weak, and in looking at opportunities there, we became interested in pipeline companies. They have long-term contracts with large counterparties so revenue, cash flows, interest coverage, and leverage are somewhat more predictable than those purely in Exploration & Production (E&P).
One name we liked was Williams Partners L.P., a company that owns, operates, and acquires a portfolio of energy pipeline assets. Its business was challenged and its securities had been beaten up, but we already understood its business and decided to take a deeper dive into the company’s fundamentals.
First came an examination of its overall level of indebtedness, the maturity cycle, and how much cash it would need in the short run to meet obligations. Next we focused on its actual assets, determined their worth, whether they have well-defined contracts, and the contracts’ length relative to that of the securities we want to buy. Its assets were very good and the contracts well structured, giving us enough confidence around the cash flows to conclude it would be able to service its debt and ultimately pay us back.
With Williams, the 500–600 basis points of spread over respective Treasury appeared to us to offer a lot of compensation. This came with a lot of risk, but we thought it appropriate at the time and added Williams to the portfolio.
Another example comes from the new issue market, namely Black Hills Corp, a diversified energy company utility company. It wanted to finance the acquisition of a business we liked, and in addition, we liked the mix of assets Black Hills already had. These included a lot of regulated utility activities and some non-regulated businesses.
We were looking at a three-year piece of paper and felt the utility industry would not change significantly during that period, even with more solar and wind investment. Black Hills had some riskier exposure in coal mining, but that was a small portion of its overall business. Also, its contracts for merchant power extended beyond the maturity date of the bond we were considering. While leverage was high, there was sufficient cash flow to service debt over our timeframe, making it a fundamentally interesting investment.
Black Hills is a work in progress. It is important to get both fundamental analysis and valuation right. We have been disciplined around pricing (i.e. spread levels) and if it gets expensive, we don’t participate.
Q: How do you construct the portfolio? What role does diversification play in your process?
The portfolio has a couple hundred issuers with around 500 CUSIPs. Presently, 60% is corporate bonds of all types. The rest is a mix of asset-backed securities including agency-backed mortgages, non-agency mortgages, private issue asset-backed securities and government paper—Treasuries and export/import bank-backed paper. About 20% is international names. A large portfolio position is 1% and many positions are between 0.5% and 0.75%. Our largest exposure is just over 1%; it is in bonds issued by GE and GE related entities.
Being cognizant of where risks are concentrating is as critical to portfolio construction as bottom-up fundamental analysis is. A daily risk report shows us exactly where our bonds are and what kind of exposures we have. Technology like this helps us monitor risk on a real-time basis, make adjustments as needed, and maintain a well-diversified portfolio.
The bottom-up process informs us of what is going on in the financial markets and where economic trends are happening. Though we pay attention to data releases that affect U.S. interest rates, we do not take significant timing bets on rate movements. Our thought process focuses on years, not months and quarters. This approach builds discipline into the portfolio and the amount of turnover created. We have no desire to trade just to create turnover. Though it changes from year to year, turnover remains around 30%. In a low-yielding and low-opportunity environment, it is preferable to hold cash than make bad investments.
Q: What is your sell discipline?
First and foremost, if a security is deteriorating fundamentally and our investment thesis no longer holds, we sell it. Sometimes a combination of pricing and weakening fundamentals leads us to sell. Lastly, when there is a valuation risk—when we see a great business but unfortunately the market does too—it presents a different kind of risk. It may become too rich and we will sell. In such situations we are better just to hold cash than something that is not valued appropriately.
Q: What is your definition of risk and how do you mitigate or control it?
The safety of principal and the day-to-day volatility in the NAV are paramount. They inform how we think about position sizes, types of exposures to riskier names, sectors, asset classes, and portfolio construction. To us, position sizing is very important both in terms of exposure to a specific market segment and to a specific name or opportunity.
Fixed income faces credit risk, interest rate risk, and liquidity risk. We use fundamental analysis and diversification to limit credit risk. A laddered portfolio—in which we constantly have bonds maturing—mitigates interest rate, or duration, risk. As bonds mature, we can reinvest that cash flow at the most appropriate place along the 10-year yield curve. This regular reinvestment process is conceptually like dollar cost averaging.
To manage liquidity risk the portfolio holds differing amounts of cash; right now it has more than is usual in case we get a redemption environment. Also, we know the hierarchy of our liquid investments—starting with U.S. treasuries, some of the agency mortgages and other government securities, and highly rated corporate bonds. We are extremely cognizant of the percentage of each type of investment and how quickly they can be turned into cash.
