Q: What is the history of the company and the fund? A: Standish has been managing fixed income portfolios for institutional investors since 1933 and is now a wholly-owned subsidiary of BNY Mellon. Our investment strategies span a wide range of fixed income disciplines, sectors and securities around the world. Standish Mellon Asset Management Company LLC manages approximately $104 billion of assets and provides investment management services across various fixed income asset classes including investment and high yield corporate credit, local and U.S. dollar-denominated emerging markets debt, and opportunistic U.S. and global strategies. I have been with Standish for 24 years. I managed the trading desk from 1997 to 2008. I was promoted to Deputy CIO and was in charge of our absolute return strategies. We had already been managing funds that invest in fixed income securities that are expected to increase in values and then in late 2008 a client came asked us what we could do to take advantage of the dislocation in the marketplace. They liked what we had been doing with our sector and bond valuation and returns. We worked with them to fashion a benchmark agnostic absolute return strategy, which also allowed for full allocations into sectors that were attractive. As we moved through various market cycles including credit market dislocation in 2009, it became obvious that the correlation to any one particular sector was reasonably low. That speaks to the amount of sector rotation we are willing to do, the amount of movement we are willing to do in the duration band of zero to seven years. It has been as high as 6.8 and it has been as low as 0.5. The result was that we had something that had pretty strong risk adjusted returns, too, because it does not seem to follow the natural ebb and flow of interest rate moves, or of spread moves. Since October 2010, the fund has been investing on an opportunistic basis but the strategy had been in place since January 2009. Institutional investors began to gravitate towards the idea that sectors could be rotated more broadly than something like the core plus strategy. They also appreciated the idea that the correlations to anything, especially direction of interest rates, would be reasonably low. Q: What is the foundation of your investment philosophy? A: When we say, “Best of Standish,” there are three key elements. First, you have to have a strong top-down and a strong bottom-up investment approach; you need both. You need good strong security selection but you cannot just have a portfolio of good-looking bonds that do not work together to form the macro view. Second, a broad opportunity set is the best way to achieve, not just risky returns, but strong risk-adjusted returns. The broader the opportunity set, the more you can use the different elements of fixed income, and the more likely you can provide consistent returns. That is because you are not relying on one or two particular sectors for your returns. For example, we do not own U.S. Treasuries in any significant way at the moment, but we do own Australian and New Zealand government bonds. We also own Italian two-year bonds. Having a broad view, being able to cover all the ground, is really important from an opportunity set. Third and last, risk management. We look at it at the macro-economic level and also at the individual bond level for upside and downside. We use puts and calls on different markets that tend to be flight-to-quality markets, as a way to help mitigate the risk in case of flight to quality. Risk management is another element of the liquidity. Q: What is your investment strategy and process? A: The first thing we do is to develop a macro-economic view. We have a macro strategist, Tom Higgins, whose role is to help develop that view by drawing upon our different investments teams and researchers, especially the ones that have a macro focus. For example, the interest rate, global sovereign, currency strategy and emerging market teams all come together with Tom to help form a set of potential macro scenarios. As a firm, the leading investors of all of those different teams, and our multi-sector managers, discuss the probabilities of these views that are laid out in front of us. We have this meeting every month. We come away with that weighted probability Standish outlook. The other thing we do is review objective valuation models that compare valuations that the models generate -- for sectors like investment grade credit, or local yield in emerging market bonds - and compare those to current valuations. We get some sense from an objective standpoint of the place to start a discussion. In additions, we apply models to different scenarios - even scenarios that we apply a very low probability to - but if the team has come together and said this is possible, we assign our models to those scenarios so that we have some valuation metrics around detail. According tour models, how bad could something like high yields get in a recession? How bad would Treasuries get if inflation were at 4%? The second thing we look at as multi-sector portfolio managers is how convicted we are with our view and what sectors are most attractive, how convicted we are about risk. This uses a risk range of 3% to 7% tracking error over LIBOR (London Interbank Offered Rate.) Our convictions have gotten stronger, so our risk has gone up. Q: Can you share some examples of how you look at opportunities? A: First, we look at the valuations, then we look at fundamentals, then we look at sentiment. We think about things in terms of value, cyclical patterns, and market sentiment. For example, one sector that stands out is investment grade corporate bonds. The yield spread on these bonds to U.S. Treasuries has widened out quite a bit. The sentiment has been weak because people have been worried about Treasury volatility, but in addition, the demand by long pension funds gives us a technical backstop. We have been adding to long, investment grade corporates. We have also been adding most recently to emerging market local debt. Without having defaults it has been destroyed as the Treasury rates have sold off, much more so than Treasury rates. We had almost no position there because we were concerned about treasury rates rising and the correlation being high, but now it is to the point where it is overdone. We have a macro-structural view that emerging market countries are in a lot better fiscal shape and fiscal discipline than they were during any previous bouts of volatility, so those rates should behave reasonably well. Those are examples of taking the macro view, selecting sectors for portfolio, and then evaluating risk. The reason for the risk increase is because we have concerns about global growth, especially China being a drag. We do not think it is going to be an engine of growth but we think it has stabilized. Europe has stopped being a drag and the U.S. has begun moving forward. With that global backdrop, that scenario, we view the risk has increased and valuations have improved quite a bit over the last couple of months. Q: How do you view the world of fixed income investing and what sectors do you rotate in and out? A: When we talk about global we think in terms of region. Within our teams we have regional country analysts. We have someone in our emerging market local team who is dedicated to Asia and to Latin America, and to Eastern Europe. In our global sovereign team, we have people focused on Western Europe and developed Asia. The idea is, as a benchmark, to outperform by 300 to 500 basis points over LIBOR, but the reality is that there are certain environments where things are much more attractive than in others. Having consistent returns is very different from having strong risk-adjusted returns. The fund seeks to maximize total return through capital appreciation and income. Because we have a strong downside protection element, the result of that is good risk-adjusted returns. You can usually achieve good returns by maximizing risk but the reality is if you are just focused on maximizing all of the time regardless of the market volatility and environment, you are not going to be able to manage the downside very well. That is why we rotate sectors aggressively and also scale duration up and down depending on our conviction regarding market outlook. When I talk about the duration of the portfolio, it is going to be the accumulation of all of those different sectors. Duration is not necessarily a U.S. interest rate; it is just the accumulation of all of those different sectors together. Q: What sectors did you look at closely to rotate in 2009? A: Between late 2009 and early 2010 there was a lot of value in different spread parts but one of the things that was really hard to sort through was in the structured product area; for the most part no one would touch it unless it was the AAA TARP-eligible security that the government was sponsoring. Our auto analysts identified during the credit dislocation in 2009, subprime auto loans which generally trade at LIBOR plus 500 basis points that had sold off drastically and at times they were trading at high eighties and low nineties. The fear in the market never played out and most subprime auto loan borrowers kept making payments on time unlike subprime housing borrowers. So, the market selloff in these loans offered an attractive opportunity. In fact, the payments were very steady through this financial crisis. The autos, unlike home, credit cards and other durable assets or large ticket items were much more stable. Even at the subprime level where no one wanted to get involved in the secondary market. As we rotated away from some of the extreme allocations in investment grade credit and in high yields in early 2009, which was an area that was ideal from a sector standpoint, we liked it fundamentally because it was U.S. based, we liked it from a sector level because although the sentiment was not good the value, the fundamentals, and the cyclicals were strong. By the same token, the CMBs were even tougher. While we identified that as attractive, we were more concerned about what was going to happen with real estate, especially in the commercial real estate market. Our CMBS analyst put together a list of 10 bonds he thought were reasonable and which had enough interest coverage, and which securities are likely to withstand new financial stress. We focused on several CMBs on the bottom tier which still met our risk criteria because we thought the risk reward ratio was better at the bottom end of the list. Those are examples of sectors and then drilling down to how we got to that standpoint from a macro view, but it started with the fact that we began to get comfort from the U.S. economy in mid-2009 starting with the rotation of sectors and rotating some of that into the subprime auto space and selective CMBs positions. Our macro view in 2012 was that the euro and the euro zone was not going to fall apart. In 2012, you could have bought almost anything. You could have a list of 10 countries - Italy, Spain, Portugal, etc. - but one of the things you may not realize is the difference between, for example, Ireland and Spain. Spain’s returns were actually very small that year; they were in the 3% to 5%, whereas the returns on Ireland were 27%. There was a macro view but we really had to get into the country. We focused a little bit on Ireland but another one we focused on was a smaller market, Slovakia. The reason we focused on Slovakia was because our analyst in Europe said the Slovakian economy was driven more by German factors than by peripheral European factors. Even though the debt rating of the country was likely to get downgraded from A+ to A, that may be an opportunity for entry points to own this country. The point of that discussion is that, that country was never in question as to whether it was going to be in the euro or whether it was downgraded, bank issues, etc., , it was basically a micro German-type economy with peripheral-type yields. The other key element is that Standish is not so large that it cannot take advantage of a market like Slovakia. The market is about $40 billion, it is not very large, but we can really make a difference in security selection because we have enough analysts and enough coverage to cover the globe and make detailed security analysis. We can make a difference in our security selection, take our macro view, and translate it to sector rotation and really strong security selection. Q: What is your portfolio construction process? A: One of the main things is how we look at risk. We look at it from the standpoint of both correlated risk, we use tracking error tools to do that, but we also look at individual sectors and individual securities and ask what the downside is. We have never had too much difficulty thinking about the upside because there are always opportunities. Our portfolio allocation is based more on what is the downside and are we willing to have this position. We are going to have periods where we are negative but we measure that downside in such a way that it is both on a correlated basis and on an uncorrelated basis. We also look at the possibility of a downside situation. That is not model driven at all; it is just experience. Q: How do you define and manage risk? A: Liquidity is important, not only for sector rotation, fund structure, and access to your capital, but also for risk management. For example, in 2011 we were not well positioned for the contagion that occurred in the Treasury market. In a matter of a few days we increased our Treasury position to 40% at the cash bond level. You cannot do that unless you can sell 40% of something else. We look at tracking error versus LIBOR. We look at the downside protection, especially below zero. You cannot look at downside on a once a month basis because you would never invest in anything. So we look at it over a six-month rolling monthly basis, our macro view and security level view. We look at the downside within that context. When you look at principal and protection and that zero number, you do have to guess at a sector’s downsides and then the securities. One of the ways you need to position for is maybe we are extremely short duration but we own a lot of Treasury calls. Why? Those positions are opposite. That is because the Treasury calls are a fixed cost and it protects from a very strong flight to quality. If you are very short duration and you have a very strong flight to quality, then fixed income asset classic government bonds are going to have strong positive returns, but this product would have negative returns, and of course we do not want that. So how do we fix that? One of the ways is to look at what our positioning is at a particular time. Let’s say we are going to own a lot of calls on the Treasury market. Is that opposite to having a short duration position? Not really, because it says that when interest rates rise a lot - which we think over the intermediate time they will rise a meaningful amount - when that happens, we will perform very well because the Treasury calls will have a limited downside. If we happen to have a flight to quality, we do have this position that will help offset some of the things that may not do as well. We look at it at the macro level, tracking error, experience, performance, etc. I look at it every day to make sure that the performance we are experiencing is in line with what I saw in the market and then what I thought our positioning was. That is not a model. This is what actually happens. You can take that conclusion and see whether you expected that and, therefore, it is positioned correctly. You do that every day so that when six months have elapsed and the positions you thought were going to do well actually do well, then it translates to performance. We look at it in a lot of different ways but we also look at what are the ways we can actually protect with a position that makes sense.