Q: What is the history of the fund?
The investment style of the fund has remained the same since it was launched in 1993 with the focus on bonds maturing in short terms. We use a team-based approach led by four portfolio managers, each of whom brings expertise from a fundamental credit standpoint. Should something happen to one of them the fund will maintain continuity.
In general, the fund purchases securities in a maturity band of one-to-five years. Duration is kept at two years, similar to its benchmark, the Barclays 1–3 Year Credit Index. Because this is a credit index, we focus on corporate bonds supplemented with asset-backed structured products.
The mission of all our fixed-income strategies is to deliver a consistent stream of income through securities that offer attractive risk return profiles with an average yield above the index. Though we may try to capture capital gains through undervalued bonds, capital appreciation is not a primary objective. Turnover is approximately 35% on a running basis, which is equivalent to the index. Some peers have turnover in the 100% to 150% range.
Q: How is the fund different from its peers?
Several variables differentiate our investing. First, we run the strategy against a peer credit index, while many of our peers manage against a Government/Credit or Treasury Index. Also, at the time of purchase, we buy only investment grade securities. If there is a downgrade to high yield we have the leeway to hold the security if we are comfortable with the underlying fundamentals.
Over the last five or six years, a lot of peers took active positions in either or both high yield and emerging market securities (EM). Our portfolio does not have a dedicated allocation to EM. On occasion, when our fundamental bottom up research identifies an investment-grade EM security as a potential investment option, it typically only represents a small percentage of holdings.
Another difference is our style is very much driven by fundamental research and bottom-up stock picking. Alpha comes from security selection and sector allocation rather than interest rate positioning or sector rotation. We maintain our duration in narrow band relative to the benchmark.
Q: What is your investment philosophy?
We live by three primary tenets: fundamental research, a long-term view of the marketplace, preparing for and executing on a contrarian/opportunistic bias e supported by our long-term view and research we’ve conducted. It is a cash bond approach with the goal to identify good businesses or issuers to invest in within the current market environment or ideally over multiple business cycles.
Investors should be able to understand the strategy without having to ask too many questions. They should get the exact service they would expect when buying a mutual fund. That is, the style and approach they see today is the same as what they will see in six months or twelve months or two years. We deliver that income stream for them by not moving the strategy all over, so everyone can sleep at night.
Q: How does your investment process work?
We follow a four-step process that includes idea generation, fundamental research, portfolio management and construction, and finally portfolio monitoring, feedback, and risk management.
During idea generation we leverage the expertise of the firm’s other asset classes. The team establishes an outlook for the economic cycle and how it may evolve. We look at various factors including government rates in the U.S. and Europe, the actions of central banks, age of the current economic/credit cycle, and various regulatory environments.
Relative value is assessed across the sectors we invest in to identify those offering an attractive risk-adjusted return at a given time. This allows us to narrow the broad fixed-income universe to a few specific areas where we will conduct more extensive research. As securities mature or funds come in or leave, this helps us determine where to put the incremental dollars coming into the strategy, or what to sell to fund the outflow.
Q: What is your research process?
Our research has two objectives. First, to identify issuers to invest in for the long term, though even a short-term strategy may have bonds from a certain issuer over a ten- or 15-year period. Second, when there is dysfunction in the marketplace and a contrarian opportunity presents itself, we use research to gain a solid understanding of how a sector and/or issuer should operate in a normal market environment. Is the event that is occurring a real change in fundamentals, or is it something that is more short term in nature, and thus a buying opportunity?
We then conduct fundamental research to evaluate companies in three different areas: the business, the management team, and any business, economic or regulatory risks to the company or to the industries itself.
When assessing the first component, a company’s business, we ask many questions. Does it have a moat and is it defendable? Can the business can grow, expand its margins, and take market share? What are operational efficiencies, and do they need improvement? What is the general financial strength of the business: does it have free cash flow, access to credit lines and capital markets—be it issuing equity, issuing debt, convertible debt, bank loans, any of those variables?
Though the second component, a company’s management, is joined to its business to a certain degree, we believe it can be assessed separately. In certain industries the business drives more than what the management team can, while in others the opposite is true. This often has to do with what is happening from a regulatory standpoint.
We consider whether management can execute and communicate on their mission in a believable manner. Because we are bondholders we watch whether they are good stewards of capital: do they use free cash flow in a balanced approach to meet debt obligations, keep shareholders happy, reinvest in the business, and do all the things that keep a nice balance across the company?
The third component, often the most difficult, identifies the risks to these various pieces. You can have a judgment on management and what is happening in the industry, and whether the business is built in such a fashion that it can continue to grow and take market share. But it is just as important to understand what is happening in the economic and/or regulatory environment.
If the economy is peaking there are risks to the business from the economy rolling over and potentially heading for a recession, which usually is not good for a non-discretionary company. We pay a lot of attention to what is happening with central banks and how that influences our opinion on the banking sector.
Based on our research, each of the three components will be assigned a grade from one to five, with one being the weakest and five the strongest, and we then take a flat average of the three. If the average is four or better, we usually consider that a “sleep at night” type of business. It is then up to the portfolio manager to determine if there is appropriate relative value for that business profile. Companies rated between three and four are likely to have something happening, or the business may not be as attractive from a long-term bondholder perspective. But these also tend to be the ones that present contrarian or opportunistic places within the portfolio for a shorter time period.
Q: Can you provide one or two examples that illustrate your research process?
Coming out of the financial crisis and recession in 2009, auto manufacturers were financially stressed because no one was really buying new cars. We studied the buying cycle for automobiles and the average age of automobiles in the marketplace. The pieces were aligning. The economy was improving, rates were low so financing vehicles became attractive to consumers, and we expected monthly sales would improve.
We started investing in the automotive sector, transitioning from dealerships to manufacturers to parts companies. Among manufacturers, Ford Motor Company was the one in the U.S. that did not file for bankruptcy. As ratings were improving, we watched it closely and as it transitioned from high yield to investment grade we built a position in Ford.
The management was very credible; at the time the CEO of Ford had previously held positions at Boeing Co. Between the fixed-income and equity teams we had had conversations with different levels of management at both Ford and Boeing, so we had a strong understanding of what to expect from the CEO and the people he brought in. Because we felt the economy had turned we did not foresee many risks.
At the same time, we owned two other investment grade auto manufacturers, Toyota Motor Corp and Honda Motor Co Ltd. Even in the recession their securities were attractively priced and we did not anticipate the same challenges to face them. When General Motors moved up the ratings spectrum we added its securities where appropriate as well. Today, we still own some of the manufacturers but would not necessarily reinvest in them today, because they are in the tail phase of their business cycle.
We also saw opportunity in the banking sector when the financial crisis was ending. Changing banking regulations had become favorable to bondholders. While risks to their business existed due to investments on their balance sheets, we saw sufficient support from a number of entities where the actual government was the equity holder—whether in the U.S. or Europe—and felt such government support overrode the risks.
In the past we owned securities at Lloyds Banking Group PLC, ING Groep NV (ADR), and Royal Bank of Scotland Group PLC. As those securities matured, we did not reinvest in the issuers. Today our primary focus is on U.S. banks. The U.S. economy is strong, and the risk-return profile of banks appropriately compensates investors. This is less true in Europe given what the ECB and the Bank of England are doing policy-wise.
Q: What is your portfolio construction process?
It comes down to the economic outlook, the fundamental research, and marrying these with the objective and guidelines of the strategy. We want securities we can hold to maturity and evaluate them based on whether they possess the needed characteristics, and tend to maintain an average credit quality of mid–high A, which is in line with our benchmark.
Our strategy allows up to a 5% concentration in any issuer, though we do not believe that is necessarily prudent in fixed-income. Positions are generally between 0.5% and 1.50% depending upon the issuer’s percent in the benchmark. The only sector where the concentration is waived is government securities. We could be 100% in U.S. Treasury if we deemed it appropriate, but in practicality, 20% is the maximum we have had in government-related securities.
Guidelines permit up to 25% of the portfolio can be in any one individual corporate industry—banking, materials, communications, and technology. In most cases we rarely own more than 8% or 9%, with exception of banking industry. Because that sector is 28% in our index we can never be equal weight relative to the benchmark.
In corporate bonds we generally have 80 to 100 unique issuers, and may own multiple bonds from a single issuer. We buy corporate bonds out to a five-year maturity, as they offer a more-than-adequate incremental yield for the additional two years in maturity, and because many companies issue in this space we benefit from a bit of a discount in new issues.
We also have exposure to asset-backed securities in the form of credit cards, auto loans, home equity loans, agency commercial mortgages, legacy residential mortgages, and agency corporate debt of Fannie and Freddie.
The balance between corporate bonds and structured product—which helps create rate insulation—is determined somewhat by relative value as we watch flows in and out of the strategy. Another component of the mix, given relative value and expectations of action by the Federal Reserve, is today we have approximately 20% in securities with adjustable coupons tied to LIBOR.
Factors at the macro level are important during our idea generation phase. For example, while we do not directly invest based on U.S. Treasury rates or what the shape of the yield curve will be in six to 12 months, these do influence how we evaluate sectors. Should it appear the U.S. Treasury curve is going to flatten, which is what we believe today, the banking sector becomes less attractive.
The economic cycle influences the balance between owning consumer cyclicals and consumer non-cyclicals. If we believe it has peaked and may be heading into a recession, we bias the portfolio toward non-cyclicals and away from cyclicals. If we believe the economic cycle is coming out of a bottom, like with the auto industry, we would look to add into cyclical sectors for the companies we believe have the most upside compared to peers. Typically, bond returns should follow.
For our fixed strategies there are four areas of the market we consider good bond investment sectors: utilities, which are backed by hard assets; real estate investment trusts, which own buildings and have strong bond covenants—almost high-yield bond covenants for investment grade companies; the healthcare services industry, which has positive dynamics as the population ages and with the Affordable Healthcare Act; and the energy sector specifically with pipelines.
In the pipelines, we like companies that transport oil, gas, and natural gas. There is still a lot of demand so it has to go from point A to point B—acting as a toll road. Also in energy larger multinational E&P companies have a strong asset base behind their businesses as well. Not only do they have proven reserves, but also a long history operating in $15 oil, $25 oil, $50 oil and $100 oil.
These four sectors make a good foundation for any strategy today, so we tend to overweight them relative to the benchmark.
Q: How do you define and manage risk?
Everyone on the team came up in the business as credit analysts. As we are building the portfolio—even though its guidelines may allow a certain amount of risk—we make sure to do what is prudent for the overall strategy while operating within the spirit of the guidelines.
It is a fixed-income strategy with two primary risks. One is interest rate risk, which we minimize by managing duration in a narrow band relative to the benchmark. The second is credit risk, which our core competency, fundamental bottom-up research, helps to mitigate.
Generally, per issuer percentages are capped at 1.5% so the portfolio is diversified across issuers. This helps minimize the credit risk on any one issuer. If a name is bigger in the index, as is often the case in the banking sector, we may have a larger percentage. The portfolio is also diversified across industries so if something happens in one it does not become too much of an issue for the strategy, especially relative to its benchmark.
These practices, when combined with our long-term approach, mean there is rarely a surprise regarding what has driven alpha—positive or negative—at the end of a period.
Over the last few years we upgraded our analytic systems. These systems provide detailed performance attribution, which helps support our belief and expectations that alpha is coming primarily from security selection and sector allocation, and less so from interest rate positioning.
These analytics also give us the ability to test and stress the portfolio. Based on anticipated actions by the Fed and the resulting yield curve, we can stress the portfolio and evaluate its performance based on different rate scenarios. We can scrutinize even more robust situations using the system’s built-in scenarios. If there is a Russian currency crisis, it shows how the portfolio would act based upon those factors. What if oil spikes to $100? Or there is inflation?
We formally test the portfolio quarterly against developments like these, across all strategies. Given our low turnover, a quarterly measure is appropriate. Its output is one factor that gives us a contribution to risk for the portfolio. What we find is really no surprise; it is balanced between what is delivering positive alpha and what is contributing negative alpha. As we build the portfolio we actively manage risk, and the quarterly feedback ensures the portfolio remains in alignment with expectations.
