Q: What is the history of the fund?
The fund traces its roots back to 1998 and has had a corporate bond specific portfolio for a while. When the portfolio was launched, the firm managed about $2 billion of corporate bond assets. Since 1998, this fund has grown to about $1.2 billion in assets under management (AUM; as of 11/30/15) by itself, so the firm has seen significant growth in fixed-income assets and the corporate bond fund specifically.
Primarily, the fund has been investment grade, at 20% maximum for high yield. However, over the last five years the maximum exposure to foreign-based issuers has increased from 25% to 40%. That reflects the changing dynamics in the investment grade (IG) investable universe.
Q: What are the underlying principles of your investment philosophy?
Generating predictable and consistent excess return relative to the benchmark in both capital appreciation and earning income is the primary objective of the fund. Our philosophy is based on the belief that individual security selection is the main driver that produces these consistent excess returns. We look for inefficiencies within the credit markets and exploit them through bottom-up, fundamental credit research: building financial models for specific issuers and analyzing the balance sheet and free cash flow derivation of each.
Q: What is your investment strategy?
The fixed-income team’s investment strategy at Delaware Investments begins with our proprietary, bottom-up, fundamental research that emphasizes security-specific risk over sector allocation. Idea generation comes from a team that includes all investment professionals in trading, research, and portfolio management—there is no monopoly on where investment ideas come from. Regarding corporate credit risk, we seek to identify bonds that are mispriced by the market and thus offer attractive yields and/or capital appreciation. For example, a research analyst might identify a name that looks cheap, on a relative value basis, to a sector or when compared to an existing issuer in the same sector. Or our trading desk may identify technical conditions where an issue or specific point on the credit curve may be more in demand from counterparties, creating opportunities.
Next comes our proprietary research, which involves financial statement analysis on current financials and trends. We also try to project over a reasonable period to assess how a company’s fundamentals will perform over time. The capital structure of these various issuers and the strength of their management teams are also very important—especially for investment grade companies. Sometimes the biggest risk is what management can do to a company.
Our research analysts cover the entire credit spectrum from AAA to CCC ratings. Once analysts do the fundamental work, they classify a security into one of four objectives. If a security cannot be classified in one of these categories, the particular issuer will not get into the portfolio.
The four objectives determine the size of the position, the holding period, and whether the return expectations target excess income or capital appreciation. For example, we would take a large position in a security classified as a core, as big as 2% (our largest exposure). A security classified as opportunistic would be among our smallest holdings in terms of exposure, and with our shortest holding period, with 25 to 50 basis points as parameters. This allows us to construct diversified portfolios.
We develop our investment opportunity set by applying fundamental research to the security selection phase of our process. We want to find where the relative value lies within that opportunity set, examine the different relationships within a capital structure and credit curve, and then ascertain the optimal spread per unit of risk. As previously noted, our investment process is focused on the free flow of information and ideas among the research, trading and portfolio management teams, which is key to portfolio construction.
Although we are a bottom-up manager, we remain macro aware. We take a high-level view on the economic growth in the U.S., the direction of interest rates, what the Fed is doing, and global growth.
Q: Would you illustrate your research process with a few examples?
The analyst begins by digging into financial statements, getting to know a company’s capital levels, understanding its multiple business cycles, assessing the management team, and determining whether management prioritizes both bondholders and shareholders in a balanced approach.
A good example is JPMorgan Chase & Co., a core holding that has been in our portfolios a long time. It is one of our largest holdings in the senior unsecured level of capital structure. We also added subordinate debt and hybrids sized suitably for the market’s liquidity. So, although JPMorgan is a large issuer with a lot of exposure in the portfolio, we may own three different particular securities to make sure we get the optimal value. We size it to optimize trading liquidity because liquidity has gone down in the market since the financial crisis. This has happened not only with the biggest and best names, but also on an individual security basis.
On the flip side is the energy sector, where there has been significant fundamental deterioration. We reduced our energy sector exposure at the beginning of the year to select issuers in the independent and midstream subsectors of energy. These were relatively defensive subsectors with good underlying names. Though we made a large bet on the absolute price of oil, we believed capital expenditure cuts would lead to a prolonged downturn with some type of U-shaped recovery by the end of the year. That kind of recovery would benefit issuers in the independent exploration & production and midstream sectors.
We continue to reduce exposure on the independent E&P side. From a fundamental perspective it is a moving target, despite the fact that spreads continue to widen and look “optically” cheap. In the midstream space, some issuers were not as defensive as we thought; the market focused its attention on their access to capital, and they have exposure to weaker counterparties.
Two examples are Energy Transfer Partners, L.P. and Enterprise Product Partners L.P. One stayed in the portfolio while the other has not, as its fundamental deterioration was greater than expected, and it is hard to put a value on something that continues to decline.
It is important to evaluate individual investment grade (IG) positions in a portfolio on a contribution-to-spread duration basis rather than on market-value terms as the first measure more accurately depicts the impact of moves in the underlying risk premiums (spreads) of issues relative to a benchmark.
However, we continue to closely monitor the fund’s energy exposure in the face of deteriorating fundamentals, which may not be fully reflected in valuations, including negative trading technicals related to increased Fallen Angel volumes. There are names that have done a good job navigating the low-price environment and have appropriate cost structures, so we believe these are still viable investments, especially in the front end of the credit curve. However, on a contribution-to-spread duration basis, we maintain a considerable underweight to the sector.
In the banking sector, Bank of America Corp and Morgan Stanley are good examples. These two improving credits remain undervalued by the market, and they continue to do the right thing both from regulatory and bondholder perspectives. We have involvement at the bottom part of their capital structures to both subordinated debt and hybrids. Given the market’s supply dynamics, there were opportunities to add to our exposures. In the new issue market we got considerable concessions and own the on-the-run bonds.
Q: How do you construct your portfolio?
To a certain extent, fundamental research is the cornerstone of the portfolio construction process and our analysts classify securities based on four objectives: core holdings, expected rating upgrades, undervalued bonds, and opportunistic. These objectives have sizing parameters that allow us to build appropriately diversified portfolios.
Although there are no hard limits, the sizing parameters for core holdings would be a 2% position; for a rating upgrade or an undervalued between 0.5% and 1%; and opportunistic probably 25–30 basis points. We also consider contribution to duration — a 2% position in a 30-year bond is a big exposure. And in this environment, it is very important to remain cognizant of the underlying liquidity in the market for an issuer or a security. A senior bond has better liquidity than a preferred or hybrid and sizing should take that into account. We also build portfolios with cash-based bonds, compared to some of our larger competitors who rely on derivatives to gain credit exposure.
These objectives and parameters generate our opportunity set. The portfolio manager and the traders on the team synthesize these recommendations and come up with an optimal portfolio from both a curve and a capital structure perspective. Relative value is always a very important consideration.
Our approach typically generates more than 100 names in an IG-only mandate. Right now the portfolio has about 185 names.
The portfolio’s benchmark is the Barclays U.S. Corporate Investment Grade Index, but we are not index huggers. Performance is generated by security selection rather than large deviations in terms of duration from a specific benchmark; the fund is benchmark aware, but not owned or dictated by its benchmark. As a result, sector allocations and over/underweights are a by-product of our bottom-up process.
Q: What is the reason for investing in foreign issuers?
The U.S. dollar bond market is the deepest bond market there is. It continues to pull foreign issuers into the market in a dollar-based perspective, so we believe there are opportunities there. But investing in foreign issuers is really a byproduct of this market, a market that has grown significantly since the credit crisis and even since 2000 in terms of attracting foreign issuers.
We want a sense of a country’s macro view to make sure there is positive growth, and to understand its regulatory environment. No matter how good a company is its earnings will be under pressure if there is significant economic contraction.
A sovereign analyst (or team) helps us get a sense of the backdrop in a country in which we are investing. This can be especially important in quasi-sovereigns, to make sure the government is solvent enough to support a particular entity. Examples of this are Petróleos Mexicanos (Pemex), the Mexican state-owned petroleum company, and Petróleo Brasileiro S.A. Petrobras, a semi-public Brazilian multinational energy corporation. They may trade differently depending on concerns with Mexico versus Brazil.
Next, a corporate analyst will look at individual foreign issuers. In many cases, he or she can apply much of the same discipline used to evaluate U.S. opportunities. In telecom, for instance, the analyst will assess companies not only in the U.S., but also in Europe, the Caribbean, and elsewhere.
Q: How do you define risk? How do you mitigate or control it?
We look at risk in a multitude of layers. With fixed income, risk control is important in sizing positions. Unless we adequately risk manage the portfolio, bondholders get a small bit of capital appreciation and income. If we make a mistake, they get a lot less back in terms of principal. So it is a very asymmetric risk-return profile.
Credit risk of course is the largest risk faced within a fixed-income portfolio. We mitigate this through our bottom-up, fundamental research and security selection process. Liquidity risk is another factor that needs to be considered when investing in the credit market. We focus on building truly liquid, cash-based portfolios and have avoided bonds that do not fit our liquidity criteria. Sometimes this risk is a result of deteriorating market conditions and entirely impossible to protect against, although for the most part we have been able to exit positions when needed, at wider bid/ask levels.
Our proprietary fixed-income risk management system gives us portfolio analytics and attribution and allows us to see a portfolio’s different risk parameters even before it is constructed.
Daily attribution shows whether the portfolio is performing as expected, and that translates into monthly attribution. We see how we are positioned, making sure there is not too much risk at individual security or sector levels.
Next, it is important to examine the total portfolio in terms of quality, overall duration, how duration deviates from the benchmark, where it is on the U.S. Treasury and credit curves, and how it is positioned from a spread perspective — whether there is more spread duration than the index and whether that is appropriate in a particular market environment.
If there is too much exposure to one bucket on the credit curve we might use futures to reduce interest rate risk. So if the curve really shifts, we capture the credit spread tightening or the income opportunity there, but not necessarily the changing Treasury curve.
Risk management is an important part of our process. In addition to our proprietary systems, analysts provide updates on issuers during daily credit meetings. Bi-weekly performance meetings and macro meetings help us understand what is performing and what is not, and how the daily news might impact various holdings. We keep an eye out for fundamental deterioration and event risk, and watch the credit curve and our curve exposure. This year, with spread widening, a lot of supply, and significant weakness in high yield, in order to perform we have had to avoid these situations.
Q: How do you view interest rate risk?
The credit market is inefficient with respect to credit risk, but that inefficiency can be captured with fundamental bottom-up research. Interest rate movements are more technical, especially as the Quantitative Easing phase of the economy ends; trying to make a directional investment on where they are headed in the near term is not something we do. We look at rates on a year-over-year basis.
Taking spread duration deviations against the index is something we are comfortable with because our bonds either offer superior yield per unit of duration, or offer superior spread tightening versus the index. Pure interest rate duration is something to be controlled. It is not a large driver of alpha or additional return—75% of the fund’s performance is derived from security selection, so controlling those risks is important. We try to keep the overall duration of the portfolio within a half year of the index to mitigate any interest rate risk and allow our fundamental security selection process to generate the vast majority of alpha.
