Q: What is the mission of the fund?
The fund’s emphasis is on income with a quality positioning and a risk-averse perspective. The primary investment goal of the fund is to provide current income, while the secondary function is capital growth. As part of the Wilmington Trust family, the same people, philosophy, and process are applied to separately managed accounts.
.
Our focus is in the investment-grade space and on large, liquid deals. Though other sectors are permitted, we predominantly invest in corporate bonds, U.S. treasuries, and U.S. government agency bonds—generally around 45% is in corporates and the remainder positioned within Treasuries and agencies. The prospectus allows for up to 15% of high yield, but the fund rarely participates in that sector. When it does, they are usually cross-over names that we anticipate to migrate to investment grade.
It has a maturity range out to 10 years and its benchmark is the Barclay’s Intermediate Government Credit Index. In terms of duration the fund is traditionally plus or minus 10% of the index.
Q: Would you describe your investment process?
In fixed income it is common to apply both top-down and bottom-up perspectives. We believe this approach will ultimately create an optimal portfolio that meets our clients’ objectives.
From the top down, macro-economic analysis determines our expectations for economic growth and inflation, and is centered around Fed policy. We continually question the position along the inflation spectrum: Is the inflation environment benign? Is it a deflationary environment? Or is it an environment where the Federal Reserve has a target of 2% over an extended period, and if so, are we on track for that?
Continuing from a top-down perspective, our focus is on duration management, yield curve position, sector selection, security selection, and finally the credit evaluations of particular securities—are they accurately priced relative to expectations?
Working through the marketplace to find securities, we ask whether they are supportive of our economic outlook and our top-down view. Sectors like industrials, utilities, and finance are evaluated first, followed by their subsectors—for example, banks, brokers, and REITs. Within the municipal sector one of our greater concerns is pension obligations. Examining these liabilities relative to the issuer size and ultimately what it means for the area is part of our process. All sector views are married with our broader outlook of the economy, and together these provide the framework for the portfolio’s construction.
With issuers and sectors that are more global, the impact that a stronger dollar would have relative to their earnings is reviewed to determine their global exposure relative to their income statement. During 2015, we pared back on names in this space feeling the dollar would strengthen and their earnings would be suspect or challenged, and focused more on those issuers that are more domestic in nature.
The portfolio may be over- or underweight certain sectors, and the same is true of duration. Sometimes the greater reward is to have a little more income than the credit component, but be concentrated on a shorter end of the index. At other times the portfolio may have market weight but the duration is considerably less than the index because we have deployed floating rate corporate debt to take advantage of a change in Federal Reserve policy.
In the current environment we do not believe the Federal Reserve is going to be active—as it was in 2004 to 2006. Each credit exposure is evaluated to determine the benefits of being either floating or fixed rate. When in a rising interest rate environment, an equally important question is where are rates rising?
Our current belief is the yield curve will continue to flatten, and that flattening will present opportunities for positive excess return. A barbell approach with exposure further out on the long end has helped to position us accordingly.
Q: What is your research process and how do you look for opportunities?
Our credit analysis is independent. Obviously, credit rating agencies inform us, but it is the analysts’ independent work that leads to a security or issuer being placed on our approved list.
The team totals 10 analysts, with five on a dedicated tax-exempt research team and five on a dedicated taxable team. They follow industry fundamental trends and the companies within it, and discuss macro perspectives with company management. The analysts actually sit on the trading desk where there is a free-flowing exchange of ideas throughout the day.
Portfolio managers work closely with the analysts and meet weekly to discuss investment strategy. We review sectors and individual names, see whether they are part of the bigger picture of where we see value, and look at the general supply expected—and again, marry these to macro-economic expectations.
The portfolio managers act as the strategy team, working with credit analysts to establish a framework for how much we should have in credit and how much in non-credit relative to our economic picture. Duration, yield curve position, and sector position are the three legs of our strategy. If the general credit spread of the index is attractive, then it becomes a question of where are we relative to duration, and then where are we relative to the yield curve.
There are times when credit and credit exposure relative to the index are foremost on our minds even though current income is our primary focus. It can be necessary to forego current income when soft economic periods would ultimately lead to wider spreads like we experienced through 2015.
When evaluating particular issuers we look for those with a complete yield curve and where points along that yield curve are attainable and reflect the better credit picture of that issuer. If a new issue comes to market and it is only a five-year deal, we would not be very interested—a supply/demand imbalance can lead to price distortions when the full credit exposure is not available. The fact that our focus is on large, readily available liquid issues lends itself well to the purpose of the fund.
Q: Could you give a specific example?
In 2015, a tremendous amount of issuance came to market and is expected to continue in 2016 due to mergers and acquisitions, and to pay for shareholder-friendly activities like buybacks and dividends. Issuers within that space that are congruent with our top-down economic outlook are attractive to us.
One such issuer is Anheuser Busch Inbev SA. Recently the brewer accessed the market to pay for the SABMiller plc acquisition. It was a very large deal that had been well advertised, and was in a sector of the economy we feel will remain strong in this uncertain time. The analysts were confident with the name and its credit quality, and their work led to it being on the approve list we operate from. The price was fair, relative to expectations, and it was in line with our macro view
Q: What is your portfolio construction process?
The portfolio is constructed using sector analysis supported by fundamental research, and combined with duration management and yield curve positioning. These focus together to achieve the fund’s primary objective of income, which is the larger component driving the total rate of return.
Duration is plus or minus 10% of the index. In addition to providing duration that is almost equal to the index, our yield to worst is trading around 12 basis points greater than the index. Obviously, we overweighted our credit exposure to drive additional income.
Looking at credit in terms of its respective sectors, the index itself is roughly 38% and the portfolio is at 47%. Interestingly, given our concerns with credit spread and credit widening, we are underweight in our contribution to duration while getting duration from Treasuries and agencies. So as spreads widen in this challenging environment, we are protecting some principal with lower duration, but still benefiting from the flattening of the yield curve.
Credit quality is also very important. On a blended level we want to maintain AA rated and the credit quality of the portfolio is Aa3.
The financial sector is one we have felt most comfortable with and where we have the greatest overweight. It has benefited from all the regulations that have come to market. While other sectors have been able to leverage up their balance sheets, take advantage of low interest rate issues, participate in M&A activity, return capital to shareholders—all at the expense of the debt holder—financial institutions have not been allowed to do that to as great a degree in the current environment. But they have taken advantage of low interest rates to enhance shareholder activity.
Q: How do you define and manage risk?
Risk can be measured or interpreted in a number of ways. Foremost, we look at risk relative to the benchmark—are we taking on risks not associated with the benchmark because this portfolio is constructed with a particular client in mind? Also, the portfolio, its compliance, and the trading platform are continuously monitored for risk. Within the trading platform, the investment policy statement is embedded, and pre- and post-trade analysis is completely done, so securities are not allocated to the portfolio that are prohibited.
When evaluating risk, we consider the duration, exposure, and liquidity levels, as well as interest rate risk. Duration is managed by continuously being plus or minus 10% of the index—those are our outer bands—though most often we trade within plus or minus 5%.
Duration has been key in this extended period of low interest rates, because if you get duration wrong, you do not have enough income to compensate for it. As a result, we have been fairly tight in our interest rate exposure. But as interest rates move higher, our inclination would be to shorten duration relative to the index, even though there is very little income being generated that would offset that change in principal value.
In terms of sectors, having securities that are liquid in nature is critical in an environment where brokers and intermediaries have been challenged by capital restrictions and market liquidity. There is a need to be able to transact at prices that are relevant to the market and focusing on larger liquid deals provides us a greater opportunity to execute at those levels.
