Q: How has the fund evolved since inception?
The fund, which was quite small, was struggling when we inherited it in December 2008, following the credit crisis, having been down as much as 38% that year, so much so that the existing portfolio manager left Henderson. We were running a similar, larger fund in the U.K. that had weathered the crisis better. It’s taken us a long time to repair the track record after such a bad year, but about two years ago we began to see growth, and today the fund stands at just under $460 million, up from about $50 million when we took over.
The fund markedly differs from its peer group in the World Bond category, but we have no emerging market exposure and hedge our currency exposure back to U.S. dollars. We focus primarily on the U.K., European, and U.S. markets. We do global bonds, but only in the developed market space, never in emerging markets.
In the prospectus we list LIBOR, the London Interbank Offer Rate, as a benchmark but it is a bit meaningless, and we don’t pay attention to indexes.
Because we are a relatively small fund, and have only operated it since 2008, we are not very well known in the U.S. Our style is better suited to managing bear markets than bull markets. We are much better known for this style of fund management in the U.K., where our track record dates back to 2003, revealing how we perform in a bear market.
Q: What is your investment philosophy?
We want income to drive return, the traditional bond approach, especially when looking for sensible income, primarily through corporate bond investing, albeit with a duration overlay. We define ourselves less by what we do than by what we do not do. There are many industries and companies that we would never lend money to, at any point in the cycle. We have no commodity exposure, no chemical exposure, and no retail exposure beyond food retailers.
A lot of our time is spent saying no to offerings, because we seek sensible income to drive returns over the long term, and so we allocate assets to different points in the economic cycle. We typically prefer higher quality high yield to investment grade or government bonds, unless we need to be more defensive.
Our clients want a bond fund that behaves like a traditional bond fund—no excessive volatility—and, over time, provides an attractive income stream.
Q: Would you describe your investment strategy?
We are unconstrained, enabling us to invest in loans or bonds, and occasionally preferred shares. There is a whole range of assets we can invest in, but all investment choices are driven by our investment philosophy.
We largely prefer large cap, non-cyclical defensive companies where we can reliably predict cash flow, and we have an aggressive sell discipline if things go wrong. We are quick to get out of bonds, if need be.
However, we are not one of these unconstrained over-engineered bond funds attempting to generate returns through complex curve, derivative, and relative value trades. We simply seek long-term reliable bonds we hope we never have to sell that deliver a decent income.
Q: How do you develop your macro view and asset allocation?
We begin with a top-down worldview. Interest rates affect the fund’s duration, whether we favor high yield or investment grade. Since 2012, we have not been meaningfully short duration, and that top-down worldview, where we thought sovereign bond yields would pay low or drop even lower, is a function of our having read a defining book by Japanese economist Richard Koo four years ago. It influenced our worldview and we have rarely been short duration since.
Set in Europe, we look more globally than the average U.S.-focused manager who might concentrate on U.S. unemployment and payroll data. Here, we get a clear perspective on the structural features that weigh down growth, such as inflation, demographics, politics, and productivity.
While our top-down worldview drives duration, it also colors whether we favor investment grade versus high yield. When we inherited the fund, it was heavy in high yield, given its 2008 performance, and we maintained that relatively high weighting in junk bonds and high-yield bonds until about 2014, at which point we brought it down dramatically and increased the investment grade weighting. Some of that was a duration view, that global macro view of the world I mentioned, but it also affected the relatively high yield we get in long-based investment grade bonds.
Once we have the asset allocation, stock selection is driven primarily by macro structural factors: industry trends and themes. One such theme is the re-regulation of European banks under Basel III, a regulation that is forcing a whole class of bonds issued 10 or 15 years ago by European banks to become redundant under the new capital regulations, and to spawn legacy bonds. That opportunity set, which is about 12 % to 13% of the fund, consists of bonds generating a healthy income. We think the banks will be forced to buy those bonds back from us as the new regulation gets implemented and prove a nice driver of performance.
Another theme in our stock selection has been how risk-averse European companies have become, relative to U.S. companies. European companies in this business cycle appear to have limited appetite for debt, to leverage up their balance sheets, to fund activities like share buyback or mergers and acquisitions, versus others that have been notably aggressive in that kind of activity.
We strongly prefer more cautious European investment grade companies which have been prudent with their balance sheets, companies like Deutsche Telekom, Orange S.A.—lots of big European investment-grade incumbents that represent a range of reliable income generators who seem unlikely to risk their balance sheets to satisfy aggressive equity investors.
High-yield bonds, which occupy the more default-sensitive areas of the portfolio, have riskier corporate securities. That’s when meeting the management becomes important. By definition, the credit ratios that we, or a rating agency, would look at are backward looking. What matters to us, as investors, are the balance sheet structure and management priorities in de-leveraging and paying down debt.
Q: Can you give an example?
Take Phoenix Group Holdings, an insurance company here in the U.K. They issued a bond a few years ago. Now, it is rare for a chief executive to appear at a bond road show—normally you see the treasurer or, if you’re lucky, the chief financial officer. But Phoenix’s chief executive was there, and publicly stated he was intent on getting the company back to investment grade within two years.
That kind of assurance on strategy and prioritization of equity investors is highly unusual and helped convince us to buy into that bond. And he delivered on his promise. That personifies how important the management team and credibility are to our decision making.
The standard financial metrics we look at boil down to free cash—free cash flow as a percent of total debt, and its sustainability. That is why we favor non-cyclical sectors, and also the equity cushion that we have underneath us, the EV (enterprise value)/EBITDA (earnings before interest, taxes, depreciation, and amortization), looking at how much of that EV, that enterprise value, is debt. We want a nice equity cushion underneath us, in case anything goes wrong.
Despite that, we are not slaves to credit ratio. It is much more important to us how management treats equity investors, the credibility they have, and how focused they are on de-leveraging. We want to confirm the equity investors are being told the same as the bond investors, that theirs is a consistent, reasonable strategy. The benefit of working at a big organization is that we can sit in on the equity meetings and discover what the equity investors are being told relative to bond investors.
We do not pay much attention to the ratings that the external ratings agencies give bonds, and we do not manage money against any index. Our analysts do their own financial modeling and analysis of the bond documentation. From that—not credit ratings—they assess relative value and decide what is a comparable security.
Q: What is your portfolio construction process?
Most of the time, this is predominantly a corporate bond fund because eight years out of 10, we want the income. Only when we hit a major default cycle do we get defensive and move to government bonds. The fund has consciously changed its shape over the last two years to catch the duration rally we thought would happen, and make the fund more defensive.
Today, investment grade and sovereign bonds make up about 50% of the fund. Cash is about 8% of the fund, loans about 10%, and high-yield bonds comprise the remaining roughly 32%. Over the last two years we have given preference for duration risk over credit risk, essentially buying investment grade over high-yield bonds. That has resulted in income falling, but the flipside of that is we’ve made money through capital appreciation as government bonds and, by extension, investment grade corporate bonds have rallied.
The other area changing is the fund’s geographic weighting. As European companies in this cycle appear more conservative than U.S. companies, we have about 39% in U.K. bonds, about 33% in European, and the remaining roughly 28% in U.S.
Q: What are your position size parameters and sell discipline?
The maximum position size we have is just over 2% in an investment grade company called Virtual Telecomm (T-Mobile in the U.S.). In high yield, the maximum issue size is about 1.5%. We run a diversified portfolio in terms of single-name concentration by design to manage downside risk. We do not set a minimum holding—we’re more focused on limiting the maximum position size.
In terms of companies, we target 60 to 80. However, the number of actual holdings is typically over 100, because we hold more than one type of bond in certain companies, e.g., Lloyds Bank, in the U.K. These bonds have different maturities, different legal language, etc. So our holdings overstate the number of issuers or companies in the portfolio.
We hedge all our bonds back to U.S. dollars, and performance is reported in U.S. dollars.
From a single-name perspective, sell discipline is important, particularly in a year like last year, which was a bear market for credit, for corporate bonds. When a bond trades low, 90 cents on the dollar, which tends to only happen with high-yield companies, we review the credit with the analysts. But regardless of what the analysts say, we almost always sell that bond, because once it gets that low, it starts behaving like a distressed bond and the price becomes “gappy,” particularly to the downside.
In a more normal environment, duration and interest rate management tend to drive performance. We actively manage that with interest rate futures and government bonds.
Q: How do you define and manage risk?
What risk means to our end client is drawdown—how much we might lose in a single month, quarter, or year. We aim to achieve sensible income, but we blend up different asset classes at different times in the cycle to manage that drawdown risk through diversification and stock selection.
Also, the range of assets we own plays a role, i.e., more credit-sensitive high yield versus more duration-sensitive investment grade versus sloping rate loans, along with getting the right blend of cash. Cash is an important asset class within the fund. We’ve run that up as high as 20% in the last year or so.
Since we took over this fund in December 2008, after it dropped 38%, the worst rolling 12-month drawdown has been a 2.8% negative return. And during the periphery crisis in Europe, there was one month where drawdown hit 4.4%.
By losing less when the markets are down, we make it up more in the longer term, when markets begin to move up, as well from consistency and compounding of return. We won’t always succeed, but that is our goal.
