Q: What is the history of the fund?
In the 1990s, fixed income funds were plentiful, with many focused on yield. We wanted to create a fund that focused on total return instead. A fixed income fund with the flexibility to weather bad times by going into more of a capital preservation mode when necessary.
I have been involved with the Delaware Diversified Income Fund since its predecessor fund launched on December 29, 1997 and have been the lead portfolio manager since 2001. The Fund was initially offered only to institutional clients, but it transitioned to a retail structure in 2002, as we saw meaningful demand for this type of product from smaller investors.
The fund has seen some modest modifications to its investment parameters throughout its nearly 20-year history, but we have always maintained a strict discipline with respect to risk limits, as we want the fund to satisfy client expectations over the long term with minimal surprises.
Q: Would you tell us about the objective of the fund?
We seek total return and specifically excess returns above the fund’s benchmark the Bloomberg Barclays US Aggregate Bond Index over a full market cycle. The fund’s core-plus flexible approach allows it to exploit opportunities in various sectors, within and outside the index. The main sectors include: investment grade, high yield corporates, emerging markets and international developed nation investments.
Our objective is to generate alpha over a full market cycle while delivering a smooth pattern of returns, similar to a core-plus bond fund, yet with sufficient flexibility to enhance liquidity. Additionally, capital preservation is an integral part of the investment objective and we strive to protect the portfolio during spread widening and credit crisis-type events.
Q: What core beliefs drive your investment philosophy?
What we do is predicated on in-depth fundamental research, with a bottom-up approach to portfolio construction enveloped by macro risk management to avoid building a portfolio that would collide with the macro environment in a harmful way.
We are less concerned about making portfolio allocation decisions based on interest rate expectations. In contrast we prefer to capitalize on the mispricing of corporates, structured products, loans, and local-currency government bonds.
Q: What is your investment process?
Our investment process is predicated on a bottom-up approach to portfolio construction enveloped by a top-down risk management component. We maintain a team structure where idea generation stems from not just the analysts but the portfolio managers and even traders who spot opportunities among their respective areas of expertise. It’s an equal partnership with the same compensation pool, and everyone communicates—no area is siloed. We are all on, or proximal to, the same trading floor.
We generate ideas based on price, investment fundamentals, and proprietary research that includes financial modeling. Additional investment analysis can include industry competition, product viability, loan characteristics and performance, and cash flow timing.
Our corporate analysts are industry experts who cover companies from the AAA level down through the distressed level. This dynamic allows them to monitor a company and its industry behavior through various credit cycles, including economic downturns when companies may be downgraded below investment grade ratings. Because the same analyst had comprehensively covered the company when it was rated investment grade, they are intimately familiar with their products, their leverage ratios or cash flows, and can immediately advise as to whether they are a good fit for the high-yield portfolios or sub-portfolios.
On the securitization side, we produce proprietary models on the loans that underlie the securitization to assess credit worthiness and overall outlook on the collateral as well as prepayment speeds.
On the international side we start with country analysis. We conduct a country assessment and establish credit worthiness, currency stability, and political makeup to create our proprietary model. If country investment checks are positive, the corporate analysis will come next. Companies with strong ties to the sovereign will undergo additional analysis. Standalone companies will receive the full bottom-up fundamental analysis process.
Liquidity is an integral component of the process and guides us on the size of an investment in the portfolio when we assess both funding and exiting a position. We want to determine whether it’s easy to get into the investment, how much size we can carry, how likely liquidity could dry up, and what our exit strategy should be. If, for example, we are buying a high-beta-type investment or other riskier investments for a potential price increase based on credit fundamental improvement, we want to have an exit strategy in place.
Portfolio construction is based on a consensus decision-making process. If the bottom-up idea generation points our portfolio investments to a certain sector, exposures will build in that area. Frequent portfolio analysis will monitor the portfolio for excessive risk within that favored sector. Additional top-down analysis will determine the appropriateness of that exposure within the credit and economic cycle.
Another important facet of our investment process is our collaboration with Macquarie partners in Sydney, Australia, and London, passing information from when one trading day ends to where another one starts. Sydney passes information to the London folks at their day’s end, London shares information with us when they wrap up, and then we cycle our information to Sydney, which is 14 hours ahead of us.
All this keeps us in touch with macro themes in environments so we can avoid building a portfolio that could collide with a Brexit-type event, a downturn in the Chinese economy, or any key geopolitical events.
Q: Can you cite some examples to illustrate your research process?
We start with the bottom-up investment approach and include a top-down macro envelope to make sure the portfolio doesn’t collide with a macro or geopolitical event. Our team approach means specialists in various industries and markets are updating each other with trends and critical issues that influence our decisions.
The auto and retail industries are good current illustrations. Our investments in residential mortgage securities explains how we maneuvered through the global financial crisis.
Recently, we identified sub-prime auto lending as a risk, where lax underwriting or diminished credit underwriting standards within these securitizations began to appear. This loosening of standards led to increased auto sales and leasing, so investors in corporate bonds of OEMs (the original equipment manufacturers) and parts makers, etc., saw good results. However, investors on the asset-backed or securitization side were growing more cautious.
Therefore, leveraging the input from the securitized team, we began upgrading the quality of the auto loan portion of the asset-backed investments. This information was passed to our corporate bond investment team who were seeing auto sales plateau and market saturation. Together, we began upgrading the corporate side to where it could withstand the more challenging auto-sales environment ahead. The team is moving forward with auto sector bond investments with strong balance sheets and good liquidity and less dependence on loose financing.
Another recent example would be retail sector bonds, where Internet-based retailers have created a hyper competitive environment. Traditional brick-and-mortar companies are challenged by evolving consumer behavior. The team began building more conservative exposure in the retail industry to address this environment. Retail company metrics and results were relayed to our commercial mortgaged back securities team who took further steps to upgrade their respective portfolios.
In the residential mortgage-backed securities sector, we spotted significant deterioration in mortgage underwriting during the period from 2004-2007. This was occurring in both home equity, agency and non-agency residential mortgage-backed securities. In 2006 we visited a few investment banks to discuss their mortgage activity and became increasingly concerned. The team reduced portfolio investments in sub-prime, home equity, and alternative A-type mortgage investments. We may have been one of the few fund managers to utilize the subprime CDX hedge that was highlighted in the film the “Big Short”. This action worked out well for the portfolio in 2007. The team was sufficiently concerned about significant macro risks in general and that concern influenced overall risk level in the portfolio. Portfolio investments were upgraded in quality and credit enhancement to withstand what we saw as the coming storm.
Q: What themes do you focus on in the retail sector?
We identified three areas we thought were affecting retail. First our commercial mortgage-backed securities team identified an upward trend in rental costs. Secondly our communications specialists noted strong spending on mobile phones, connectivity, and media content. Lastly, our healthcare analysts were tracking spikes in healthcare costs and our municipal team noted tax increases across many states and localities. All of these items took a large bite out of potential consumer spending.
Q: What did you learn from the financial crisis?
We saw the events leading up to it and did a good job of managing risk from 2007-2009. The post global financial crisis period taught us a hard lesson of the propensity for governments and central banks to move into and support the market with extraordinary measures. At times our conservative portfolio positioning was overwhelmed by significant unorthodox monetary policy by banks.
Accordingly, we learned to be vigilant and flexible. The team learned to control and minimize hedging costs and to allow for the potential for government entities and central banks to address big macro risks.
Q: How do you construct your portfolio?
Diversification is critical to the portfolio construction process. The portfolio has exposure to over 15 sectors and over 500 issuers. For example, we have over 100 names within the investment grade corporate sleeve of the portfolio, and within the high yield sleeve (corporates and bank loans) of the portfolio we have over 150 names. Within emerging markets the portfolio has exposure to both U.S. dollar-denominated bonds as well as local currency denominated bonds, which are fully diversified from an issuer standpoint.
As portfolio construction is consensus driven, team members attend meetings for individual investments and sub-portfolios that identify opportunities and return potential in each sector. Those bottom-up inputs funnel into four monthly meetings that help us control and move the portfolios through time.
The first meeting is on performance attribution. We identify what’s working and what’s not within the portfolio and address those items with risk management.
Next is a top-down macro risk meeting, where we determine the appropriate level of risk based on macro themes. We address credit and interest rate risk during this meeting. That being said the team de-emphasizes interest rate anticipation in our process.
The third meeting is on market liquidity. The trading staff runs the meeting and provides their insight on the liquidity within each sector. Sector portfolio managers assess whether to exploit opportunities in a highly liquid environment or if they need to risk manage in a market of deteriorating liquidity.
The fourth meeting is focused on relative value. We use our bottom-up input and return potential to assess relative value. Risk and liquidity are also valued inputs during this meeting. For example, in recent years we had liked agency residential mortgage-backed investing for their combination of liquidity and yield premium. Central bank influence has reduced both yield premiums and return potential in this sector.
Additionally, Federal Reserve tapering of balance sheet reinvestment could potential dampen returns further. We have harvested dollars from this sector to add to traditional high-yield bonds and emerging market securities. Yield premiums and a more favorable fundamental environment make their risk adjusted return potential more favorable.
These four monthly meetings, along with our quarterly strategic forum meeting serve to identify macro themes to help portfolio construction.
Each sub-portfolio is also consistently measured against its respective benchmark. Additionally, we have a test of the portfolio at the fund level that measures the overall risk exposure relative to the fund’s benchmark.
Q: How do you define and manage risk?
Our primary portfolio risk is the potential for price volatility. The team minimizes this risk through diversification and credit enhancement. Price volatility measures can include duration, spread duration, duration times spread as well as measures of convexity. There is also a downside price potential to consider.
Quality measures are important to the team. We make sure that quality barbells are not masking average measures of quality in the portfolios. Liquidity measures are used both at the security and portfolio level to address the potential for flexibility and risk management.
These risk management techniques ensure that the portfolio performs as expected during various credit cycles.
