Q: What is the core mission of the fund, and how does it differ from its peers?
The core mission of the AB High Income Fund is to provide a high level of income to investors while limiting losses over time. We compete with other high-yield funds, but try to do better by providing income the best way we can.
In our view, the best way to provide income fluctuates over time – it is different today than it was yesterday and it will be different tomorrow. As a result, our approach to generating income is both global and multisector, creative, and opportunistic.
We have no problem going where other high-yield funds typically do not, for instance, outside the U.S., in emerging market debt, or in structured mortgages. In late 2011 to early 2012, we bought bonds in Europe when the periphery was under pressure, and even bought municipal bonds in 2012 when analyst Meredith Whitney infamously scared most investors away.
Similarly, we do not have to chase what everyone else is buying, and this might be even more important in asset classes such as most areas of fixed income that have a negative skew. Look at what happened in energy in the past few years. Investors who were focused solely on the U.S. high-yield market basically had no choice but to buy energy because it accounted for over half of the issuance in 2012 and 2013.
I would love to say we knew the energy sector was going to be a bad place to invest. We were aware that the issuance was not coming at extremely cheap levels, and we thought the E&P sector was levering themselves up at the wrong time. But the actual reason we did not buy energy was simply because we did not have to. Instead, we invested in emerging markets, in Europe, and in the parts of the mortgage markets.
Philosophically, the way we generate income for investors is different and quite flexible. A decade ago we had more than half of the fund in emerging market debt, while today that has decreased to 15%. Over time, we move assets to wherever we see the best income opportunities.
Q: What drives your flexible approach?
Our calling card is research. We do a tremendous amount of research on economies and companies using a slew of quantitative tools to help value securities. But essentially, our approach boils down to finding the most prudent sources of income.
Bonds are different from other asset classes. They really have only two outcomes: either the entity that is loaned money pays it back or it does not. So we never want to simply buy as much yield as possible, but look for things we feel comfortable are going to pay us back.
We do not sit from a top-down perspective; for instance, we would not say “European high-yield is trading at X, so put 10% of the portfolio there.” Our approach instead looks at opportunities from the bottom up, and compares them across different regions and asset classes using tools to make quantitative measures along with our judgment as to what is more or less attractive at a given time.
Q: How does your investment process work?
It is ongoing and iterative, and starts with a formal monthly process to go over where we are in the overall market cycle, the economic cycle, and the credit cycle. From there, the discussion turns to how much risk to take relative to our expectations over the lifecycle of the fund. Even if we are quite bearish, we are still going to have a decent amount, remaining in the high-income area.
Next we look for the best opportunities at that time. Because many of the markets we deal in are not particularly liquid, the starting point actually matters a lot. Unlike an equity portfolio or a currency portfolio, where frequent changes can be made with little cost, a fund like ours cannot be changed on a dime. In fact, trading too much is one reason why so many high-yield managers do not outperform indices, even before fees.
That is not what we do. Before putting something in the portfolio, we do a tremendous amount of work because we know we may not have the ability to trade out of it – or at least at a price that makes sense – down the road.
We tend to have long time horizons on our holdings – the average life of a bond we buy is usually five or six years – and use more liquid instruments to adjust the beta or the risk profile of the fund. Not only do we reinvest much of the coupon income in the fund, but also the 15% to 20% of the portfolio that is turning over every year, and tend to move the marginal dollar to where we see value.
Q: Where do you find investment opportunities?
Although people always ask about the process we use to put things in the portfolio, I believe it is much more important to have a good process for keeping things out of the portfolio. Because of high yield’s asymmetric risk, investors can lose a lot of money if something does not pay them back, but under normal circumstances they will rarely see a bond double in price. So, first and foremost, we have a robust process for analyzing an entity’s long-term sustainability.
We find opportunities through the various primary markets around the world; the best time to get liquidity is buying at new issue only things we are comfortable are going to pay us back. Because we are always doing work on individual companies and sectors, opportunities present themselves when our view on a certain area changes or when the price of a security changes.
But there is no one way of doing things, and we constantly have to find opportunities because of all the cash that comes into the portfolio. Although we avoided most of the E&P space in 2013 and 2014, about a year ago we started buying a lot of it because it could be purchased at discounted prices ranging from 30 to 60 cents on the dollar.
We do not really follow benchmarks. Obviously, we know our exposures, and are aware of our absolute levels. But our focus remains on determining the best way to generate income at a given time, and the rest works itself out.
Q: Would you describe your research process?
Eight economists around the world cover its different regions, and we have just over 30 credit analysts in New York City, New York and London, U.K. and scattered throughout Asia and Latin America. A team of nine quantitative analysts build models and valuation tools which support the totality of our fixed income – about $250 billion globally.
Analysts assess the fundamentals and the trajectory and build models – and importantly, we always insist on scenario analysis. An analyst then makes a formal recommendation. But the most important part is whether an opportunity going to be good money or not, and we will then have a discussion around it.
In a formal monthly research review process, the senior members of portfolio management, trading, and research get together to review the different signals from the fundamental work versus those from our quantitative tools. As portfolio managers, it is our job to figure out the best construction of the portfolio given these differing views.
But we definitely try to reach a consensus, and expect analysts to advocate when they have a strong view – if the portfolio managers are not allocating to a specific idea, the analyst is supposed to pound the table and try to get it into the portfolio.
I think it is good that we do not always agree. We want diversity of opinions and diversity of thought. However, when there is consensus, we tend to make bigger bets, all else being equal. I have the ultimate say, but try to build upon the different talents, expertise, and wisdom of the team and size bets according to our confidence level.
Q: What motivates your sell decisions?
We always do a lot more buying than selling, saving selling for situations when we have insights into the fundamental deterioration of an entity that is not fully appreciated by the market. Our view is that it is not good to sell something because it is fully valued or a bit rich, because it costs so much to trade and liquidity is tough to come by. Relative-value trading is too expensive and ends up making the broker-dealer community rich instead of our clients.
Q: What drives your diversification strategy at the portfolio level?
On the equity side, if a stock purchase goes horribly wrong, the next stock can quadruple in price. In bonds, we do not have that ability to make up for mistakes, so we try to limit positions in any one entity to 50 basis points – quite frankly, I am more comfortable at 35 basis points or less. We want diversification, because taking too big a bet on an idiosyncratic name is just not a paid risk in fixed income – you are much better off taking your concentration risk in the equity markets.
Q: Which segment of the market do you like to focus on?
This question highlights something I talk about a lot, which is there are two types of managers: the higher quality manager who has good risk-adjusted returns and few defaults, and the manager who goes all the way down to CCC rated bonds and takes a lot of risk, and tends to have a little better return but a lot more volatility.
Both of these styles have merit, and my view is that I do not have to choose between them; we can vary our style depending upon market conditions over a cycle. In times when there is not a lot of value and spreads are tight – not dissimilar from today – we want to be more conservative, owning fewer CCCs and more BBs.
But in an environment like the beginning of last year, or 2009, or early 2012, we want to be much more aggressive and own more of risky securities. Being dynamic about the amount of risk we take in the portfolio is one of the key value adds we offer.
