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Smoother Ride Through Diversification
Delaware Diversified Income Fund
Interview with: Paul Grillo

Author: Ticker Magazine
Last Update: Sep 18, 10:32 AM EDT
In an investment universe as broad and diversified as the global bond market, disciplined and well-prepared investors can choose from a broad array of opportunities. Macquarie Investment Management portfolio manager Paul Grillo and his team take a flexible approach managing the Delaware Diversified Income Fund by identifying opportunities with attractive risk/reward profiles from various sectors around the world.

ďOur objective seeks maximum long-term total return, consistent with reasonable risk by utilizing a flexible portfolio with sufficient liquidity.Ē
Q: What is the history of the fund?

A: 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?

A: We seek total return and specifically excess returns above the fundís benchmark the Bloomberg Barclays US Aggregate Bond Index over a full market cycle. The fundís 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?

A: 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?

A: 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. Itís an equal partnership with the same compensation pool, and everyone communicatesóno 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 itís 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 dayís 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?

A: We start with the bottom-up investment approach and include a top-down macro envelope to make sure the portfolio doesnít 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.

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