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Active and Diversified in Bonds
Interview with: Joseph Higgins

Author: Ticker Magazine
Last Update: May 12, 11:01 AM ET
U.S. interest rates have been so low for so long that the possibility of a rate increase is one of the largest embedded risks in the widely followed bond market indices. Joseph Higgins, portfolio manager of the TIAA-CREF Bond Fund, keeps risk at the forefront by seeking to mitigate volatility and achieve diversification both in terms of assets and returns.

“The fund looks for diversified returns – not diversification for the sake of diversification, but diversification based upon directional views, relative value within asset classes, and in a specific asset class through security selection where we seek idiosyncratic fundamental outcomes.”
A: We try to understand the spread today, but also how it relates to other opportunities in terms of potential volatility or how one spread moves vs. others in times of stress. This comes back to the notion of the bond fund manager as risk manager, and to information ratio as a long-term assessment of a risk manager’s efficacy – a notion which feeds through to every element of the firm’s culture and recommendations.

Spread as a notion of value is assessed contextually. Within an individual space, say corporate emerging-market (EM) spread, we evaluate whether it makes sense relative to the specific country being looked at – for example, sovereign Brazil risk. Once contextualized, we decide what the stress characteristics of that spread would be, and the research team will seek the most spread from the space, whether corporate or sovereign, local currency or USD that maximizes spread relative to volatility. .

Buying a bond merely because it has a wide spread is not the manner in which we operate; generally, recommendations should be spread compression stories relative to their peers. On rare occasions, we may add a bond that is more a spread story, though typically these have extremely short duration – one or one-and-a-half years to maturity such that their volatility component is low.

When something doesn’t work we try to understand what went wrong with the thesis, which is important to managing risk vs. return. These findings are shared publicly so everyone benefits, creating a safe and open environment. Culturally, the best trades are those where there was a thesis change which was caught early and acted upon.

Q: Would you describe your portfolio construction process?

A: The fund’s benchmark is large, with nearly 9,000 securities. Although our portfolio contains 1,400 to 1,500 names, it’s still considered quite large for a bond fund. Each of our holdings must tie in relative to other securities and have volatility characteristics that we expect to outperform in a market-stressed environment.

Position sizes can be large. By prospectus, the fund can go up to 2% of non-government or government-guaranteed sectors, although typical positions rarely exceed 1% in terms of non government bottom-up construction.

We want sector allocations that do not all move in tandem with the general credit beta of the market. At the close of our last quarter, for example, out-of-index municipal bonds represented approximately 4% of the fund. What we like about munis is that they tend to be longer duration and uncorrelated with the broad credit spreads of high-yield bonds, loans, and investment grade corporate bonds. By asset allocations to less correlated investment categories, the fund can behave in a more resilient manner.

At the core of portfolio construction is our belief that asset allocations must work together in order to maximize return relative to risk. For example, when oil prices recovered, the fund’s high-yield bond holdings represented approximately 3.5% out-of-index. They were partially sold off and moved into floating rate leveraged loans where there was a much lower exposure to oil. Doing so basically maximized the recovery in energy with a view that rates could rise and moving into floating leverage loan paper could help reduce price risks that were embedded in fixed rate high yield bonds. Currently, the fund’s exposure to leveraged loans is around 2%.

In emerging markets, we have a higher allocation than the average core bond fund. We generally find emerging market bonds to be an attractive out-of-index holding, even though the space can be underperforming for extended periods of time when the dollar is rising or in risk-off periods.

However, we’re willing to ride through that because of the lack of long-term correlation between emerging market sovereign and corporate bonds versus domestic high yield or investment grade bonds. At the close of the last quarter, emerging market bond allocation was around 7% or 8%.

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