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Relative Value Across the Global Fixed-Income Spectrum
Neuberger Berman Strategic Income Fund
Interview with: Thomas Marthaler

Author: Ticker Magazine
Last Update: Aug 26, 7:08 AM ET
Neuberger Berman Strategic Income Fund employs a relative-value strategy to find opportunities from high yield bonds to Treasuries across the globe. The fund uses dedicated sector specialist teams that formulate investment views to develop forward-looking ideas about the distribution of risk and return.

“Our goal is to achieve the highest risk-adjusted return possible at any point in time, given our views on the market and how much risk we think is appropriate to take.”
We look at all these factors together to objectively assess the path of interest rates. We think the U.S. economy shows signs of marked improvement, and conclude current interest rates are not sustainable. Over the next year, for example, we see the U.S. 10-year Treasury bond moving higher and the Fed increasing the target rate most likely at its next meeting in September.

Beyond that, we think things will get interesting. The cycle following that initial short-term interest rate hike will likely be very, very slow, and will probably extend until the end of 2017—maybe even into 2018. The fundamentals suggest gradual improvement, not only in the U.S., but also in the other major developed countries.

Q: How do you select securities and manage your portfolio?

A: Our starting point as a relative value manager is to understand what’s currently priced in the market. You can easily gather this information by turning on your favorite news channel to see real-time prices. These tell you what market participants consider fair values based on trading activity.

We look for views on expected return that differ from what’s currently priced in the market. Are 10-Year Treasuries trading at fair value? Are they cheap? Or are they rich?

When our research team formulates ideas on factors that are not priced into the market, we think about these opportunities, and about how much risk we want to take. We also take relative value a step further, and ask, “How much confidence do we have in the views we’ve formulated?”

There are certain times you look at the market and are more confident than others. This is important when you’re trying to decide how to allocate your portfolio. If you have two different asset classes that have similar expected returns, and one has more confidence than the other, certainly that’s going to influence which one is more attractive.

Confidence is one way to measure that distribution of potential outcomes. We get that information by, among other things, asking our teams to answer open-ended questions every week that require them to address both the probable as well as extreme range of outcomes. Week-to-week those views could change, as they’re influenced by new information in the market or by pricing changes. As such, the team constantly reassesses what it thinks will occur looking forward.

We view this information on a weekly basis through our proprietary asset allocation framework, which is based on the Black-Litterman model. This model looks at our investment views, combines them with historical performance, returns, volatility, and the correlation of those returns.

This optimizer tool is influenced by what we know about the past and our assumptions about the future, and it uses this information to come up with a range of portfolio solutions that seek to achieve the highest risk-adjusted returns.

When we get these optimized results, our senior team reviews and makes the final decisions on how to allocate the portfolio. Our process is unique because we’re looking at risk and returns in a continuum of outcomes.

Q: What is your benchmark?

A: Our benchmark is the Barclays U.S. Aggregate Bond Index but we characterize our strategy as benchmark aware. This means we acknowledge our benchmark, and we measure tracking error versus the benchmark, and we have a target risk budget—but we don’t have any restraints that require us to replicate the benchmark. Today, for example, the absolute volatility of the portfolio and the benchmark are similar, but we believe our portfolio, comprised of both benchmark eligible bonds and expanded opportunity set, has higher potential return than a portfolio comprised only of benchmark eligible bonds.

The question we ask is, “If we introduce other asset classes not in the benchmark into the portfolio, could that potentially lead to a more efficient result?” Historically, that answer has been yes.

As a result, we have quite a bit of tracking error, meaning we have a significant difference in how our portfolio’s constructed compared to the benchmark.

Q: How do diversification and risk play a role in your portfolio construction process?

A: We are big believers in diversification. We don’t want one decision to dominate our return. Looking back over the last 10 years, one of the reasons we’ve been able to achieve long-term success is because we believe in multiple sources of value-add.

The proprietary framework I described helps us decide how to achieve our optimal allocation based on how much risk we’re willing to take. To estimate risk, we look at the potential tracking error of the portfolio relative to the benchmark. The second thing we evaluate is the actual absolute volatility of the portfolio.

Each of the factors that influence risk is partitioned in a risk report. For example, we know exactly how much of our risk is coming from interest rates, how much from exposure to high yield, and how much from any mortgage securities we own, etc. Most importantly, when we get together as a group, if we modify the portfolio, we know immediately what the implications will be for risk and return.

Q: What is your allocation strategy?

A: From a global perspective, as of 6/30/15 about 86% of the portfolio was comprised of domestic exposure, while the non-U.S. exposure is split between global developed and emerging markets. Then we allocate across fixed income sectors for exposure to a number of asset classes: high yield, bank loans, emerging markets, non-agency mortgages; all of those would be out of benchmark. Also out of benchmark, we have some exposure to TIPS (Treasury Inflation-Protected Securities) and global developed market bonds.

To put some numbers on the weightings, as of July 31, 2015 about 60% of the portfolio right now is in benchmark, and about 40% is out of benchmark. We don’t have a specific number in terms of how much we want to have in or out of benchmark. It’s really about building the optimal portfolio at any point in time. In 2008, which was a much different environment, only about 20% of the portfolio was out of benchmark.

Q: Why not have the majority of the fund invested in TIPS?

A: We think it is appropriate to not have much Treasury exposure. We currently have only a small exposure to TIPS, which may provide an inflation hedge. Most of our exposure in governments is selling futures in Treasuries, so that means if interest rates go up, the value of those securities would increase.

Q: How do you define and manage risk?

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