Q:  How do you use this risk monitoring system?

A: Risk management is integrated from start to finish within our investment process. We use the system to actively reposition risk at the time of security selection, as a way of monitoring the overall risk at the company level across all of the portfolios within Putnam, and as an individual portfolio management tool to analyze how much active risk we are taking and to analyze the risk-reward balance.

Q:  How many people are there in your fixed income group?

A: We have about 100 security specialists who work to identify independent investment strategies across all major bond sectors. One of the key issues is that our specialists are active risk takers. We want to put as little friction as possible between the strategy identification, development, and final implementation into the portfolio.

Another important component of our process is the portfolio construction team. This team takes these investment strategies and determines the best way to blend them into the portfolio. We are really fulfilling the traditional role of the portfolio manager – how much of this idea goes into that type of portfolio. We believe that a team of people focused on construction and implementation can be very systematic and objective about building a diversified pool of income earning strategies. Our process assures, for instance, that a portfolio manager, who has a background in credit, can’t imbed more credit basis risk in a portfolio than an objective analysis might warrant.

We may have our specialist in the investment grade corporate bonds area, and somebody in the high yield area or commercial mortgages area, identifying strategies that they think are independent, but when we analyze them in our risk system, we can see whether they have the same factor exposures or a diverse range of exposures.

In many cases, we hedge out overlapping factor exposures from the independent return strategies. If we cannot hedge out these interrelated factor exposures, the portfolio construction team determines the optimal mix of investment strategies that result in a portfolio that efficiently balances the trade-off between risk and reward.

Q:  Can you give some historical examples to illustrate your process?

A: Manufactured housing is an area that develops mobile homes in the US. In the early 1990s, this area was quite new in the market and there was a lot of opportunity. Most of these mortgages were held in structured CDOs (Collateralised Debt Obligations) or CBOs (Collateralized Bond Obligations) that had inflexible guidelines about selling time frame and prepayment risks. It was an area that was not widely covered or understood.

Having a team of sector specialists to delve deep into this complex sector proved advantageous for us at the time. It became clear very early on that some bonds were downgraded because they were going to have some default-related issues - not because the corporate entity was in trouble, but because the underlying structure meant that there was going to be some principle loss on the underlying holdings. As a result the entire sector was downgraded.

There were entities that held the bonds with very inflexible restrictions on CDOs and they had to sell them because they didn’t fit in their ratings buckets anymore. All of a sudden these bonds began trading at huge spreads relative to Treasuries and with a 30% discount and our specialists in the mortgage credit area managed to uncover many interesting securities to add to the portfolio.

Back then, this was a brand new sector in the market, so there was no historical data available and there was no factor exposure in our risk system that told us what manufactured housing risk looked like over time. But we knew we had a security selection, idiosyncratic return that was very attractive in that area, so we started to add into that.

Once we got up to 2% or 3% of the portfolio we proxy-modeled this to check what was the worse loss scenario, and then we tripled it and looked at it to see what impact that would have on the portfolio. That was a situation where we could use our risk system. Today, we have a separate manufactured housing factor in our risk system, because we have enough investment data and time horizon experience with the sector.

The world of fixed income investing has evolved significantly over the last 20 years. We believe it is a difficult task to rely solely on interest rate views and sector allocation calls as a way of generating return in a bond portfolio. Instead, the proliferation and complexity of fixed income instruments available today provide a fertile ground for identifying security and sub-sector specific risk. In order to tap that potential, you need specialists to really understand the complexities and opportunities of each individual bond. You need a systematic way of putting all these pieces together. Finally, you need a platform that allows you to track and monitor this varied landscape of investment ideas.