Q:  Do you invest in the high-yield sector?

A: We have limited and tactical exposure to securities below investment grade, usually in the range of 0% to 5%. We invest primarily in “cross-over” names, or bonds that may be rated investment grade by one agency and just below investment grade by another. The high-yield market tends to shun these securities because they are not “yieldy” enough, while investment grade buyers cannot always purchase these securities, due to investment constraints. As a result, they are often neglected and we see this as a great opportunity. They have quasi investment-grade characteristics, but are cheaper than they should be.

Q:  What is the risk control aspect of the fund management discipline?

A: Even though we do our homework, it isn’t reasonable to assume that we’ll avoid every single problem, so we manage risk at multiple levels.

At the security level, we keep small position sizes. For corporate bonds, they decline in size with credit quality. Our average exposure to a company is about 0.4% of the portfolio and that's less than half the exposure of a typical bond fund. If there is a blow-up, we make sure that we can weather it. Core bond funds are meant to be a safety net for investors who also have equities and alternative investments. They are not meant to express bets on companies like the equity side of a portfolio.

At the duration level, we actively manage duration versus the benchmark, setting a risk tolerance of plus or minus three quarters of a year. These constraints are important because shifting your duration to be longer or shorter than your benchmark can add a tremendous amount of volatility to performance.

One reason we have been very consistent in our peer rankings because our interest rate risk is narrower.

Q:  When deciding your exposure on the corporate side, do you take into consideration merger situations?

A: On the equity side, a fair amount of money can be made on mergers, but on the fixed income side, a fair amount of money can be lost from M&A activity. The trend in credit quality of corporate America has been down for 30 years as corporations become more savvy about optimizing their capital structures. In the current stage of the business cycle, with low yields and a well-performing stock market, management teams, and especially buy-out funds, have extra cash and feel they have to do something with the cash for their shareholders, so they are starting to make deals. When they want to make deals, it often involves more leverage, which means more pressure on credit quality, ratings, and spreads.

We are cautious now because M&A risk is high and has the potential to hurt the corporate bond market.

Q:  How many securities do you hold in your portfolio?

A: As previously stated, we have a very diverse portfolio, with on average 200 to 250 securities. But part of our large diversification is due to the different pools of mortgages. Sometimes different mortgages may have 20 to 50 little pools and that creates the illusion of more positions. We typically have about 80 to 100 corporate bonds.

Q:  Aren't there too few investment grade companies nowadays in the US?

A: There are still about 1000 companies, but a lot of them are small companies that have issued just once and this tends to obscure the numbers. There are probably 250 big, household names such as GE or IBM who are regular active issuers on the market. That's the area where we do most of the mining for ideas because they are well-known names, trading every day, with ample liquidity.

Q:  Can you give us an example of the peculiarities of research on the corporate bond market? What is your advantage over your peers?

A: One example is our strategy of focusing on short maturity corporates and overweighting them. There has always been a demand for long-maturity corporates from big insurance companies – some of the largest participants on the bond market – who tend to chronically overpay for longer-maturity corporates. Because there aren't many natural buyers for the shorter bonds, they are cheaper.

When you buy a short-maturity bond, the analysis is simplified. You need to figure out whether the bond will make it through maturity in a year, if the company has enough liquidity and cash. A 30-year bond is much more complex because it acts like an equity, and its performance is a lot more volatile. Owning short-maturity corporates simplifies analysis, gives us an edge on the market and limits the volatility in the portfolio.