Q:  Could you give us a couple of examples that illustrate your process?

A: Over the last couple of years, we have had a lot of success in energy. The driver of this view was not the direction of the energy prices, but the very attractive capital structures of the companies, which don’t have much bank debt. They have been investing a lot of money into building up the reserve basis and have been hedging out their commodity exposure. Generally, we believe that these companies are underrated.

We reflect that view in a number of different ways. When there is a sector that we like, we have more flexibility to go down in the capital structure, pick up yield, and achieve potentially greater appreciation. We overweight the sector and we have come down to the riskier part of the capital structures in Chesapeake, Williams, and El Paso.

On the other hand, we have been skeptical about the homebuilders not because of the macro picture, but because it is very difficult to have a sustainable competitive advantage in such a fragmented market. In addition, the homebuilders never really deleveraged. Even at the peak of the cycle, the homebuilders were still buying up land, so weren’t well positioned for any kind of a downturn. Now the downturn appears to be larger and more significant than expected, but the team did a great job of positioning us at an underweight.

Sometimes we also rely on good old-fashioned picking within an undistinguished sector. For example, we made a lot of money on Playtex, the consumer products business. Our analysts thought that it was a well-run company, which was far more valuable to an acquirer who could take out the corporate overhead and run the brands over a larger base. We had an overweight in Playtex, owning different parts of the capital structure, and we benefited from that strategy when the company was acquired. We didn’t have to sell out because the company was taken over.

Q:  What are the key features of the portfolio construction?

A: We manage a diversified portfolio, where granularity is key feature. The number of issuers varies depending on the market outlook, but we may hold as many as 250 issuers. Our beta or market sensitivity is typically in the range between .95 and 1.05, but we may increase our aggressiveness when appropriate in the range of 85 to 1.15. We don’t take many sector or industry sector bets, but when we do, we classify the bet as no more than 2% of the benchmark weight.

Also, we tend to be duration neutral. The high yield market has different levels of interest rate sensitivity, so a quarter or a third of the year is duration neutral. But the most important feature of the portfolio construction process is the risk limit on what we can lose on a given name, which is 30 basis points versus our benchmark.

Q:  Which benchmark do you follow?

A: We use the JPMorgan Developed High Yield Index which is similar in construction to some of the constrained benchmarks. We took that decision 10 years ago because in a maturing market, the bigger companies can have very large weights in unconstrained benchmarks. The JPMorgan DHYI takes only the two largest issues of a company, not all the bond issues. Typically, the two largest ones are the most liquid and investable bonds.

The utilization of a constrained benchmark was not very relevant initially but started to pay off when a number of the larger automakers were downgraded and became very large weights in unconstrained benchmarks. That strategy wasn’t very relevant initially, but it started to pay off. We believe that it is appropriate for a credit benchmark to be constrained because we want to avoid concentration. In the end, diversification is much better because of the inherent asymmetry of the market.

Q:  What is your view on risk? How do you manage and mitigate it?

A: Putnam has a proprietary risk system that uses trailing spread volatility over the last five years. We apply trailing historic volatilities to the current portfolio to come up with a forward-looking assessment of the market beta. It is a very useful tool, which allows us to see the portfolio beta model every day. We apply quantitative tools at the portfolio, issuer, and sector levels, to make sure that we are being objective about the risk.

As any investor in the high-yield market, we are exposed to credit risk, and we need to know that we are compensated appropriately. That is why we make sure that we measure risk accurately and that we take advantage of our views. How the portfolio comes together as a whole is also important and we make sure that there are no unintended correlations.

As part of our top-down process, we cut the portfolio in many different ways and consider risk on a forward-looking basis. That means looking at bond ratings, yield spreads, yields, and industry over-weights. Ultimately, the goal is to manage the risk more efficiently.

Q:  How would you deal with a potential decline in interest rates combined with an economic slowdown?

A: Our investors pay us to be invested in the asset class. Therefore, we remain highyield investors in all environments, but we shade our view of the market to be defensive or more aggressive. Clearly, as the market looks forward, it is expecting some deceleration in the economy and pressure on certain sectors and companies, but I believe that a big part of the bad news is already reflected.

Only seven months ago, the spread was at 2.65% over Treasuries and today it is at about 7% over Treasuries, and that is a dramatic change. The average spread is about 5.3% over Treasuries, and we have gone through that average and well beyond it. Nevertheless, managing credit risk in a decelerating economy is always a challenge and we believe that the diversification helps. We have the tools and the team that help us to avoid the bigger pitfalls in the market.