Another factor is their sector and market. We may like a firm, but it is also important if we like the current dynamics of its sector. Sometimes we may select a premier issuer in a troubled sector, but it all comes down to the fundamentals of the issuer, their position and strength in the market, the management team, and its experience in managing mergers.

Some companies are relatively acquisitive, but some are also good at it. Often we would consider such a company for the portfolio after an acquisition. If it just did an acquisition, its debt will be higher, but we do not mind that if the management team has the experience of working the debt down and integrating the new company well.

Q:  What are the key aspects of portfolio construction?

A: The portfolio construction process is tightly related to the risk management. After we have identified a number of opportunities, portfolio construction is about allocating the risk to the ideas with the highest return potential. We go through our sector weightings in terms of agencies, Treasuries, corporate bonds, and mortgages to establish our view, and that affects the security weightings. Individual holding size is influenced by our investment conviction, the appropriate level of overall risk and risk relative to our benchmark.

We hold a diversified portfolio, where the number of securities varies between 50 and 125. Our exposure to any corporate bond is limited to 0.5% to 1% of the portfolio. When holding a corporate bond instead of a Treasury, the idea is to get additional income, but it should be an appropriate amount income for the incremental volatility. If a corporate bond runs into trouble, it could have a significant price decline, and we make sure the portfolio can still perform well, even if one or two securities are under pressure. However, the foremost goal of our decision process is to identify securities that will not experience problems.

For the mortgage securities, we maintain a larger position size, partially for trading execution. We are comfortable with agency bonds from a credit quality standpoint, so we may take larger positions. Overall, we are very cautious in the security selection process, and we have a risk management framework to minimize future problems.

Q:  How do you navigate through the mortgage market in this difficult environment? How do you make sure you avoid the largest losses?

A: In the mortgage market, the focus for us is on fixed-rate bonds with high quality collateral. We get consistent cash flow, both principal and interest, and that provides safety and reinvestment opportunities for the portfolio.

Typically, we avoid the adjustable rate mortgages in all of our accounts. As the rates adjust the quality of the borrower’s composition changes over time, as a rate change creates a different type of product for the borrower. We like the certainty that comes with fixed payments and we feel that is a way to mitigate the risk in the mortgage sector. The fixed payment products provide more analyzable positions and more definable cash flow.

Moreover, we don’t just analyze the type of product; we also look at the details. We get into the details of the collateral, its stratification, its location and regional economic dynamics. We look under the hood to see the characteristics of the borrower as well.

Q:  Would you explain your risk control and risk-budgeting process?

A: Our goal is to invest in risk-managed opportunities, and we measure the portfolio risk through multiple forward-looking scenarios. The process involves both judgment and a quantitative approach. The quantitative aspect helps to show how the portfolio will perform and identifies hidden correlations between securities or sectors.

We maintain a tracking error that we feel is appropriate for the product, but we don’t do that blindly. For example, in 2006 and 2007, we intentionally brought down the risk of the portfolio because, going forward, the number of opportunities was not as great. Overall, we are opportunistic, but we maintain a risk level that is appropriate for the specific environment.

Our risk management framework involves a number of constraints, such as the corporate issuer limit and sector limits. We also maintain a high average credit quality and a yield advantage. We are bond portfolio managers and we do not invest in CDOs; we don’t take currency risks; and we don’t participate in total return swaps.

For the risk management framework, we use an analytical platform. It helps to ensure that our relative risk contributions are aligned with our investment convictions. It provides a broad array of sector and security details that help both the portfolio construction process and performance attribution. We can examine our past performance and analyze the reasons behind this performance, and see what we could have done differently.

Because we know that we cannot be 100% right in all our decisions, we prefer to take many small risks, and we analyze if the risks we took paid off. Overall, the diversified and risk-managed approach tends to work in our favor.