BMO Short-Term Income Fund
US > Investment Grade > Short-Term
Feb 13, 2012
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Inception Date
Nov 03, 2004
Q: What is the investment philosophy of the fund?
A : Our fund focuses on the U.S. dollar denominated fixed income obligations that offer better relative values compared to the general market. We value a diversified portfolio of fixed income securities to reduce our volatility of returns and minimize downside risks.
As our investment philosophy is based on maximizing total return, we utilize a macro-economic view in our selection of individual securities that meet our fundamental investment criteria. Our relative value approach to fixed income market is an important style and philosophy. It allows us the ability to rotate in and out of sectors of the fixed income market we find attractive.
Q: What are some of the critical factors in your decision making process?
A : The fund is essentially an all-cash bond fund that invests in short-term maturities ranging from zero to five years in overall duration. Generally speaking, it is a U.S. dollar denominated bond fund which currently does not utilize any credit derivatives or futures contracts.
Nevertheless, we may own companies that are domiciled outside of the United States as long as they offer dollar denominated securities. Typically, these companies will have at least some presence within the United States.
Being open to new ideas, we challenge each other a lot in our investment analysis while expressing views of the economic trends and data analysis, or when reviewing specific investment themes or securities.
However, when it comes to selecting a specific bond or a security we are guided by the relative value approach. In our view, relative value is not only the analysis of the spread or additional yield, but is that additional yield worth the additional risk we are taking. In fact, it is this trade-off that we analyze before deciding whether to take the exposure or avoid the selection.
Another factor of significant importance to us is the price we end up paying, and we watch very closely ongoing changes in spreads. We also use the credit default swaps marketplace and equity prices as barometers to the risk profile of credits that we may or may not own in the portfolio.
Furthermore, we spend a lot of time in understanding the dynamics in various industry sectors like energy, finance, or utilities. Our analyst group spends an inordinate amount of time evaluating sectors as well as drilling down further to individual names within them. Through this process derives superior credit selection.
Q: How do you generate alpha?
A : We generate alpha relative to our peer group in primarily four ways: through asset selection, yield curve exposure, opportunistic investment, and credit selection.
The first step for us is asset allocation. Based on our technical views of the marketplace, supply and demand, relative spread levels, and relative risk profiles, we are not hesitant to move between asset classes at any time. Thus, asset class allocation is one area where we generate a lot of alpha for our shareholders.
The second area where we strive to add value is in looking at the yield curve and, in particular, where we are taking risk on the term structure of interest rates. That generally means altering allocations on the yield curve in line with our view from an economic or a yield curve perspective.
Then, we seek opportunistic alpha in three different ways. Being a provider of liquidity to smaller issue bonds, we can buy bonds at more attractive valuations and in our view is mispriced in the marketplace. Also, from an opportunistic sense we strategically add story bonds or fallen angels. In addition to that, we look for some longer term type assets that the market is currently underappreciating, and the best example right now are floating rate bonds.
Lastly, we add alpha through our careful selection of specific bonds. To this end, our analytical team employs a rigorous research process to track both individual credit and sectors where these companies may be trading.
Q: What is your research process?
A : As mentioned earlier, we combine a bottom-up and top-down approach. While looking at the macro economic situation we also look at individual bonds and evaluate merits of investments.
As part of my ongoing dialogue with analysts, it is extremely important for me to have a deeper insight into the overall situation in each fixed income sector, as well as in the companies’ competitive position and its cash flow.
Then, we look from a technical and a risk-return perspective at the dynamics in each of those subsectors. Once we have identified subsectors, we track from a bottom-up perspective, and that is where the analysts lead. At that stage we like to understand where the relative return story is. While it is important to identify the negative factors driving the weak market segment for the security, we also want to gauge the upside and are there any catalysts in place.
We narrow down our bond selection to a group of core names that we watch while waiting for our price targets to hit. If we do find the attractive price point to enter a position, and as long as the fundamental case is still the same, we will add the bond to our portfolio.
We have all the technical skills and system tools at our disposal to analyze bonds across the fixed income universe and we use trading platforms and other tools that perform spread analysis. The toolkits that allow us to evaluate the spreads across sectors are equally important with tools that we use to generate alpha.
For example, the current worries in the global sovereign bond markets and the potential for one of the smaller countries in the euro zone to default on their debt obligation are quite high. Just as we did in 2011, we could experience significant volatility for a sustained period in the current year too. That is why, looking at the risk-return profile of the bonds relative to Treasuries, I think short duration corporate bonds make a lot of sense at this moment.
Q: How did the Greek debt crisis affect your investment process?
A : Our view was that Greece was ultimately going to restructure. Yet, we also viewed Greece as a relatively small economy and as an example of what ultimately happens in other sovereign nations that are heavily indebted in the euro zone.
The surprising factor was the degree of the contagion spread and how severe it actually became. So, when we had the initial view of Greece as a problem, the structure of our portfolio was to be primarily domestically focused, which helped us when the actual contagion became more severe and started spreading beyond Greece.
What transpired as the contagion effect took place and spread beyond the Greek economy to the economies of Spain and Italy is that it created additional volatility which ultimately impacted the corporate bond market where spreads did widen.
We felt we were in a reasonably good position with respect to U.S. corporate bonds and the way they are performing as well as the strength of their balance sheets. We were overweight in these bonds; but the market volatility did create some price volatility within our portfolio.
Q: What is your buy-and-sell discipline?
A : Our buy decisions are primarily focused around two areas. First, if the bond is mispriced for a technical or fundamental reason then that is an attractive candidate for an addition to the portfolio.
Second, we try to buy securities that are improving stories because of the underlying industry improvement or a result of an acquisition that improves their business profile, or it could be general trends in a particular industry that has a higher growth profile or an improving cash flow and from a risk-return perspective are still trading at attractive levels.
From a sell perspective, we have targets of where individual corporate bonds should trade relative to one another.
Additionally, we look for negative trends - highly levered acquisition that does not make sense to us, deterioration in the competitive landscape of a particular credit, or shrinking margins.
Apart from looking at the risk-return analysis every two weeks, we take a more in-depth approach on a monthly basis when we look at each individual bond’s return relative to its peer group and industry, so that we can identify underperformers.
Once we have the list of such bonds, I discuss them with analysts to get a fresh perspective on the investment rationale. In our detailed discussion we try to identify if the rationale has changed. If the investment case has turned negative either at the industry or the company level, we will sell the bond.
Q: How do you build your portfolio?
A : We keep a fairly diversified portfolio. Typically, the maximum exposure to any individual name is going to be 1.5%, and that might be across multiple bonds. Currently, we hold 150 positions in the fund.
Since we view Treasuries as a relatively unattractive asset class, we own very few of them currently as a rule. Approximately 11% of the portfolio right now would be considered direct or semi-direct obligations of the U.S. government. Apart from that, we take credit risk in individual companies or structures that we see as attractive from a yield and a risk perspective.
When we take into account that we also have about 6% in cash, we can conclude that about 80% of the portfolio is in other securities that have a risk profile to them.
Our mandate allows us to buy up to 10% in bonds below investment grade. We can certainly find individual credits within sectors that we view as attractive or we can have overweights for sectors, but we believe a diversified portfolio of securities reduces our downside risk.
Q: What kind of diversification are you looking for?
A : Our core philosophy is that over time a diversified portfolio of securities improves the standard deviation of returns. What is more, it may not only outperform on the upside but it definitely helps to reduce volatility and overall downside risk in the event that something goes wrong.
Q: How do you measure risks?
A : We view corporate credit from that three-pronged perspective on an individual basis – financial risk, event risk, and operational risk.
Financial risk is based on balance sheets, income statements and cash flows. Event risk is more associated with mergers and acquisitions, whereas operational risk is more about the drivers at a macro level in the industry.
When we are evaluating risk at the security level, we look at risk from a fund perspective or a portfolio level by looking at our spread risk.
At a security level, some of the important drivers that we scrutinize are equity valuations and credit default swaps, as well as ratings, trends that diverge from what our analyst may view as the trend for a particular name as well as daily news events.
We evaluate our returns daily, weekly, and monthly as a barometer of whether we are gauging our compensation relative to the risk and if we are losing relative to our peer group or an index. If we seem to be underperforming, we want to find out why and re-evaluate our thesis.
We are cognizant of risks at a macro level. We are always weighing these macro risks as an increasing risk, stable risk, or a risk that we think we understand. Also, we evaluate if we are being compensated relative to the risk profile that may exist in the current environment.
Macro risks have an impact on our portfolio construction, which leads us to certain asset classes of the bond market that we find more attractive. But certainly, from a security level perspective, the risks contained within an industry or a company are much easier to identify and have more of a fundamental, scientific number-based model. From a technical perspective, we assess the risks in certain areas of the bond market such as corporate credit, mortgages, and commercial mortgage-backed securities. We view the fixed income market as extremely technical and believe investment opportunities exist as a result of this dynamic.
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