Researching Global Credits
Western Asset High Income Fund
US > Non-Investment Grade >
Aug 28, 2012
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52 Week HL
97.71 - $84.56
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Inception Date
Dec 14, 2006
Q: Would you provide a brief description of the company?
A : Legg Mason, the global asset management company, acquired Western Asset Management Company in 1986, and in December 2005 the firm purchased a substantial part of Citigroup Smith Barney’s asset management business to expand into fixed income investment.
Q: What are the tenets of your investment philosophy?
A : The depth and experience of our research group form the cornerstone of our philosophy.
The fund mirrors the same high yield bond investing philosophy and process that we have adhered to over the last two decades. When we inherited this fund, we simply continued to leverage our global team of credit professionals and decades of experience in disciplined fundamental credit research.
Q: What is your organizational structure?
A : We manage $110 billion, of which about $25 billion is in below investment grade credit. We have nine offices around the globe and over 60 professionals dedicated to credit research with about 17 years of research experience on average. The assets under management provide us with the scale and resources necessary to attract and retain what we think are the most seasoned and talented professionals.
In addition, our organization structure is global, as we believe that there is a lot of strategic benefit in having a geographically diverse credit research infrastructure.
Finally, even though there has been a convergence and global markets are moving closer together, there are still unique ways in which markets operate. Therefore, it is important to have local experts who understand how these markets operate and who serve as sources of local intelligence and access to management teams.
Q: What is your investment process?
A : Our process starts with what we call a strategic portfolio. It is a top-down portfolio framework that incorporates two key elements – our macro-economic views and our individual risk bias ranging from aggressive to conservative. The second objective in our process is the overall industry exposure. In the end, our strategic portfolio is a combination of all those elements.
The macro insights come from our broad market strategy committee, which is made up of several senior generalist portfolio managers, who are more multi-sector in nature, together with the heads of various asset classes.
Another key input to our strategic, top-down portfolio comes from our global credit committee, which includes all the senior credit portfolio managers. We meet on a regular basis to ultimately establish and drive the overall credit strategy at the firm. That constitutes the top-down portion of our portfolio construction.
In terms of alpha generation, or excess return, our clients can expect approximately 35% to 40% to come from the top-down themes described above.
However, the dominant portion of alpha generation in our portfolios historically comes from our bottom-up process, which is the population of the targeted industry allocations with what our research team sees as the best relative value ideas. Our resulting portfolio ends up being the result of the bottom-up and top-down strategies described above.
An important aspect of the process is our belief that idea generation can come not just from the research analyst but also from the portfolio manager or the trader. In the end however, the analyst is the ultimate driver of that decision.
Finally, there is a significant layer of risk management that is applied as an oversight to ensure that the portfolio is within our overall risk budget and that there are diversified sources of risk contributing to the overall tracking error of the portfolio.
Q: Would you elaborate on your research process?
A : Our primary strength is our ability to benefit from an experienced research team. With this combined effort we look at all the different credits and bonds that are out there, honing in on not just how a company is doing at present but also projecting where a company is going and whether it has an improving trajectory.
For instance, around the middle of 2008 we saw that there was a significant amount of concern regarding the economy as well as credit fears, but the market was overcompensating for the downside. Our research efforts identified several compelling opportunities in the market, and at that point we made a tactical decision to increase the overall risk budget in our portfolios. We felt that trading levels were more than adequately reflecting all the risks that we saw in the market.
By the third quarter of 2008, we started to dial up our portfolio risk, as it became clear that there was extreme fear in the market and that was already being reflected in pricing. But most importantly, we believed that our research process could identify the best risk-adjusted opportunities in the market. We continued to keep that trade on, and as 2009 started to roll out, the portfolio started to get the benefit of that strategic move.
On average, our clients can expect between 60% and 65% of our portfolio’s alpha to come from bottom-up, fundamental research.
For us, the research process starts with a thorough and critical evaluation of management, which includes one-on-one meetings to better understand the management teams that we are investing in. We view this type of management scrutiny as the first hurdle in our approach.
Once we have evaluated management teams that we favor, our analysts use their own proprietary models to assess the merits of the individual companies that we are going to invest in.
What is unique about our process is that our analysts have different models for different industries We see that as a core asset in our methodology, because the key drivers of value can differ from one industry to another, and what really drives credit improvement and deterioration can differ between industries.
When we do our company research, we spend a lot of time on the projections, trying to understand the overall trends and trajectory of a business.
We also take into account financial flexibility. At this stage we want to understand the sources of liquidity for each company and to determine where our bonds are positioned within the overall capital structure - are they senior secured bonds, senior bonds, or subordinated bonds?
In addition, we spend a lot of time on covenant evaluation – understanding the specific limitations and constraints that are afforded in the bond indenture through covenants.
We also do rigorous asset analysis. We try to understand the underlying value of the company and whether their underlying pool of assets are sufficient to more than cover the amount of the company’s debt. This is why we focus heavily on industries or companies that tend to be asset rich. Companies and industries with significant asset value give our clients an added layer of protection.
For instance, we have an overweight right now in energy exploration and production companies, where we can look at proven reserves in the ground and apply a multiple to those reserves in order to obtain a measure of asset value. What we have found is that this industry looks attractive from this perspective.
Another example of our emphasis on asset analysis would be our investment within the airline sector. All of our investments are collateralized so that we do not own any unsecured airline debt.
Ultimately, we perform relative value analysis to settle on the right combination of risk and reward.
Q: Could you illustrate your research process with an example?
A : There is a company that recently came to the market called Zayo Group, LLC, a provider of fiber-based bandwidth infrastructure services.
We recently invested in the company and one of the things that we really liked in this particular investment was the company’s experienced management team. Quite a few of their management team members had come from Level 3 Communications and had experience in successfully operating a telecom infrastructure company with significant leverage – something that we liked a lot.
Also, Zayo bought AboveNet in June. The purchase of AboveNet was interesting because Zayo had previously had too much reliance on carrier traffic. They had a very limited amount of their business exposed to enterprise customers, but AboveNet had significant exposure to the enterprise market, which we think is much more lucrative because of its better margins and diversification.
We thought that the combination of these two companies was a good merger because it practically created a 50-50 revenue source between carriers and enterprise.
Q: Is rating revision an important criterion in your research process?
A : For us, it is less about rating and much more about placing the proper assessment of risk on particular issuers. We are certainly cognizant of what a company’s rating is and understand that upgrades and downgrades can effect a bond’s pricing. However, the reality is that with the limited staff that rating agencies have, combined with being responsible for the entire credit universe, it is simply too much to expect that rating agencies will be right all the time. That is why we conduct our own internal rating analysis as we look for a mispriced credit in the market. For us, security selection is more of a concept of relative value and finding the mispricing of various securities.
Q: What is the role of diversification in your portfolio construction?
A : We do not insist on necessarily being overdiversified, which might dilute the advantage that comes from research, but we certainly want to exercise prudent risk management.
It is a question of subtle balance and we have found that the range of anywhere from about 120 to 150 different issuers in the portfolio gives us the right blend of managing risk, yet getting the benefit of what we think is our strategic research advantage.
We get a balance from our overall industry exposure by not necessarily trying to make dramatic bets on any given industry. We want to overweight those sectors that have better relative value characteristics while at the same time underweighting those that are overvalued or likely to disappoint.
Q: What are your views on risk? How do you manage risk in the portfolio?
A : Our portfolio is designed to have about 300 basis points of tracking error. We are always aware of the risk and tracking error in our portfolio, and for us it all boils down to the contribution to that tracking error. Looking at the sources of tracking error, we want to see good diversification that is evenly spread out between sectors, credits and risk profiles.
Tracking error is the byproduct of historical measures, and as much as historical measures are somewhat reliable in normalized times, we cannot count on the markets to behave within the constraints of a historical or normalized pattern, so diversification comes as the most adequate measure against all those risks.
We are also cognizant of liquidity risk. With the markets growing to the extent that they have and dealers facing more and more constraints on their balance sheet, either from risk management or regulatory measures, we are seeing less corporate inventory at dealers contrasted with an increasing size of the overall credit market. In the high yield market that specifically translates into less liquidity. Therefore, we take a proactive approach to evaluating the overall liquidity of our portfolio at any point in time.
Furthermore, we have about a dozen different scenarios that we put our portfolio through, trying to see how it holds up under a range of different risk regimes and gain insight as to its overall structural integrity.
In addition to looking at our overall rating profile versus a specific benchmark, we also look at our overall industry exposure, and there it is basically the maximum of three times the index weighting or 15%, the lesser of the two. That is our basic measure for managing the overall industry risk.
By far the dominant risk in our portfolio is on the credit side. If we are going to outperform or underperform in any given year, the primary driver of that is going to be our credit selection process.
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