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Fixed-Income Insights

Andrew O'Brien, Lord Abbett Partner and lead Portfolio Manager for Taxable Fixed Income, discusses how his team seeks a high level of current income consistent with preservation of capital and limited duration.

Q. How would you describe this strategy's investment philosophy?
A. Our goal is to consistently provide our clients with a high level of income consistent with preservation of capital and limited duration.1 This dual purpose—high relative returns and management of risk—is actively pursued via a research-intensive investment approach. We construct a diversified portfolio with undervalued securities from fundamentally attractive sectors.

Q. How does that translate into practice?
A. We typically invest at least 65% of the portfolio's assets in investment-grade debt securities, including U.S. government and other government-related issues, U.S. and foreign companies, and mortgage-backed and other asset-backed securities. We may invest up to 35% of its net assets in high-yield (below-investment-grade) debt securities; non-U.S. debt denominated in foreign currencies; senior loans and loan participations; and convertible securities.

Q. Please elaborate.
A. The investment process can be described as value oriented and thematically driven. Value comes from bottom-up security selection in concert with the identification of salient investment themes. We have three formal meetings each week to discuss the issues affecting business, political, and regulatory conditions and capital markets valuations and determine appropriate sector weightings. Sector specialists are then charged with the search for those issues or issuers that best reflect our investment thesis and offer the best risk-adjusted return opportunities. We continually assess the market environment in an effort to maintain a dynamic understanding of the drivers of valuation across all sectors.

Q. What's your universe?
A. We select from a broad universe of securities that includes CMBS, ABS, high-grade corporates, and other fixed-income sectors, although we focus primarily on securities whose average life 2 falls within the range of one to three years. We will also opportunistically have limited exposure to high-yield bonds, non-U.S. debt securities, and bank loans.

Q. Please describe your purchase criteria.
A. Sector teams are responsible for purchases and make them based on an assessment of expected risk-adjusted return in the context of our strategic opinion. Once we identify investment themes and attractive sectors, our sector specialists are responsible for individual security selection. The security selection process is sector specific. In the corporate bond market, a proprietary spread model is used to determine valuations based on ratings and maturity, which are then compared with market pricing to produce a rich/cheap metric. This analytical model, the Relative Valuation of Credit Spreads (RVACS), interpolates a security's fair value on a maturity- and quality-adjusted basis. The RVACS screen identifies dislocations by sector, subsector, industry, and issuer. Once excess spread is identified (spread in excess of fair value as determined by us), we employ bottom-up, fundamental analysis. Our fundamental research on corporate credits includes: a) an understanding of the metrics of a given industry; b) the state of an issuer’s balance sheet; c) the quality of the assets on that company's balance sheet; d) the quality and trustworthiness of management and their insightfulness in responding to change in their industry; and e) financing needs relative to the liquidity of the investment market. For mortgages, we employ a proprietary prepayment model to identify mortgage-backed securities with what we believe is the most attractive valuation. For asset-backed securities, we survey the market for opportunities to purchase the highest-yielding securities without sacrificing creditworthiness.

Q. What about econometric models?
A. Econometric models range from adjustable-rate mortgage prepayments to forecasting payroll employment to disentangling interest-rate and term structure risks.

Q. What factors dictate the sell discipline?
A. Sale candidates are typically those with the least attractive risk-adjusted return profile or those whose inclusion results in suboptimal portfolio characteristics. Sales based on deteriorating credit fundamentals occur as appropriate and tend to be done incrementally unless dramatic events unfold. In order of frequency, sales occur for the following reasons: 1) bonds attain the spread target we established when we opened the position; 2) we change our strategic outlook; 3) more attractive alternatives are identified; 4) our risk management discipline prompts us to reconsider an exposure; and 5) an issuer’s credit fundamentals evidence deterioration. We constantly monitor portfolio summary statistics to ensure consistent risk profiles.

Q. To what extent do you work with other parts of the firm?
A. Our short-duration team is fortunate to be able to draw on the extensive analysis of our colleagues in equity investments, who have ready access to senior management of companies they follow and invest in. Such cooperation can be quite valuable.

Q. How do you approach risk management?
A. We invest a great deal of effort identifying and measuring risk. Our quantitative team, led by Walter H. Prahl, Ph.D., Partner & Director of Quantitative Research, has built proprietary risk management systems to quantify relative exposures to sector, subsector, and issuer, as well as interest rates, volatility, prepayments, and term structure. For corporate bonds, on an industry level and on an issuer-specific level, we utilize a value at risk methodology that calibrates exposure to a variety of risks, taking into account credit rating, maturity, and sensitivity to changes in financial market credit conditions. Position limits are set to certain tolerances to minimize the risk that any individual credit would penalize portfolio performance beyond a specified amount.

Q. What about position limits?
A. There is no limit on the weighting of an individual Treasury or agency security. However, for other securities, we would generally not hold more than benchmark plus or minus 3% per issuer in the highest-rated securities [i.e., 'AAA'] and no more than benchmark plus or minus 0.25% per issuer in below-investment-grade securities.

Q. To what extent do you use derivatives?
A. We use Treasury futures to manage the overall duration and term structure of the strategy. This is often the most efficient and effective way of managing such exposures. Eligible derivatives may include options, futures contracts, forward contracts, or swap agreements.

Q. How would you sum up the competitive advantage of the strategy?
A. The strategy's sector rotation emphasis has been a significant source of value added over time. The anomalies we have exploited emanate from insights based on a value approach. Another source of value added has been our internal research, both qualitative and fundamental, and inherent investment flexibility. We have material quantitative expertise, enabling us to utilize a diverse set of strategies. Team members with doctoral degrees in finance and economics have designed a suite of quantitative models that provide insight into financial markets. Strategy diversification has provided access to multiple sources of excess return while reducing systematic risk. [Of course, there is no guarantee that the strategy will perform in the same manner in the future.]


1 Duration is the change in the value of a fixed-income security that will result from a 1% change in market interest rates. Duration is expressed as a number of years, and generally, the larger a portfolio’s duration, the greater the interest-rate risk or reward for underlying bond prices. A duration neutral protocol means we manage our portfolios such that each portfolio has the same duration as its index.

2 Average life is a term that defines the length of time the principal of a debt issue is expected to be outstanding. It is an average period before a debt is repaid through amortization or sinking fund payments.


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