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Fixed-Income Insights

Today's fixed-income market demands a team approach.

Lord Abbett Partners Rob Lee, Director of Taxable Fixed Income; Andrew O’Brien, Portfolio Manager, Corporates; Kewjin Yuoh, Portfolio Manager, Liquid & Securitized Products; and Jerry Lanzotti, Portfolio Manager, Emerging Markets, discuss their approach to managing a fixed-income portfolio.

Q. Rob, you joined the fixed-income team in 1997 as one of its first hires. How is today’s market environment different, and how has your team evolved?
Lee: 
One of the things we’ve learned over this time is that collaboration is critical. In today’s fixed-income market, you can’t be a generalist—there is simply too much information out there for one person to master. To be successful, you need specialists who have deep knowledge of their particular area and who can communicate and coordinate well with one another. So, you need to have experts in residential mortgages, commercial mortgages, structured products, corporate credit—all the market’s sectors—as well as trading and portfolio management.

So, we employ what I like to call a “SWAT team” approach for investment decisions. Each person has their own area of expertise, but a small group of specialists can attack market problems with remarkable efficiency. And that collective expertise generates more consistent results than any one person would be able to generate. The key is maintaining an atmosphere of teamwork and collaboration, where the clear goal is finding the best way to invest our client’s money.

Today, we have a team of 45 professionals, including research, portfolio management, and trading. Our key members have worked in the field for two or three decades. In fact, many of them have worked together here at Lord Abbett for 15 years or more. That kind of team longevity just doesn’t happen unless everybody works well together.

Of course, the fact that our whole team is located here on one floor also encourages interaction. We expect our team to keep up a continual dialog throughout the day, so there’s a constant buzz of information about what’s going on in the market. One of my primary areas of focus every day is to make sure that everybody is informed and on the same page.

Q. How do you generate value for investors with this team approach?
O’Brien:
 Our investment process combines top-down with bottom-up analysis, employing both quantitative and in-depth fundamental research. We’ve found that our approach has generated remarkably consistent risk-adjusted returns for more than a decade, through all kinds of market environments. 

We generate value through model-informed sector allocation and thoughtful security selection, with rigorous risk management at every step of the process. And every material investment decision is collaborative. The conversation starts with our sector-allocation process, using proprietary quantitative tools that draw on an extensive historical database to help us frame relative-value discussions. But we don’t take a “black box” approach. The model informs our sector decisions and is used as a basis for discussion, but we don’t follow it blindly. We know that these models, like all models, have limitations, so we start each conversation by asking ourselves what the model doesn’t know. The team approach is helpful in terms of considering the macroeconomic backdrop, but it is critical when we have detailed discussions about the dynamics of a given sector.   

When it comes to actual security selection, we rely heavily on our 20-member research team and their bottom-up fundamental research. There’s a lot to this research process, including all of the company-specific analysis you might expect—analysis of publicly available documents, meetings with company management, and field research. But because our credit analysts are industry experts, and cover the entire credit spectrum, we are able to draw on information from their bottom-up analysis that may have a broader impact on the portfolio. For example, our transportation expert may be able to provide insights on current railroad shipments that may help us make a more informed decision about coming retail trends. 

Every security we purchase has been examined by a team that includes our portfolio managers, who are assessing optimal risk/reward trade-offs in the portfolio, and the research analysts, who have insights into the credit fundamentals of the issuer. Also, our traders work closely with the portfolio managers and analysts to ensure we are aware of all relevant market dynamics and that we are getting best execution.

Q. What about interest rate forecasting? Does the team also try to predict the direction of interest rates?
O’Brien:
 We remain duration neutral. If we dedicated all our resources into predicting the direction of interest rates, we would probably be right more than half of the time, but we’ve come to the conclusion that it’s just not worth putting up with the resulting volatility. If you try to base a strategy on predicting interest rates, you may get it right one quarter—and get it wrong the next. Over time, we believe that it is difficult to add value—it just adds to volatility of returns. We’ve learned that it’s best to concentrate our efforts on areas in which we can be right two-thirds to three-quarters of the time, and I think the consistency of our returns suggests we are on to something there.

Q. Kew, Andy mentioned that risk management was central to the investment process. Can you expand on that?
Yuoh:
 There are a number of different risks in fixed income that are critical to understand and quantify. We seek to understand our risks at the portfolio level, the sector level, and at the security level. At the security level, we seek to mitigate credit risk through in-depth fundamental credit research. As noted earlier, our credit research analysts are sector-focused, with deep knowledge of the industries and companies they cover. On a company-specific level, for example, we analyze earnings, cash flow, and leverage ratios, and then model future cash flows under base-case and worst-case scenarios. At the industry level, we monitor metrics that offer insights into the prospects of individual holdings. More broadly, as part of our top-down process, we monitor the overall pace of the economy and the outlook for monetary and fiscal policy, and we actively debate which sectors and industries may be affected by these larger economic trends.   

But we want a full understanding of where our risk exposures are across the portfolio at any given time. To that end, we have developed a robust series of risk analytics to monitor absolute and relative portfolio exposures. These analytics are derived from security-level data and aggregated to the industry, sector, and portfolio levels. 

We want to avoid a reductionist framework for understanding that risk, so while we do aggregate risk in order to think about an overall risk budget in the portfolio, we make sure to aggregate that risk in a number of different ways. It forces us to constantly consider all of the ways that market moves can affect portfolio performance—and to make sure that the risk we are taking is the risk we intend to take.

Q. Can you provide more details on the approach to quantifying risk?
Yuoh:
We go to great efforts to identify and measure risk. Our Quantitative Research team, led by Walter Prahl [Ph.D., Partner & Director of Quantitative Research], has built proprietary risk-reporting systems derived from security-level data that quantify exposures to sectors, subsectors, and issuers, as well as interest rates, volatility, and term structure.  

Over the years, we’ve developed some very thoughtful tools for considering and quantifying our true performance-at-risk. So our systems provide us with up-to-date relative risk exposures in the portfolio. We’ve developed some ways of standardizing our conception of risk, which really helps us to compare risk across sectors and up and down the credit-quality spectrum. We can say we want to move 5% of the portfolio to agency mortgage-backed Securities [MBS], but if we reduce corporate credit, is that equivalent risk? Of course, that depends on the credit quality and a number of other factors. But our tools help us to quantify those trade-offs.

Also, our proprietary trading system has a risk-management component. When a trade is entered into the trading system, but prior to trade execution, we’re able to do a scenario analysis. Our system can assess how the trade will increase an exposure to a particular bond sector, individual issuer, or particular issue, and how that affects the portfolio in real time. It also helps us to determine the effect a trade has on firm-wide risk to a particular bond sector, individual issuer, or specific issue.

The goal of our proprietary risk analytics and risk-reporting system is not to eliminate all risk in the portfolio or to reduce risk to one summary data point. Instead, we seek to understand and quantify risk exposures in the portfolio at many different levels. By making risk management a central part of the investment process, and by having a clear understanding of portfolio exposures at all times, our process has delivered consistent, attractive risk-adjusted returns.

Q. Jerry, emerging markets have changed quite a bit in your 18 years at Lord Abbett.  Can you talk about the role that sector plays in our total return strategy, and why it is so important?
Lanzotti:
 We have been investing in emerging markets for more than 15 years, and it is one of the fastest growing and most rapidly evolving sectors of the fixed-income markets today. It will likely play a growing role in all of our strategies as the structure of the global economy continues to shift. Already, it’s impossible to look at one part of the world in isolation. How can we talk about a mining company without understanding demand in China? Even when we aren’t aggressively positioned in emerging markets in our total return strategy, we need to be aware of the global landscape. So the value goes well beyond excess returns specifically generated from our emerging markets investing. 

And the same goes for other asset classes, too. The entire team is contributing to each of Lord Abbett’s strategies. Our high-yield and bank loan portfolio managers, for example, aren’t specifically named on this fund, but they contribute meaningfully to our views of each asset class. And this collaboration extends beyond the fixed-income department, as our team of equity analysts works closely with our credit research team, and helps all of our portfolio managers. For example, we can leverage the knowledge of equity analysts in the retail, lodging, and REIT [real estate investment trust] sectors to better understand factors that may affect fundamentals in the CMBS [commercial mortgage-backed securities] market. As Rob said earlier, our collaborative style—the “SWAT team” approach of multiple sector specialists—allows us to use multiple resources to make the right decisions. And the more expertise we can bring to the table to make informed decisions, the better we are. 

O’Brien: To summarize our overall approach, I would say that by focusing on sector rotation and security selection—areas where we think we can be right two-thirds to three-quarters of the time—and by avoiding riskier plays, such as duration bets, where it’s more difficult to consistently add value—we’ve been able to avoid some of the big blowups of the past decade. And our clients have appreciated knowing exactly what to expect from us.

Lee: And I think the impact of our collaborative approach can’t be overstated when it comes to that consistency. We can bring the deep market knowledge of sector specialists to each discussion, but because the focus is always about how best to invest each dollar our clients give to us, we’ve removed ego from the equation. We aren’t trying to hit home runs to get our portfolio managers’ names in lights; we scratch out singles and doubles, over and over again. And the entire team wins together.

Q. What’s the team’s view of the current market?
Lee:
Fundamentals are still strong, but the market is fragile. Tapering is now old news, and the next chapter of the Fed’s playbook, and of media and investor focus, is about Fed rate hikes and about the continued withdrawal of these extraordinarily easy financial conditions. And there’s no precedent for this, no script. We are now vastly removed from any historical context in which to understand market behavior. We should expect prior relationships to continue to break down, and for a liquidity-challenged market to continue to punish the ill-prepared, and to provide opportunities for those who are prepared.

So we are watching economic signals in the United States closely, but we are also paying close to attention to this continued decoupling between the U.S. and U.K. economies and central bank direction, and those of Europe and Japan. We are seeing some early signs of wage growth, which tends to accompany trending inflation, even though inflation expectations have been cratering recently on weak global growth and recent CPI [Consumer Price Index] prints. Broadly, valuations don’t justify enormous amounts of risk in here, but that’s fine with us. We will just keep chipping away.

I would just add to what Andy said about consistent results. I think the depth, experience, and philosophy of our taxable fixed-income team contributes to that consistency as well. We’re not going for home runs—we’re going for a high batting average, and I think the Total Return Strategy exemplifies that approach.

 

TOTAL RETURN FUND

 

video

The Total Return Fund seeks to deliver current income and the opportunity for capital appreciation as a core fixed income portfolio. It offers:
• An Experienced, Tenured Team
• A Disciplined, Flexible Approach
• Consistent, Risk-Adjusted Returns

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