Mirror, Mirror

My style is simply to create the portfolio within the parameters and the risk tolerance that we identify versus the benchmark, and to deliver second-quartile consistency over a three- and five-year time frame. Since we overweighted the non-Treasury, non-government parts of the market relative to our benchmark, and that’s a theme that doesn’t go away over time, we are not closet indexers but instead take pretty active sector allocation positioning strategies relative to the benchmark.

What do you look for in a corporation before investing in its debt? Do you simply look at its debt ratings and then buy the duration you want, or do you look hard at the company’s fundamentals? Have the corporate accounting scandals changed the way you evaluate a company’s debt offerings? While we live by the mandated guidelines that suggest we can’t buy something rated below investment-grade in these portfolios, we evaluate the issuers ourselves and do not depend on agencies. In the recent past, we think the agencies have gone “weight overboard.” The fact that they had investment grade ratings on Enron and WorldCom two or three months within default is a significant miss. Our evaluation is a combination of company-specific issues and the sector-related environment, the overall industry, and then some evaluation in the context of their valuation in the marketplace. There are securities we buy where the fundamentals were neutral but valuations were good, and there are securities we buy where the valuation was fair but the fundamentals were good. It is not just that I buy the best names; [rather] I try to buy the best names appropriately priced for their risk. If my portfolio was only made up of names like Wal-Mart that trade very tightly on a spread basis to Treasuries, I would have a tough time outperforming despite the fact that the risk of the portfolio would be lower.

That whole line of thinking becomes acute when we have investment-grade companies trading like high-yield companies. We see that as a large opportunity. Overall, large chunks of the corporate bond market have repriced to a level of risk that I think is unrealistic. My job is to take advantage of that in a focused and diversified way.

Your fund had average annual return of 6.5% for the 10 years ended July 2002, compared to 6.2% for all bond funds in your category. Why has your fund performed slightly better? A year to a year and a half ago, on the credit side we started to become a little more focused and take a little more risk in some specific names, but that is only in the wake of this reevaluation in certain parts of the market. Prior to the last six months we had simply implemented a very concerted effort to get more diversified in our credit exposure. We felt the idiosyncratic risk in individual names had grown to levels we couldn’t stomach; this means two or three years ago it wasn’t uncommon to have 1% to 2.5% in individual names. Over the last two years we moved that to a much more modest positioning, from 0.5% to 0.75%. You could say that that was a modest change. What it meant was that we didn’t let any single name blow up the fund or any single name take down the fund, in a way that was out of line with the risks we are trying to take relative to the benchmark. Now that we are in the middle of this period of extreme valuations of individual names, particularly in the subsector of communications, at levels that are relatively extreme for investment grade credits, the diversified fund approach may be less helpful. Now, are we going back to 1.5% to 2% positions? No. But are we stuck to 0.5% positions as the highest number? No. I think you can start to see some allocations begin to get higher. But we are starting to move into names that we think have been overdone, and warrant the higher exposure.

Has there been a big inflow into the fund since the beginning of the bear market? Two years ago, this fund was probably $550 to $600 million-ish across all share types. [At year end 2000, the fund had net assets of $542 million, according to Lipper.] Recently it’s up to about $1.15 billion, so it’s doubled in size. It’s been steady and I think things have picked up over the last six months.

You currently maintain 6% cash holdings. How does this level fluctuate? It’s probably a little high at the margin right now. Right now, on a relative basis we have a negative view of the two-year part of the marketplace relative to the five-year part; in order to implement that trade on a duration-neutral basis, we maintain a slightly higher cash balance. The other piece is the fact that flows do continue to be steady, and sometimes I will leave it in cash for a little bit. A comfortable cash number is really 3% or lower.

Are you at all concerned that the bond market is in a bubble at the moment just as stocks were in the past? This is the big picture: the classic shareholder trend is to chase performance and to chase the recent winner. Clearly the extreme example is the aggressive growth in the late ’90s, where the last guys in suffered the most pain. I think we’ll see nothing like the growth fund debacle of the last couple years, but we may see some smaller version of that. We may even be at the front end, with the way investors have started to pile into bond fund products, and maybe even more specifically government bond fund products. It is remarkable to me how popular bond fund products are, with five-year yields at 3% and two-year yields at 2%. For my money, even now at these depressed yield-levels, you have to take a bigger picture view from a total return standpoint. I am not sure you are maximizing your risk-adjusted returns by just going into government bond fund products. I think a longer-term view would lead you to products like Advisor Intermediate.

You have a significant amount in mortgages, especially Fannie Mae mortgages. In terms of the mortgage performer, these are agency-backed, mortgage-backed securities so there is really very little credit risk. The fact that Fannie explicitly backs it is even better than a Fannie Mae divestiture or street Fannie Mae issue. You also have the collateral of the underlying houses as security for the transaction in a way that you wouldn’t on a Fannie Mae agency bond. So it is not just the implicit or explicit backing of the government of Fannie Mae, but also the collateral that exists in these structures that makes them so strong. The real risk is what you take on in terms of the timing of cash flows, and the repayment risks involved in these securities.

Our allocation in mortgages has started to creep up relative to the May-June time frame. We’re doing it on a conservative basis on some of the more pre-protected parts of the market that are going to secure us well even if the market gets more volatile again.