The Legg Mason Income Optimiser fund is characterised by its capacity to secure a strong income yield for its investors while also protecting capital on the downside. For portfolio manager Regina Borromeo maintaining a high quality fund with reduced volatility is as important as obtaining a good yield and, in essence, she is tasked with maximising total return while minimising the risk exposure.
She says: “While we target an attractive yield, the other objective is to preserve capital in periods of volatility and during market downturns. We do not want to be yield hogs that get slaughtered every time there is a market correction.”
Indeed, while Ms Borromeo is justifiably proud of the stellar performance the fund has generated to date, she is also keen to emphasise that this outperformance – the fund returned 16.35 per cent over 2012, compared with a sector average return of 13.72 per cent – was achieved without resorting to exposure to the higher risk sectors that performed strongly over 2012. Instead, the team at Legg Mason subsidiary Brandywine Global Investment Management seeks out securities in less cyclical sectors and tends to stay at the higher quality end of the spectrum, preferring single B or higher rated quality levels.
Importantly, while the fund has just celebrated its one-year anniversary, it represents an extension of the Brandywine Global established credit-orientated strategies, which have a three-year track record, while the broader country and currency leanings used in the strategy have a 20 year history as part of the firm’s long-standing global bond strategies. As of December 31, Brandywine Global manages $34bn of global fixed income assets.
“As an investment house, Brandywine Global has three key philosophies that drive how we invest,” Ms Borromeo adds. “First, we are a global value investor and, as such, we seek attractive real yields throughout the market cycle from around the world. Second, we are benchmark agnostic and tend to manage more concentrated portfolios. Finally, we are a macro-driven house and are, therefore, dominated by the top-down before taking a bottom-up view.”
The fund is managed by a team of three managers, with Ms Borromeo joined by Gary Herbert and Brian Kloss. Every buy and sell decision has to be agreed by all three co-managers, encouraging debate and a collegiate environment. Underpinning those day-to-day decisions is the top-down value-oriented strategy that characterises Brandywine Global’s approach to fixed income investing.
As Ms Borromeo explains: “We start off with a systematic top-down research approach. Francis Scotland, the head of our macro research, has developed a robust macro chart-book facility which analyses around 50 developed and developing countries, as well as individual currencies and sectors, using different quantitative valuation and fundamental models.
“We look at both price and information risk to shape our macro and valuation process. Based on the model outputs and our discussion on the state of the economy and price and information risks, investment themes are established on country, currency, duration and credit. Then, we screen the investable universe using both quantitative and fundamental factors. We use the country and currency as well sector and quality views to screen the investable universe of over 11,000 securities, combined with our fundamental model scores and valuation metrics to find the most attractive bonds to do the deep-dive bottom-up research on.”
The screening process is carried out daily, with the help of the IT team at Brandywine Global to develop dynamic tools that aggregate the broad range of information from different sources, as well as using algorithms to score the investable universe. The process leads the team to approximately 200 securities that are considered to be undervalued, these are then debated with the end fund typically having between 50-100 securities that are chosen for their income generating potential, as well as being considered high quality relative to the state of the economy.
Since inception, exposure to three sectors in particular has driven the majority of performance and income yield for the fund. The largest position to date has been in global high yield, with the fund currently targeting both European and developing market corporates. This has been complemented by an allocation to local currency sovereign issues, with the managers given the freedom to either keep the positions unhedged or to hedge back into sterling depending on the opportunity present in the individual position.
“As it stands, the local currency sovereigns we are choosing are favourable not only because of the exposure they give to a particular country, but also the strength of the currency relative to sterling,” Ms Borromeo says. “For example, our exposure to Mexican longer-dated government bonds has been driven both by the fact that they are yielding around 6 per cent, but also because we view the currency as being attractive relative to sterling. However, with some of our exposure to European high yield we have chosen to hedge back from euros into sterling.”
The third most significant sector exposure has been to US non-agency mortgages, which is a play on the US housing recovery. In this area the managers are willing to move further down the investment grade scale, generally opting for securities that were previously A-rated or higher but which have been downgraded. This is balanced out by the fact this exposure is well diversified geographically and thoroughly stress tested and the fund has no exposure to the sub-prime area of the market.
Overall, the performance of the fund and, specifically, the reduced level of volatility when compared to its strategic bond peers have been enhanced by the skilled use of beta hedging tools. Indeed, the managers have the capacity to use derivatives as well as FX forwards, default swaps and interest rate futures to hedge out currency, credit and duration risks, respectively.
“So far, most of the risk in the fund has been credit risk and so the majority of hedging has been in credit default swaps,” Ms Borromeo says. “To that end we have been buying protection on index positions as well as single name contracts to hedge out the credit risk. Essentially we view this as a way to decrease the volatility of the fund and protect it during periods of spread widening. Since the fund is still yielding over 7 per cent, it is a way for us to be prudent considering the uncertainty in the market. It allows us to have lower volatility and less downside capture when compared to many of our peers.
In terms of the outlook for the sector, Ms Borromeo remains “cautiously optimistic”, with the team positioning the fund to reflect that view.
“While we would characterise last year as a period of self-preservation and the reflation trade taking hold, this year can be characterised by the risk of success,” she says. “Expansionary policies are succeeding in reflating the economy, particularly in the US, and there is a risk that the quantitative easing may be reduced sooner than the rest of the market may expect, which would drive a renormalisation of the yield curve in the US. We view a lot of price risk in the negative real yielding safe-haven bond markets such as gilts, bunds and US treasuries.
“With this in mind, we will continue to keep a shorter duration while having exposure to higher real yielding assets in Europe and the emerging markets.”
