Portfolio manager Gary Herbert explains his multi-sector approach to achieving value across different bond market segments
WELCOME
The Legg Mason IF Brandywine Global Income Optimiser Fund seeks to provide an attractive income while preserving capital by investing actively across global fixed income sectors. In this eBook Fund manager Gary Herbert reveals his research-based, top-down approach when evaluating the most attractive fixed income markets. Herbert also provides his view on investor concerns regarding liquidity in the bond market, and why it is important to take a multi-sector approach to define value.
THE INTERVIEW
Investing for income: meeting the challenges of a low yield environment
Gary Herbert, Brandywine Global
10-Year government bond yields (%) since 1986
Historically, fixed income investors have looked towards a particular segment of the market to generate income. Safe haven sovereigns such as gilts, European government bonds, US treasuries and investment grade credit have met the need for ‘secure’ income, while high yield and emerging market bonds have been part of the consideration process for those taking higher risk for a higher return.
But for several years asset managers and advisers have been grappling with an accommodative interest rate policy which has resulted in yields declining across the asset class, while credit spreads have also diminished. In this environment investors have been more exposed to interest rate sensitivity and the challenge for managers has been how to maintain a decent level of income in a low-yielding environment. “What we’ve been advocating,” says Gary Herbert, Head of Global Credit at Legg Mason subsidiary Brandywine Global, “is a more multi-sector approach to defining value.” Herbert co-manages the Legg Mason IF Brandywine Global Income Optimiser Fund, an unconstrained global strategic bond fund which seeks to provide an attractive income while preserving capital by investing actively across a range of global fixed income sectors. “When a manager is good at identifying opportunities on a top-down and bottom-up basis they can deliver more yield than higher quality sovereigns, but with lower risk than the most risky segments of the fixed income markets, such as emerging markets or high yield. So we’re big advocates of a global multi-sector approach because this allows us the flexibility to determine where there is value across different segments of the market.”
A multi-sector approach
“We think it’s also important to include derivatives. This gives us the ability to mitigate risk using either credit derivatives or adding more high quality duration in the portfolio when there are periods of risk aversion. By doing this we avoid being a forced seller at bad prices when there is less liquidity in the markets.” Four years ago, roughly 80% of the Fund was invested in high yield. Today it’s closer to 25%. Currently, US high yield and emerging market issues are where Herbert and the team see the best opportunities. These are often commodity-oriented: oil and chemicals as well as more export-led companies. Herbert says: “We tend to think in valuation terms that are based on statistics. Today, we would suggest that high yield is about half a standard deviation overvalued in aggregate – about 50 to 70 basis points. And from our perspective, in aggregate, we don’t want to have a large systematic exposure.”
Increased market volatility and the impact of global political events such as Brexit combined with rising US interest rates means that now more than ever, investors need to watch out for liquidity red flags in many areas of the fixed income market. The way to manage such risks, explains Herbert, is to diversify across investment grade credit, high yield credit, structured credit, local currencies, and safe haven sovereigns.
Sector outlook
The accommodative monetary policy seen in recent years has led to central bank balance sheets expanding, however according to Herbert the central banks are now moving away from this unorthodox monetary policy and back to normal growth drivers like private sector investment and expanding consumption by the household sector. “This is our perspective. If we are right, it implies that rates are going to move higher and therefore managers should consider opportunities beyond traditional safe haven sovereign bond markets, particularly those with negative yields.
Australia
Japan
UK
US
EUR/German
“We are fairly negative on European sovereigns. We think they are going to generate negative returns over a three to five-year cycle and so the way to generate income is to consider unique opportunities in Latin America, US credit and high yield. Economic normalisation – I won’t call it reflation – is occurring and this allows us to remove the crutch of unorthodox monetary policy. “And as that happens, investors, particularly those in global fixed income markets who aren’t exposed to higher real yielding markets, either through credit or in terms of duration risk, are going to be faced with losses. But the more multi-sector-oriented managers will be better served over time.”
Source: Brandywine Global, as at 31 March 2016.
FUND OUTLOOK
How has the Legg Mason fund performed?
In association with
Source: PureGroup As at 31 March 2017
How Brandywine Global invests
Brandywine Global’s macroeconomic views, sector/quality rotation, and valuation fundamentals drive their investment process.
Legg Mason: Future outlook
Even though central banks have finally started to indicate that the consensus around their long running monetary policies may be about to shift, it is likely that removal of these supportive policies will take considerable time and unlikely to be consistent on a global basis. Investors, who are still keen to identify sources of yield, will now need to take this into consideration when allocating on a global basis. The Legg Mason IF Brandywine Global Income Optimiser Fund has a flexible mandate allowing the investment team the ability to manage credit quality and country allocations, providing an ability to navigate fluctuating markets. Currently the portfolio tilt is more towards US country exposure than has historically been the case. Therefore the wider global macro trends, while interesting, will have a more indirect impact on the fund.
What are the downside risks?
Where is the most attractive yield?
Global Income Optimiser
500 to 100 positions that offer the most attractive income, with price potential stability or appreciation Hedging strategies manage the portfolio’s interest rate, credit, and currency risk Attractive income distribution yield over full-market cycle with downside protection
What is the intrinsic value?
Where is the price risk?
Where is the valuation opportunity?
Valuation Inputs
Sovereigns We evaluate each country’s real yield and its relative attractiveness compared to outputs from our macro research process Credit and spread sectors We actively screen for opportunities based in financial models and projections, combined with fundamental analysis Other factors may include liquidity analysis and hedging costing
Where is the risk?
Where is the information opportunity?
Macro Inputs
Country-by-country analysis, analysing macro factors such as: • Each country’s business and liquidity cycle • Long-term shifts in inflation • Secular and political factors • Demographics • Debt and pension liability trends
Fundamentals
A rigorous fundamental analysis is deployed which encompasses earnings power, liquidity, and capital structure.
Fixed income sectors
Long positions among the cheapest sectors are emphasised. The most overvalued sectors are avoided.
Macro approach
Top-down research is used to identify potential and significant opportunities across global sectors.
FUNDAMENTALS
MACRO APPROACH
FIXED INCOME SECTOR
PureGroup analysis:
Managers of the Legg Mason IF Brandywine Global Income Optimiser Fund use a top-down approach to assess the wider economic cycle. On balance, the fund’s lower duration position enables the team to capture inflation and earnings return through exposure to high quality corporate credit, while also avoiding high sensitivity to interest rates. We can see this through the fund’s positive sensitivity to global inflation.
On both a short and long term basis, we can see that unsurprisingly the fund would be negatively impacted by an increase in short term interest rates. This is illustrated by the fund’s negative sensitivity to global interest rates.
Using a global term spread (the difference between short and long term government bonds) we can look at the fund’s sensitivity to longer term impacts across the yield curve. In this case, the fund is currently more neutral to changes in this factor.
Patrick Murphy is the founder of PureGroup, an independent company that works with management groups to provide them with a range of fund data, macroanalysis and insights that help to enhance client engagement. The PureGroup Forward Perspective Model, has been built with leading US based academics, providing asset managers with macro-economic factor analysis to explain their position against the wider business cycle and against their peers.
Currently we are seeing low volatility in US markets. Because the fund has a negative sensitivity to US volatility, the portfolio would be expected to perform well in this factor, boosting the fund’s overall returns.
Cumulative performance (GBP)
When did you launch the fund and what is it designed to do?
We launched the fund in 2011 and it’s designed to generate attractive income with modest capital appreciation through the economic cycle. To achieve this, capital preservation is an important objective. We don’t focus on any one sector or region. Instead we evaluate countries, currencies and credit globally to determine the most attractive fixed income markets. This global remit allows us to find the best risk-adjusted income as well as compelling total return opportunities.
What is your investment process and approach?
We start with an investment process that’s grounded in a margin of safety. So when we look at the global markets – investment grade credit, high yield credit, structured credit, local currencies, sovereign – we are looking for a margin of safety or a degree of cheapness, as well as a favourable macroeconomic and fundamental thesis. This allows us to generate income and hopefully modest capital appreciation, while preserving capital. There will be periods of market volatility where we aim to prevent large drawdowns by de-risking the portfolio, using high quality fixed income sectors or derivatives. We think about the portfolio risk from a permanent loss of capital perspective, while factoring in drawdowns as well as volatility. In our pursuit of attractive income, we would ideally have 50% to 60% of the volatility in high yield-oriented strategies. Year to year there may be pockets of volatility, but when we buy markets at the right time, globally, we can generate income with lower downside volatility because we bought at the right price. People think about margin of safety in the equity markets but perhaps not enough in fixed income. So we’re very grounded on capital structure, covenant quality and ultimately recovery rate for many of our credit investments.
Which instruments are displaying the best opportunities at the moment?
We view US high yield as offering good relative value. It’s a sector with lower interest rate sensitivity but still has relatively attractive yield, particularly given the benign default environment. So there are opportunities in US high yield and commodity-oriented markets like oil, gas and chemicals. Technology is another sector we’re watching. Also, we’ve found opportunities in select emerging markets like Brazil, Argentina and Poland. We see high real yields in those jurisdictions and an opportunity due to their weakened currencies to generate significant returns in the credit and sovereign spaces. And then thirdly, we’ve identified an opportunity more associated with the financial sector in investment grade corporates. We’ve seen significant recovery in financial sector equity prices, and we think there’s still some modest spread tightening to be achieved there. So we’re more allocated towards the financial sector, particularly in the US.
What risk parameters do you identify in the fixed income markets?
The risk we think about in this portfolio is principally spread duration or spread sensitivity; that’s our credit risk and emerging market risk. We also think of interest rate sensitivity which is our duration risk. Today we have a larger weighting in emerging markets because that’s where we see opportunities. So we look at a host of risks. I’d say the predominant risk, if you disaggregated our returns over time in this portfolio, is credit risk. The second most important risk is interest rate sensitivity and the third is global economic growth, which is sometimes best seen through the lens of emerging markets.
FUND MANAGER Q&A
Gary Herbert,
Head of Global Credit, Brandywine Global
Distribution Yield* (net)
%
Legg Mason If Brandywine Global Income Optimiser Fund Class X Inc (Q)
Source: Legg Mason, from 19 December 2011 to 31 May 2017. NAV to NAV with net income reinvested without initial charges reflecting annual management fees. The Fund distributes the yield on a coupon basis. Past performance is no guide to future returns and may not be repeated.
Gerhardt (Gary) P Herbert,
CFA, Portfolio Manager and Head of Global Credit
Gary joined Brandywine in March 2010, bringing with him over 20 years of high yield experience. Previously, he was a Managing Director, Portfolio Manager with Guggenheim Partners, LLC (2009-2010); a Managing Director, Portfolio Manager with Dreman Value Management, LLC (2007-2009); and an Executive Director, Portfolio Manager (1999-2007) and Associate (1994-1998) with Morgan Stanley Investment Management. Gary earned his M.B.A. with Honors from Columbia University, and a Bachelor Degree from Villanova University.
Regina joined Brandywine in December 2010, bringing with her 10 years of investing experience. Previously, she was a Vice President - Portfolio Manager and Senior Credit Analyst, Global Fixed Income with Morgan Stanley Investment Management PLC in London (2007-2010) and held various fixed income analyst positions with Morgan Stanley Investment Management in Philadelphia (2001-2007). She earned her Bachelor of Arts in Communications from the University of Pennsylvania. Regina is based in London.
Regina Borromeo,
Portfolio Manager and Head of International High Yield
Brian joined Brandywine in December 2009, bringing with him over 10 years of high yield and distressed debt experience. Previously, he was co-portfolio manager at Dreman Value Management, LLC (2007-2009); high yield analyst/trader at Gartmore Global Investments (2002-2007); high yield and equity portfolio manager and general analyst at Penn Capital Management, Ltd. (2000-2002); analyst with The Concord Advisory Group, Ltd. (1998-2000); and an international tax consultant with Deloitte & Touche LLP (1995-1998). Brian earned his J.D. from Villanova School of Law and graduated summa cum laude with B.S. in Accounting from University of Scranton.
Brian L Kloss,
CPA, Portfolio Manager and Head of High Yield
Click on image for bio
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