Giroux: Time to Put Bonds Back on the Radar

Greg Carlson: Let's turn to the fund's bond portfolio. There have been some significant changes there. Leveraged loans have been the biggest piece of that pie, perhaps, in some ways, and that weighting has come down a bit. Meanwhile, you've bought some shorter-term, more traditional bonds.

David Giroux: I think one of the things we've had in the fixed-income portfolio is a real bet that rates were going to rise someday. We didn't know that they were going to happen this year, but we've had a big pretty bet on the portfolio. That manifests itself in a very short duration. Our duration of our fixed-income portfolio is about 1.7 years. Over half of the portfolio in our fixed income was floating rate.

So specifically on leveraged loans, we did … cut back the … exposure a little bit earlier this year. You saw a lot of the leveraged loans trading above par, above 101; valuations were a little bit less compelling. We're seeing a lot more issuance being covenant-lite, so leveraged loans have come back a little bit.

Carlson: When you say covenant-lite …

Giroux: Covenant-lite means that you don't have a limitation on the amount of leverage that the company can go up to. … As a leveraged loan holder, we like to have covenants that protect us in a downturn, that … make sure there is not new debt put on top of us or beside us or in front of us, which is what happened a lot in 2009 in the downturn. So we want to make sure that we're protected, so having covenants really protects us.

I think the leveraged loan market has a very short memory of what happened to those loans in 2009, and we have a very long memory. So, for the most part, we don't buy covenant-lite loans, and most of the new-issue market in leveraged loans today are covenant-lite.

So our leveraged loan exposure has gone from 8.5% to 6% of the portfolio. What we did do in the first half of the year and the second half of last year is, we had a pretty big cash position. We took some of that cash and invested it in very high-quality, short-duration, investment-grade bonds, where you didn't have a lot of credit risk or interest rate risk, … because you were earning very little on cash, but you were earning potentially 1% on short-duration investment-grade paper.

Carlson: So basically better than nothing.

Giroux: Better than nothing. That's actually very, very fair.

I think the point where we are now is, having had the 10-year Treasury go from 1.46% to 2.9% today, we may need to moderate that bet a little bit and may need to take duration up as rates rise.

We've always said that we think fair value for the 10-year is about 4%, sort of 2% inflation, 2% GDP growth, 2% real yield, 2% inflation. We get to about a 4% real yield. I think as rates get close to that level, we think we would want to probably be adding to our duration and moderating the really negative bet we had on rates.

Carlson: Just to be clear, the fund … doesn't own Treasuries now and hasn't for several years, I think.

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Giroux: That's true. I think last time we really owned Treasuries in a big way was '06 and '07, when they were at one point, … 10% of the strategy.

Carlson: So you still don't own any, but they're getting more attractive.

Giroux: They are getting more attractive. Treasuries do a unique thing for our clients, in that one of the big things we focus on is capital preservation. Typically, in recessions or ugly recessions, Treasury prices rise as yields decline, as investors look for safety. So … Treasuries can help cushion some of the downside from your equity exposure, your high-yield exposure, in a downturn.

So we like what Treasuries can do. It's just for the last three or four years, the absolute yields have been so low as to not be compelling for us to buy. But we are getting to that point where we need to probably think about investing in Treasuries or longer-duration investment-grade corporates or high-yield.

Carlson: And capital preservation is perhaps more on your mind now that equities are looking expensive overall.

Giroux: I think that's absolutely true. … The market sentiment is positive on equities today; it's negative on bonds. That's really the reverse of what it was four or five years ago, and we tend to go against the grain. We tend to be contrarian investors. So the fact that everybody is so nervous about bonds today actually makes us a little more positive. We don't want to … take away the whole bet on rates rising, but we want to maybe moderate that over time as rates continue to rise.

Carlson: Circling back to the leveraged loan portfolio for a minute, that's fairly concentrated.

Giroux: It really is. We tend to own extremely high-quality companies that have very, very defensive business models. When we talk about Dunkin' Brands being our largest position, obviously the royalty model--they own Dunkin' Donuts and Baskin-Robbins. So it's a business that in the '09 recession, their EBIDTA was basically flat.

We own Intelsat, which has long-term contracts, which is a satellite operator.

We own a Bavarian (German) cable company that is very very stable, UPC.

So we own extremely high-quality, extremely low-risk companies, from our perspective, where … we're not really taking a lot of credit risk, we're not really taking a lot of interest rate risk, and where we're able to earn 3%, 4%, 5% kind of yields.

Carlson: To be clear, these are companies that are actually rated sub-investment-grade.

Giroux: They are. I think what happens sometimes with the rating agencies is there are certain rules that you look at: You can't be more than four times levered and be investment-grade. And I think the rating agencies don't fully take into account the business model of the underlying company. So I would argue that a Dunkin' Brands and Intelsat, at least at the leveraged loan part of the capital structure, is much more safe than buying an investment bank's single-A rated credit, from my perspective, even though the spreads are hundreds of basis points different. The real ultimate credit risk is much greater for an investment bank than it is for a Dunkin' Brands or an Intelsat or UPC.

Carlson: Finally, I want to touch on the convertible bond exposure, once a significant part of this fund. But the market has changed, and the size of the fund has grown as well. So there are a couple of factors.

Giroux: … We still like convertibles as an asset class. We like what they do. You think about the long-term of convertibles: They've generated [about] 100% of the market's return with two-thirds of the market's volatility; we love that. That's always why we had a big percentage in them.

The problem is the convertible market has really, as an asset class, just shrunk. I think it's shrunk in half [over] the last four or five years. There has been some accounting changes that make it less attractive to issue convertibles.

Obviously, in a low-volatility environment, in a low-interest-rate environment, there's not a lot of reason for issuers to issue convertibles. So especially in the mid-cap and large-cap convertibles, which has really been our bread and butter over a long period of time, there's really been almost no new issuance in the last four or five years. Hopefully that will change. I think there was a time when convertibles were 20% of the Cap Appreciation strategy, and today it's less than 1%. We only own two convertibles today. So we'd like that to be bigger, but it's really market forces more than anything else that are precluding that.

Carlson: And we should touch on cash, which is still a significant piece of the portfolio at about 10% of assets.

Giroux: Yes, and coming down. Part of the reason cash has come down is that we bought those short-duration, high-quality investment-grade paper, bonds. That's probably the biggest reason why you've seen the cash come down a little bit.

But I think over time, …we've always said we'd like the cash to be more like somewhere between 5% to 7% of the assets. Probably if you look at last couple of years, it's been consistently above 10%. So hopefully we're at a point now, especially with rates rising, that we can purchase … in an environment of more normalized interest rates, we can own Treasuries, own more high-yield, own more investment-grade. We would think cash will become a smaller portion of the strategy. Just the opportunity cost of holding cash was very, very low in the past. Now the opportunity cost of holding cash is going to be higher, so cash should become lower.