Our Investment Team
We believe successful, long-term fixed income investing starts with small, individual security decisions. To identify attractive opportunities across the capital structure, we have brought together a group of highly experienced investment professionals who excel at recognizing inexpensive cash flows with a high-quality bias.
Our team, led by portfolio managers Henry Song and Mark Jackson, is supported by three dedicated fixed income analysts — Wenting He, Charlie Minor and Dane Hudson — as well as Douglas Gimple, our senior portfolio specialist.
We value open communication and collaboration on our team with daily interactions covering everything from the portfolios to individual holdings to new investment opportunities either in person or via video conferencing.
Our team also works closely with Diamond Hill’s research team when conducting analysis on corporate bonds. Our research analysts model cash flows five years into the future — as opposed to traditional fixed income analysis which may look out only a year or two. This longer-term perspective helps us understand how corporate management teams allocate capital. It also provides us with insights into potential event risk, such as mergers and acquisitions, that could cause balance sheets to deteriorate.
While our research process is highly collaborative and leverages the expertise of each individual on the team, Henry and Mark have final decision-making authority. All team members share responsibility for trading and reinvestment opportunities, allowing us to quickly take advantage of market dislocations.
Our Investment Philosophy
We believe careful selection of undervalued securities and spread sectors offering incremental yield and total return relative to the index is the best way to generate successful long-term investment outcomes. We take a differentiated, transparent and bottom-up approach to investment management, focusing on finding relative value among the tens of thousands of securities in the fixed income market. We constantly look for value-add opportunities, which can lead to allocations outside of the benchmark with a focus on the securitized market.
What makes our approach unique?
Our Short Duration Securitized Bond and Core Bond strategies have a heavy emphasis on securitized products (asset-backed securities, residential mortgage-backed securities and commercial mortgage-backed securities) — an area not traditionally heavily allocated to in fixed income portfolios. We focus on securitized products as we believe this differentiated approach provides more opportunities to achieve higher credit quality while maintaining a yield advantage as compared to those invested in government or corporate credit-focused strategies.
A key reason we focus on securitized products is this area’s inefficiencies. Inefficiencies are abundant given the vast size of the market, the number of securities available, the lack of inclusion in the index, as well as the number of ways to structure a deal. At the same time, the securitized market tends to be an area that’s underinvested in by most investors, especially if they rely solely on an index-based investment approach.
Aside from investing in agency-backed securities, we also look for non-agency deals. Ratings agencies use different criteria to rate corporate bonds versus securitized bonds, and we don’t believe the ratings should be viewed in a similar fashion. When structuring securitized deals, issuers layer in credit enhancements to provide additional protection for investors relative to what the corporate or Treasury markets can offer. These enhancements generally fall under four categories:
- Excess spread is the remaining net interest after all expenses are covered for asset-backed securities. This interest is deposited into an account and can be used to cover missed payments and is applied to all tranches in a deal.
- The reserve account is an amount of cash set aside, usually a small percentage (typically 1%-2%) of an issue’s market value. These assets can support an issue’s outstanding tranches should any cash flow disruptions impact the trust’s ability to pay monthly interest obligations.
- Overcollateralization is a commitment to pledge collateral in excess of the value of the offered bonds.
- Subordination is the process of using subordinated classes (C, D, etc.) as protective layers for the tranches higher in the capital structure. If a loan in the pool defaults, any losses incurred are absorbed by the lowest tranche in the structure. The supported tranches are unaffected unless losses exceed the subordinated tranches’ limits. Interest payments are distributed monthly to all tranches, but principal payments are allocated to the tranche in the first pay position — meaning the A tranche principal balance is paid first, followed by the B tranche and so on until the deal is paid off.
The securitized market’s structure provides investors the opportunity to select the specific tranches in which they will invest. Investors looking for longer duration security can select bonds with cashflow lockout, like an accrual only Z-bond or a last cash flow collateralized mortgage obligation (CMO). On the flip side, investors can opt for shorter duration by investing in front pay cash flowing tranches or a more defined cashflow by investing in a planned amortization class (PAC) CMO. Investors looking for more safety can stay higher up in the capital structure to gain more protection in exchange for less yield — conversely, they can invest in lower rated tranches if they desire more yield.
Naturally, there are no free lunches. Extra yield isn’t free, so what’s the tradeoff? The securitized market, outside of mortgages, is smaller and therefore can be less liquid than either the corporate or Treasury markets. Given our rigorous bottom-up security selection approach, we think the benefit outweighs the potential for lower liquidity.
Our Investment Process
Our investment process is driven by security selection, duration management, yield curve positioning and sector allocation, in concert with overall portfolio management.
We constantly monitor and analyze potential securities to determine suitability. We primarily focus on identifying undervalued securities using a variety of methods including, but not limited to, independent research, face-to-face meetings with issuers, business publications, sell-side research reports and industry conferences.
Valuation-Focused Security Selection
The hallmark of our process is the selection of individual issues — which can include corporate bonds, residential and commercial mortgage-backed securities, asset-backed securities, Treasury securities and agency bonds — with an emphasis on identifying undervalued securities. We purchase those securities that we identify as undervalued and that offer a strong total return profile relative to similar securities. And we focus on the most inefficient parts of the market, which often results in owning securities that are not included in the benchmark and are overlooked by peers but can offer strong risk-adjusted returns.
To start, we conduct a risk/reward evaluation of interest rate and credit risk as well as an examination of the complex and technical structure of each security. We then use quantitative valuation methodologies to identify securities we believe to be undervalued, fairly valued and overvalued. One of the quantitative methods we use is total return analysis, which estimates the total return for a given security over a specified time horizon determined by portfolio managers Mark or Henry. This allows us to analyze each security for reinvestment rates and hypothetical yields based on different interest rate scenarios. We incorporate option-adjusted spreads (OAS)1 into the total return framework in our valuation methodology for structured securities and corporate securities with embedded options.
A valuation approach we use for bonds with embedded options is decomposing the bond into its component parts. For example, we conduct a creation value analysis on mortgage-backed securities. We believe securities selected after applying this analysis offer better relative returns compared to similar securities. We use various tools in this analytical process including Bloomberg and Citigroup Yield Book, as well as proprietary methodologies for valuation that provide a secondary verification of the primary analysis conducted with Yield Book.
We believe our experience, analytical systems and patience give us the ability to identify market inefficiencies. We emphasize the securitized sector in our security selection process because we believe this portion of the market historically has been relatively less efficient in pricing these securities.
We emphasize high quality in the strategies we manage as it is a central component of our philosophy and process. In the Core Bond strategy, we only invest in investment grade2 securities and work to maintain an average credit quality of AA/AA+. In the Short Duration Securitized Bond strategy, we will allocate to below investment grade securities (15% maximum) based on value and risk/reward characteristics. The average credit quality of the Short Duration Securitized Bond portfolio is targeted at A-/BBB+ over time.
The Duration Decision
Duration is carefully managed to help control interest rate risk; however, we use it sparingly as an active portfolio management tool. The duration decision is based on internal interest rate forecasts, which incorporate many factors such as the outlook for inflation, anticipated Federal Reserve policy, and the overall economic environment. The Short Duration Securitized Bond strategy will typically maintain an average duration of one to two years, with a maximum of three. The Core Bond strategy typically maintains an average duration within a band of +/- 10% of the benchmark duration, with a maximum of +/- 20%.
Yield Curve Strategy
In conjunction with the portfolio duration decision, we identify broad interest rate trends and supply and demand relationships that may influence the shape of the yield curve. For a given duration target, our yield curve strategy seeks to find optimal exposures along the yield curve. We establish expected returns using scenario analysis that incorporates yield curve shifts, the roll-down effect and time horizon.
Risk Management & Portfolio Construction
For us, risk management begins at the security level prior to the initial purchase of any security. We also make a conscious decision to avoid taking excessive risk in any given sector or security.
Although bottom-up analysis and security selection is the first step in building a portfolio of attractively valued securities, we pay close attention to sector and sub-sector valuations and weightings in portfolio construction. This analysis factors into decisions to overweight or underweight a sector relative to the benchmark. We also conduct historical spread analysis to identify sectors that may be overvalued or undervalued and to establish the risk/return trade-off between sectors. When we can identify undervalued securities in sectors with attractive sector dynamics, we emphasize those sectors in the portfolio.
From a portfolio construction perspective, it is important to not only understand each individual security but also how the individual risks associated with each security impact the entire portfolio. For example, we assess whether our holdings as a collection of securities carry too much duration risk, similar credit risk or interest rate risk. Stress-testing various environments helps to reaffirm our conviction in an individual bond, as well as build a portfolio designed to protect client assets in a variety of environments by diversifying risk.
||Short Duration Securitized Bond
||Bottom-up, security selection
||Portfolio managers engage directly with the market, executing all trades
||Typically 1-2, maximum of 3
||Typically +/- 10% (maximum +/- 20%) of the benchmark duration
||Bloomberg US 1-3 Yr. Gov./Credit
||Bloomberg US Aggregate Bond Index
||Separate Account & Fund
||Separate Account, Fund & CIT
||5 Jul 2016
||$4 billion to $7 billion
||$40 billion to $50 billion
The Off-Benchmark Benefit
Our approach often leads us to securities that are not included in the benchmark. This universe provides multiple opportunities to add value and to increase the yields of the portfolios while increasing diversification:
- Non-rated securities can generate additional yield above rated securities, but often contain similar structures to protect investors. Issuers effectively share the savings from not having to pay for the ratings services with investors.
- The index only permits securities that are rated by S&P, Moody’s and Fitch, which allows for differentiation by investing in securities rated by DBRS/Morningstar, Kroll Bond Rating Agency or other rating agencies. In fact, the big three have continued to lose market share since the great financial crisis of 2008.
- Non-rated securities are excluded by certain investors that have strict ratings requirements — often the case with insurance companies and pension plans — which limits the number of eligible market participants.
- Deals with issuance size below the minimum permitted for benchmark inclusion often result in additional yield to entice investors.
- Collateralized mortgage obligations (CMOs) provide exposure to agency and non-agency residential mortgage-backed securities with varying and unique cash flow structures, which differentiates them from the traditional pass-through mortgages found in the index.
- Benchmark limitations for sector inclusion for asset-backed securities provide the opportunity to gain additional diversification as well as incremental yield in areas ignored by benchmark construction rules.
OUR SHARED INVESTMENT PRINCIPLES
At Diamond Hill, our primary purpose is to improve our clients’ lives through better financial outcomes. That commitment is evident in our vision — to be an exceptional, active investment boutique that our clients trust to deliver excellent long-term investment outcomes from a team aligned with their success.
We believe these principles are foundational to who we are and how we serve clients, lead to excellent long-term investment results across multiple capabilities and promote enduring client relationships.
Our Shared Investment Principles
1Option-Adjusted Spread (OAS) is the difference between the portfolio yield and the risk-free rate, accounting for embedded options. Source: The Yield Book.
2Investment Grade is a Bond Quality Rating of AAA, AA, A or BBB. Investment Grade grouping includes cash position.
3Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates.