Bill Hortz's picture

[Offering a different and competitive fixed income option in the asset management industry is the result of many calculated and purposeful decisions. It requires the ability to ask a great deal of challenging questions and the patience to rethink everything about traditional business models and processes. It is not an easy exercise.

We luckily had the opportunity to explore and understand some of the thinking and steps that need to be taken when we were recently introduced to Matthew Duch, Managing Partner & CIO, of Channel Investment Partners – an Arlington, VA based registered investment advisor that manages collective investment trusts, separate accounts, and is the advisor to the Channel Short Duration Income Fund (CPSIX). We asked Matthew to outline how he structured his fixed income firm and investment process so that it was non-traditional and “built for what comes next”.]

 

Hortz: What was the thinking behind how you purposely designed your firm and its investment culture into a “partnership of diverse skillsets”?

Duch: It is no secret that in a smaller firm you must do more with less. We cannot be a firm of specialists and compete with a smaller AUM base as it is an expensive structure. Beyond keeping costs low, diverse skillsets also help to make better investment and business decisions. With the rise of certain outsourced business functions, i.e., administration, legal, some compliance, marketing, and distribution, etc., we can utilize top-notch shared resources at a competitive price and focus on investments and investor relationships.

Within this focus, we need portfolio managers with trading backgrounds who can communicate with investors, credit analysts with diverse research backgrounds and the ability to manage third-party research, and distribution partners that can market existing strategies but also engage us in finding solutions to investor needs that may lead to new products.

Hortz: Why do you have a mandate around what you characterize as the efficient Portfolio Manager/Trader model? What do you see as beneficial outcomes to this investment team structure?

Duch: Bond trading is often nuanced driven by technical levels and relative value analysis. Part of being a Portfolio Manager is absorbing massive amounts of commoditized information, digesting it in a unique way, and then expressing views in the portfolio based on risk/reward analysis. I believe there is an implicit bias in overly combining the Portfolio Manager/Research functions because if you spend a lot of time researching an investment, buy and hold it, but then you are inclined to continue to like it, thus selling becomes harder to do. Selling something you like is the hardest thing to do but price often dictates it.

For that reason, a PM/Trader function can constantly assess relative value, act quickly in volatile situations, and recognize liquid and illiquid situations. This last point is extremely important because illiquidity premiums play into relative value analysis.

My experience has been there are many portfolio managers who do not properly value illiquidity premiums and that is because they are not close to the trading function. Perceived liquidity can become no liquidity quickly in a volatile environment.

It is for those reasons that we have elevated the trading function to a key component of the fixed income investment team versus other firms that may outsource their trading function.

Hortz: As you have pointed out, certain inefficient processes and structures exist at firms which does lead to various cost-cutting efforts. How do you think this has impacted the investment process and ability to recognize investment opportunities?

Duch: A lot of leadership looks at various department costs and see fixed income groups as a very expensive operation with high headcounts - Bloomberg terminal expense, trade order management and risk systems, rating agency and research service costs, no “soft dollars,” conference travel, etc. To cut costs, cutting headcount is the easiest way to do it as it also cuts several other attached costs. And when deciding where to cut, Traders are usually the first because it is not recognized as a source of Alpha and has often been relegated to an execution function that uses impersonal electronic trading platforms at many firms.

Further, if strictly an execution function, younger and less experienced people can fill the seats. With just an afternoon of closed-door HR meetings and key card submissions, firms can close their eyes and ears to liquidity, trading and syndicate desk sponsorship, and all sense of relative value. Take for example times of market stress, as we saw in March 2020. The electronic trading algorithms get turned off and electronic platforms become far less efficient.  I heard several stories of buy side trading desks that did not know who to call or how to transact trades because they lost relationships. Could you imagine needing to get liquidity and not even knowing who to call?!"

Hortz: How does this perspective inform your investment decisions and translate into relative investment benefits for your fixed income portfolios and clients?

Duch: When I started in the business, the “Three-Legged Stool” of Trading, Research, and Portfolio Management held equal value and were their own career paths. Each complemented the other with unique views of value and strategies. To reduce expenses, the pecking order became Portfolio Management, Research, and a skeleton trading desk. Most Portfolio Managers now started in Research out of business school and run portfolios almost entirely on creditworthiness, a very equity research approach. This approach ignores the bond trader motto of “No bad bond, just bad price.” Price is everything. A great credit bought wrong can underperform and a bad credit bought right can make all the difference in performance.

I maintain if you are going to connect two functions of the “Three-Legged Stool” to reduce headcount expenses, it is portfolio management with a trading background and not portfolio management with a research background. There are many trading opportunities to generate returns that have nothing to do with fundamentals. It is always a reconciliation of whether pricing drives fundamentals or fundamentals drives prices. So often, in debt financing, pricing drives fundamentals as it gets cheaper or more expensive to borrow. 

Going a step further, I prefer to use fundamental research as an “Alpha chaser.” Time should be best used on researching excess return opportunities. By using third-party research as a monitoring tool of rather efficiently priced issuer debt, in-house research is best used to hunt for mispriced issuers and bonds because of unique or legacy covenant language, deal size, sponsorship, availability, ratings implications, company management, etc. Portfolio construction and sector allocations in combination with focused bottoms up security selection with disciplined trading strategies have proven to deliver outperformance in a repeatable, high-capacity way. 

Hortz: How important do you feel that a trading perspective – keeping a trained eye on the daily dynamics of markets – needs to be added to core, long-term investment approaches?

Duch: A lot depends on the expectations for an investor’s bond allocation. A lot of investors think about bonds only as hedges to their equity positions. They may own large, middle, and small caps, growth and value, international or EAFE, emerging markets, and a country specific strategy like Japan, China. But when it comes to bonds, they own a fund or ETF based on the Bloomberg Barclays US Aggregate Index which is nearly 75% US Treasuries, Government Related, and Securitized. This bond index has increased the exposure to government debt, extended duration, and reduced yield because of record new debt issuance, something that should continue in treasuries. Investors may have a very diversified equity portfolio but a concentrated bond portfolio that drags performance or is intended to act as a hedge to the equities. Our belief is that investors can get better returns than what the Bloomberg Barclays US Aggregate Bond Index gives them. We believe investors should reduce their Aggregate Index exposure and utilize active strategies that potentially offer better risk/reward returns.

Bond indices are weighted by qualifying debt outstanding by issuers. Unlike market value-weighted equity indices where prices can keep rising (i.e., FAANG stocks), the more debt an issuer incurs that becomes a larger part of an index is not always a good thing. Active managers can avoid troubled debt-heavy issuers, reduce duration based on interest rate outlooks, and do relative value analysis that turns bond allocations into a source of Alpha, not a possible drag on the rest of the allocated portfolio.

Hortz: From your specific perspective, how do you see the current lay of the land in the fixed income markets?

Duch: This is always a loaded question because if you want to feel horrible about the future economy, a bond manager can help you get there with their often defensive views of the world! I try to be balanced as best I can but when the math does not work, though, it is always hard to just hope things work out.

There are two major themes driving fixed income markets right now, 1) inflation concerns and 2) government debt supply. Spread products like high-quality securitized and investment-grade corporate debt trade tight and often move in tandem with treasuries. Where inflation shows up is anyone’s guess, i.e., concentrated in raw materials and commodities, weaker dollar, transitory, broad but momentary spike, etc. but we do know money supply continues to increase and huge amounts of treasury debt are outstanding and will be issued. How the interest rate curve adjusts and the effects of higher rates have real impacts on the economy and risk valuations.

In other words, supply concerns can push rates to a point that tightens liquidity in the real economy thus blunting inflation concerns. There is a long history of interest rates rising to only reverse their movement to come back down a bit as they do the Federal Reserve’s tightening ahead of schedule. There is a lot of leverage on consumer and corporate balance sheets so rising rates certainly impact things.

Be nimble and liquid because money has poured into illiquid investments the last few years. If something looks cheap when liquidity is at an all-time high, imagine how cheap it looks when liquidity tightens! Move up in quality if the give-up is historically tight. Treasuries are approaching yields that could pressure High Yield bond intermediate maturities and dividend paying stocks.

Hortz: Any other thoughts or recommendations for advisors to consider for their clients’ fixed income portfolios and portfolio construction in our current investment environment?

Duch: As shared earlier, bond investing is often nuanced based on price, capital structure, covenants, liquidity, maturity, etc. so taking a fundamental research, equity liquidity driven approach to bond investing can lead to underperformance. Bond investing is about loss assumptions, security, and asset valuations to receive coupons and principal. Equity investing is generally a subordinated perpetual security driven by growth and income with decimal point bid/offer liquidity.

With all of this in mind, it is no wonder most active bond managers beat their passive ETF counterparts. However, a lot of bond ETFs get inflows because there is an assumption that all ETFs are to be in a wealth advisor’s model or solution product because of a low fee. I maintain low fees only matter if it makes the difference in net performance.

Active management costs a bit more than passive ETF strategies but if the result is increased net performance to the investor, it is worth it. It takes a professional bond manager to see and access better risk-adjusted return opportunities. We are happy to work with wealth advisors to find solutions to their fixed income needs that offer greater value to their clients than a passive ETF product or laddering bonds. We invite you to learn more about our firm and Channel Short Duration Income Fund on this link.

 

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