Dear Mr. Market:
We certainly spend a lot of time writing to you about the stock market and all the twists and turns it brings investors. Today, we have the pleasure of mixing things up a bit as we dive into something far larger and more intricate than the stock market; we’re going to talk about the bond market!
On a recent trip out to Denver, CO My Portfolio Guide had the opportunity to meet with Troy Johnson, CFA and Director of Fixed Income Research at Denver Investments. We were able to ask him and his team several questions about the bond market and how they’re navigating it in these interesting times.
My Portfolio Guide: First and foremost, thank you very much for making yourself and your team available. As you know, we own positions in the Westcore Plus Bond Fund as well as the Westcore Municipal Opportunities Fund. We understand your team was awarded a Lipper Award. Without necessarily giving us a pitch on your firm, could you briefly expand on the recent accolades?
Westcore: The Westcore Fixed Income funds won the Lipper Fund Award for best fixed income small fund group for the three-year period ending November 30, 2016, placing first out of 74 eligible fund families. The award was granted based on Lipper’s measurement of risk- adjusted returns across our multiple fixed income fund offerings. We believe that winning the award affirms the soundness of our approach across multiple strategies as well as the hard work and talent within our fixed income team.
My Portfolio Guide: Excellent, and congratulations on the awards and success. Related to this, could you share your opinion on what makes your firm or approach different than some of the larger bond shops?
Westcore: We utilize an investment approach that emphasizes income and security selection rather than a focus on trading. This generally results in a heavier weighting towards credit oriented issues that offer enhanced income. We recognize rigorous fundamental research is a necessary component of such an emphasis and differentiate ourselves within that process in the following manner:
Our analysts “push” their best ideas through our process and into portfolios versus working within a portfolio manager “pull” process. The analysts cover securities across the ratings categories from investment grade through high yield. Analysts also discuss their recommendations with the entire team of analysts and portfolio managers before arriving at a decision.
Our analysts emphasize a longer-term orientation or investment horizon when evaluating credit through understanding the competitive positioning of an issuer or underlying asset value when gauging relative value.
Our size is an advantage allowing us to lever this research in identifying executable ideas within the secondary market to place impactful allocations across portfolios. Our larger peers are often relegated to the new issue market or credit derivatives in the effort to gain meaningful exposure to a credit.
My Portfolio Guide: What is the biggest concern you see in the bond market that not all players are looking for? For example: Everything we read seems centered on interest rate increases and how to manage that risk. Is there something else out there that should keep a bond investor up at night?
Westcore: We’re always concerned about capital flowing into areas of the market where the investor is perhaps less informed of the inherent risks. For instance, do investors that have flocked into the leveraged loan market understand the underlying credit risk and the potential illiquidity within that market or are they blinded by their fear of rising rates and the resulting appeal of the floating rate nature of loans? Years of easy monetary policy and the search for yield have caused investors to perhaps take on more risk than they are aware of in searching out income oriented opportunities.
My Portfolio Guide: It’s still a bit early to see how some of the new Trump administration policies will be rolled out but how do you see them impacting the bond market? For example, if it’s likely that Federal tax rates come down but maybe not state rates, would that be a negative for municipal bond investors?
Westcore: To the extent that the communicated components of Trump’s policies are rolled out, they are widely accepted as pro-growth initiatives and would at least temporarily be anticipated to boost economic activity. If the government follows through on such policy action, the bond market would be anticipated to react negatively due to potential increasing worries relating to the potential for inflationary pressure. Of course the probability of legislative success and scale of these initiatives remains questionable today, with changing perceptions of the administration’s effectiveness in initiating policy impacting the bond market on a fairly frequent basis. Longer term, we feel the US debt load and demographics, amongst other factors, will play a role in limiting the rise in interest rates.
As for tax rates, the initial proposal has been to lower the top Individual tax rate from its current 39.6% to 35%. On the margin this is immaterial. Part of the proposal also included taking away state taxes as an exemption. So one less tax exemption would in theory boost the value of the Municipal Bond tax exemption.
What we are watching closely is if tax reform is passed, where the corporate tax rate falls. Bank and insurance firms have been large buyers of municipal bonds as they can receive some tax exemption from the interest. They are also long term buy and hold investors, so the high and stable credit quality of municipal bonds has significant value to them. However, if corporate tax rates fall dramatically, they may look to reduce their allocation from municipal bonds into taxable bonds. These are smart institutional investors, so they not likely to blow out the market. However if there is some dislocation, we would view it as a good buying opportunity.
My Portfolio Guide: Many of our clients “grew up” being exposed to the typical CD/bond ladder approach and have been told that the best way to go was to hold each bond until maturity. There are loads of arguments on each side of this…but does active management potentially make more sense than a passive strategy in bonds?
Westcore: In our review of the performance of actively managed funds versus passive strategies or indexes, we have found that active fixed income fund managers do add value. This appears to be a fairly uniform perception in the investment community and is certainly differentiated from recent headlines concerning active management of equities. Skeptics should just take a look at the performance of the Westcore Municipal Opportunities Fund versus its comparative index since inception or look at the long-term record of the Westcore Flexible Income versus the popular high yield ETFs (Exchange Traded Funds) that are widely utilized.
My Portfolio Guide: As we alluded to earlier, the bond markets are massive and very intricate. Of all the different types of bonds (treasuries, corporates, municipals, high yield etc.), do you see more value or opportunity in any relative to previous bond environments?
Westcore: We’ve been fortunate to have identified what we feel is good value in spread product across categories. Our focus on income has driven us towards an overweight of credit, both corporates and taxable municipal bonds in the Westcore Plus Bond Fund. We feel higher quality issuers within the high yield market provide a differentiated risk adjusted return profile within the corporate bond category and that quality segment serves as the focus within Westcore Flexible Income Fund. We recently launched the Westcore Municipal Opportunities Fund given the immense amount of opportunity available in the national municipal bond market for investors.
My Portfolio Guide: Everyone is talking about the 30 year bull market in bonds and the bubble that is about to burst. We know you don’t own a crystal ball but how do you see this all panning out?
Westcore: We have been less concerned about a significant or imminent move higher in rates than most market observers over the course of the last several years and remain so today. While stages in the business cycle, policy initiatives or the continuing removal of global central bank accommodative policies could create some volatility, the longer term outlook for rates is driven by economic growth which we anticipate will be negatively impacted by our domestic debt burden, a less opportunistic demographic outlook and the recent lack of growth in productivity.
My Portfolio Guide: From an equities perspective we’re big fans of Emerging Markets. How do you feel about opportunities in emerging bond markets or is it best to not take risks in this space?
Westcore: We feel that bond funds should act like bond funds in an overall portfolio. They should provide income and serve as a foundation that is more likely to provide capital preservation during periods of equity market volatility. This provides investors with the opportunity to rebalance during such periods of volatility and market disruption. If you utilize your bond fund to seek out equity like returns, chances are you’ll experience equity like volatility during a period in which you need that stability. We feel there are plenty of opportunities in domestic bonds and that searching emerging markets for fixed income opportunities generally adds that additional potential volatility that we’d prefer to avoid.
My Portfolio Guide: Thank you again for allowing us the opportunity to do this and meet your team. In closing, what are your thoughts and strategies related to a weakening US dollar? The first quarter ended up with the dollar being softer by 3.3% against a basket of other currencies; does this present concern or opportunity within the fixed income environment?
Westcore: We monitor and recognize that a change in the value of the US dollar can impact our corporate issuers, commodity markets and even capital flows, however we do not set policy or drive allocations toward any specific sector relating to an underlying thesis or our outlook for the value of the dollar.
Past performance is no guarantee of future results.
Source: Lipper, Inc. The Best Fixed Income—Small Fund Group award is granted to the fund family with the lowest average decile ranking for Consistent Return over the 3-year period. To qualify, a fund family must have at least three fixed income funds and less than $63.5 billion in assets under management for 2016. Westcore Funds ranked 1 out of 74 eligible companies for 2016.
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RISKS: Westcore Fixed Income Funds are subject to additional risk in that they may invest in high-yield/high-risk bonds and is subject to greater levels of liquidity risk. In addition, the exposure these funds have to foreign markets can regularly affect the net asset value (NAV) and total return of these Funds due to foreign risk.
An investor should consider investment objectives, risks, charges, and expenses of the Fund(s) carefully before investing. To obtain a prospectus, which contains this and other important information about the Fund(s), please call 1-800-392-CORE (2673) or visit us online at www.westcore.com. Please read the prospectus carefully before investing.
Westcore Funds are distributed by ALPS Distributors, Inc. WES003429 12312017