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William Blair Bond Due Diligence Report

Sep 28, 2015 / Intermediate-Term Bond , Due Diligence Report, Fund Research

 
Fund Information
Ticker WBFIX WBBNX
Share Class Class I Class N
Min. Initial Investment $500,000 $2,500
Availability* S, A, F SO, AN, FN
Expense Ratio 0.50% 0.65%
Opinion Recommended Recommended
Firm William Blair
Managers Christopher T. Vincent and Paul J. Sularz
Phone 800-742-7272
Web Address www.williamblairfunds.com
*Certain restrictions apply. Please check with your broker/dealer for details.

We are adding William Blair Bond to our Recommended List in the Intermediate-Term Bond category, reflecting our confidence that the fund will outperform the Barclays Capital U.S. Aggregate Bond Index over a credit cycle. Our research involved several phone calls with the team members and a site visit to their Chicago offices. We also spoke with the chief operating officer of William Blair’s investment management division to better understand the firm’s goals for the fixed-income team (e.g., growth in assets, new strategies, investment-team retention). Below is a description of the investment philosophy and process as well as the rationale for our positive opinion.

Overview

The William Blair Bond team is comprised of six professionals led by co-portfolio managers Chris Vincent and Paul Sularz. The team seeks to outperform the Barclays Capital U.S. Aggregate Bond Index through bottom-up analysis, rather than unreliable predictions of changes in interest rates or shifts in the yield curve. While the fund will closely resemble the benchmark in regards to duration and yield-curve exposure, the team will make active sector allocations through an assessment of security-level risk/reward potential. The emphasis of their fundamental analysis is on high-quality, liquid issuers within sectors offering higher yield spreads, specifically agency mortgages and corporate securities, which typically offer a risk premium over Treasurys of comparable maturities. The team runs a concentrated portfolio of 75–100 issuers to ensure a deep knowledge of each security, avoiding issuers that require guesswork and/or complex analysis. The team’s intention when buying a security is to hold it for years; portfolio turnover has averaged 25%. Security selection is then combined with risk controls at the portfolio-construction level. The team is willing to accept short-term volatility and underperformance in exchange for longer-term results that are consistent with their performance goal of outperforming the Barclays benchmark by 75–100 basis points, net of fees, annualized.

Investment Process

Idea generation starts with the quantitative valuation screens the team uses to identify economic sectors and securities with yields that are superior to that of the benchmark. Superior yields are defined in the context of the team’s relative-performance goal, while maintaining benchmark-like interest rate exposures. Relatively high yields in and of themselves however do not qualify a security for inclusion in the portfolio. The team’s intention when buying a security is to hold it for the long term, and the idea-generation process incorporates a two- to three-year macro overlay. The goal of this overlay is not to make specific forecasts, but rather to form broad, directional expectations of the credit cycle and interest rates movements, which at the margin help shape portfolio positioning. For example, when looking at investment-grade corporate credits, the team observes trends in corporate leverage levels and economic growth, which inform opinions of whether the environment will be supportive. Their view of the credit cycle influences the level of credit risk the team is willing to take, whether it is positioning along the yield curve or credit-quality ratings. This analysis is then combined with credit-specific fundamental and valuation analysis.

When evaluating corporate credits, the team employs a relative-value approach using bottom-up, fundamental analysis. The focus is on domestic investment-grade securities, although the fund has the flexibility to invest in below-investment-grade corporate securities (up to 10%), as well as dollar-denominated foreign (developed and emerging-markets) credits. At the security level, the team seeks industry-leading companies with a competitive advantage, multinational operations, consistent cash flows, and, importantly, strong management teams with a track record of sound capital allocation.

Evaluating company management is a significant focus, and this assessment, if negative, will trump other positive factors such as a global leadership or attractive valuation. The team must see consistent and disciplined capital allocation on the part of management (i.e., how have they allocated cash flow in the past and how they plan to employ it going forward). They must also feel that management is aligned with bondholders, not just equity stakeholders, and this is often evaluated during in-person meetings with company management. The team will selectively invest in bonds of issuers at times when industries may be out of favor, provided the team is confident in management’s ability to effectively navigate the rough patch and allocate capital efficiently. The issuer must also meet the team’s valuation, fundamental, and technical (e.g., liquidity) criteria. This also speaks to their longer-term view on the names they own.

The team’s fundamental analysis involves an evaluation of cash flows, trends in leverage and interest-coverage ratios, the distribution of debt maturities (i.e., they prefer staggered maturities versus one large maturity), and bond maturities that match up with the duration or nature of the issuer’s business model, product cycles, asset lives, and client/customer tenure. For example, the team avoids debt with maturities longer than an issuer’s product cycle. For this reason, technology exposure is generally light given obsolescence risk, and any technology exposure the fund does have will be of shorter maturity given the generally shorter product lifecycles. It is important that issuers be self-funding and not reliant on access to the capital markets.

When it comes to valuation, the team’s first step is to evaluate the issuer’s credit rating, with the goal of ensuring the company’s fundamentals align with the credit rating from a balance sheet perspective. From there the team evaluates the spread versus similarly rated peers, taking into consideration differences in maturities, coupons, issuer and issuance size, among others. For investment-grade credits the team uses option-adjusted spreads to determine adequate compensation levels, while for high-yield credits they use yield-to-worst spreads. If valuations/spreads are not sufficiently wide enough, the team will avoid an industry or security.

Ample liquidity is essential, and the team pays close attention to the size of the issuer, level of issuance, frequency of issuance, the other owners of the credit (e.g., mutual funds, exchange-traded funds, insurance companies, or managers facing outflows), and the bankers behind the deal. In addition to liquidity, the team emphasizes transparency as they attempt to stack the deck in their favor. The team minimizes investments in industries where there is uncertainty. For example, they avoid areas where regulation can negatively affect industry fundamentals, such as health care and regional banks. Similarly, the team tends to eschew areas such as technology, as mentioned before; segments of the fixed-income market where transparency is opaque (such as commercial mortgage-backed securities); and elaborate and complex structures (such as MLPs), as well as niche and nuanced segments of the markets (such as convertibles and preferred debt) where liquidity can ebb and flow.

When evaluating mortgage securities, the team’s goal is to own specified mortgage pools they believe will outperform the MBS component of the Barclays index. The team only invests in highly liquid to-be-announced (TBA) eligible pools with above-current-market coupons that tend to yield 100 bps or more than the market. Within the agency MBS market, the two primary risks are prepayment and extension risk. Since the team tends to own securities with above-market coupons, their main concern is prepayment risk, which would result in a lower yield/return. The team attempts to mitigate this risk by using specified TBA eligible pools of lower-loan-balance single-family mortgages. (The low-loan-balance pools in the fund have an original unpaid balance of $85,000 or less, while the fund will also own mid-loan-balance pools, which have a $110,000 original loan balance.) The team focuses on low-loan-balance mortgage pools because cash flows from these pools tend to be steady, since low-loan borrowers’ incentives to refinance are low, especially relative to borrowers with large loan balances. The team’s criteria for well-constructed specified mortgage securities incorporates several factors including a high loan count, low weighted-average coupon (the contractual mortgage rate that mortgage borrowers are actually paying), a diverse geography of borrowers, etc. There are many other criteria such as loan to value, credit scores, and property type, but the overall general theme is to invest in diverse pools to help diminish adverse prepayment behavior.

The strategy also looks to invest in asset-backed securities when valuations are relatively attractive. Just as with corporate credits, the team seeks leaders within an industry and expects these issuers to be of very high quality (i.e., they have financial strength). It is important for the team that these issuers are securitizing loans that are of fundamental importance to the issuers’ underlying business. For example, when purchasing issues backed by credit card collateral the team seeks issuers for which credit card receivables are an important part of their business, such as a large bank like JPMorgan Chase & Co.

Portfolio Construction

Portfolio construction is driven by where the team is finding value within the various fixed-income sectors along the yield curve. When constructing the portfolio, the fund will closely resemble the Barclays Capital U.S. Aggregate Bond Index on two dimensions: duration and yield curve exposure. The portfolio’s duration is managed to be within 10% of the benchmark’s duration, while exposure to various maturity ranges along the yield curve (e.g., less than one year, one to three years, three to five years, five to seven years, seven to 10 years, and longer than 10 years) will also approximate those of the benchmark. The team seeks to outperform in each maturity segment and will overweight or underweight a segment based on their assessment of security-level risk/reward. This allocation decision is made by evaluating the tradeoff between their secular outlook for interest rates—longer maturities have greater interest-rate risk—and the attractiveness of fundamentals and valuations. Using recent positioning to illustrate this approach, the team had a net overweight to the long end of the curve (i.e., greater than 10 years) by underweighting long-term Treasurys because of unattractive yields and vulnerability to higher interest rates, but meaningfully overweighting investment-grade developed and emerging-markets corporate credits (i.e., credit risk) based on attractive fundamentals and valuations.

While most portfolio positions are based in the United States, the team also looks for opportunities abroad as there is a significant number of foreign-based companies that meet the “leader” criteria. This geographic flexibility includes both developed and emerging markets and is intended to provide a wider opportunity set to identify companies with a yield advantage relative to domestic investment-grade peers. (All foreign portfolio holdings are dollar-denominated.) Historically, the fund’s allocation to foreign bonds (developed plus emerging markets) has ranged from a low of 3.2% to a high of 16.8%, where the allocation to developed-market foreign bonds has ranged from 0.7% to 5.9%. The team limits the fund’s emerging-markets exposure to 15%; the current allocation is close to 12%, compared to 3% for the Barclays Capital Aggregate U.S. Bond Index. Positions in emerging-markets credits are limited to a 0.75% overweight relative to the benchmark due to their greater potential volatility.

The overwhelming portion of corporate securities in the portfolio are rated BBB and A from a credit standpoint, a segment of the rating categories where the team can often find attractive combinations of fundamentals and yield. But the team is permitted to own up to 10% in below-investment-grade corporate credits—those rated BB and below. This high-yield exposure will consist of higher-quality BB- and B-rated issuers within this space, not lower-quality CCC or nonrated securities.

Portfolio weightings for the mortgage holdings are somewhat more fluid when compared to corporates for two reasons. First, the maximum position size is higher because the agency MBS market is large and liquid and the MBS pools they consider are comprised of a diversified pool of loans. As a guardrail, they do not have much higher than a 5% weighting in a single MBS pool. Second, the majority of the pools are purchased through secondary markets, so trading dynamics factor into the decision. If a pool becomes available in the secondary markets, it may be advantageous to purchase the entire block available rather than a piece of the pool. As with corporate bonds, the team is comfortable taking a larger position size when conviction is high. For MBS, this would occur when a pool aligns very well with their issue selection standards (e.g., TBA-eligible collateral, low loan balance, high loan count, low spread between the weighted-average coupon and the fixed-rate coupon, diverse geography, solid originator and mortgage services).

The team combines bottom-up security selection with established risk controls. The team’s first line of defense is bottom-up credit selection. Beyond that, diversification is an elemental component of the team’s risk management, where portfolio exposure is diversified across fixed-income sectors, economic sectors/industries, issuers, and maturities. The team does not try to mimic the index’s sector or industry allocation, and the strategy is permitted to have a maximum overweight that is twice the benchmark’s weightings in credit and mortgage sectors. At the issuer level, position size limits ensure that one issuer or issue does not have a material impact on performance. Investment-grade credits have a 1% maximum overweight limit relative to the benchmark, while the higher-risk high-yield issuers, like emerging-markets positions, are limited to a 0.75% overweight. Position size is influenced by qualitative factors such as liquidity, credit rating, market cap, total issuance, issue size, and volatility assumptions.

Scenario analysis is also used as a risk-management tool in portfolio construction. The team can run historical or theoretical scenarios to understand how the portfolio would perform both absolutely and relative to the benchmark. Examples of scenarios include sharply rising interest rates or a sudden and meaningful rise in corporate credit yields. Importantly, the team does not manage the portfolio to a specific level of underperformance (i.e., a lower-probability scenario that indicates the portfolio would lag by 250 bps in a 12-month period does not trigger a rejiggering of the portfolio).

The team is permitted to hedge the portfolio, a policy that has been in place since 2013. Hedging is used minimally and is intended to protect the portfolio in the event of punishing market environments such as severe flights to quality (where credit spreads widen) and/or a sharp and dramatic increase in interest rates. To minimize the damage that could be caused by a widening of corporate yield spreads, the team purchases low-priced protection on the credit default swap index (CDX) and also owns interest-rate options that should benefit the portfolio if short-term rates rise rapidly over a short period. As in the case of the CDX arrangement, the costs are very low (around 2 bps) but the payoffs are large enough to meaningfully offset part of the potential fall in portfolio value. Despite the marginal use of hedging (and derivatives) in the portfolio, investors in the fund should be aware that cash bonds are by far the focus of the team. The team will also invest in TIPS at the longer end of the yield curve as insurance against rapidly rising inflation in the longer term. Besides inflation protection, TIPS also provide an opportunity for the portfolio to benefit should the economy face significant headwinds causing interest rates to fall.

The fund is managed to be close to fully invested (i.e., cash is kept to a minimum).

The team says their capacity for the core bond strategy is $5 billion; this includes the mutual fund and separate accounts. Currently the total assets in the core strategy are $440 million, of which $280 million is in the fund and $160 million is in separate accounts. Beyond $5 billion, the team says they run the risk of either expanding the number of names in the portfolio or owning position sizes that detract from their objective of maintaining high liquidity, which could ultimately decay the portfolio’s risk/return profile.

Team

The William Blair Bond team is comprised of six professionals: two co-portfolio managers, two analysts, a portfolio specialist, and a dedicated trader. Vincent has over 30 years of fixed-income experience and joined William Blair in 2002. He is a partner of the firm and heads William Blair’s fixed-income group. In addition to focusing on overall portfolio positioning and exposures, Vincent focuses on corporate credit, particularly high-yield and emerging-markets opportunities. Sularz has 25 years of investment experience with a focus on mortgage-back securities. Sularz worked with Vincent at Kemper Asset Management from 1990–1995.

Todd Kurisu and Kathleen Lynch are portfolio managers at William Blair and analysts on this strategy. Kurisu has nearly 25 years of asset management experience and has been at the firm for over nine years, focusing on high-quality investment-grade corporate bonds. Lynch, who has been at William Blair for over 15 years, manages low-duration strategies. As part of her responsibilities, she focuses on high-quality corporate financial securities for the fund. The two other members of the team are portfolio specialist Tom Brennan and trader Susana Sanchez. Brennan has been with the firm for nearly five years and brings a quantitative perspective that is employed in, among other things, risk management for the strategy. This includes analyzing performance attribution, tracking error relative to the benchmark, liquidity, valuations, and sector spreads. Sanchez has been at William Blair for nearly seven years.

Investment decisions are consensus driven, and the small team size is intended to promote continual informal vetting. The team has a weekly meeting, which starts with a discussion of performance attribution. Beyond that, there is no set agenda, and topics may include performance dispersion, mortgage market valuations, Fed activity, and credit-specific issues.  

The fixed-income team shares an investment philosophy with the firm’s equity team, where both teams are ultimately looking for businesses that are global leaders (in terms of brand, scale, market scope, etc.).The bond team attends daily equity team meetings and often collaborates with the equity team to discuss views and opinions of industries and/or issuers.

Performance

The core bond strategy dates back to May 2007 and has been run by the existing team members during its entire existence. Since mid-2007 (through 6/30/15), the fund’s annualized return is 5.61% versus 4.81% for the Barclays Capital Aggregate U.S. Bond Index and 4.31% for the Morningstar U.S. Intermediate-Term Bond category. This meets the team’s goal of outperforming the Barclays benchmark by 75–100 bps, net of fees, on an annualized basis.

As for consistency of performance, the strategy has outperformed the index in 72% of rolling 12-month periods. Over longer rolling periods, which is more in line with the team’s investment horizon, the fund has beaten the index 100% of the time over rolling three- and five-year periods; the average level of outperformance during these rolling periods is 144 bps, exceeding the team’s performance goal. The team hopes to achieve this performance goal without taking on a much higher risk profile than the index. In terms of downside, the fund’s historical downside-capture ratio (a measurement of a manager’s relative performance in down markets) is around 95% (i.e., the strategy has captured only 95% of the index’s negative performance, on average, and has thus outperformed the index by this measure). Over the same time period, the strategy’s upside-capture ratio is roughly 108%, implying outperformance when the index experiences a positive return. This finding is consistent with the team’s goal of longer-term outperformance through the selection of high-quality issuers and issues that have a yield advantage relative to the index.

We also examined the fund’s performance in various interest-rate scenarios, looking at two recent periods of rising and falling 10-year U.S. Treasury yields to gain context around portfolio construction and performance expectations. Between May 1 and December 31, 2013, 10-year Treasury yields rose nearly 140 bps, creating a headwind for fixed-income managers. (Bond prices are inversely correlated to changes in interest rates.) During this relatively short period of sharply rising rates, the fund realized a loss of 2.4% but outperformed the benchmark by 45 bps. Two themes within mortgages contributed to performance in this period. First is the high-coupon pools of low-loan-balance mortgages, which added value relative to securities of comparable duration. Second, the team avoided the 30-year pools that dominated the index and performed poorly as interest rates rose. In 2014, yields on the 10-year Treasury fell by around 83 bps. While the fund returned a positive 5.6% for the year, it underperformed the index by 61 bps. This is due, in part, to an overweight to emerging-markets corporate bonds and an underweight to Treasurys during a period when credit spreads widened. An allocation to TIPS also negatively impacted performance, as they underperformed nominal Treasurys.

During the 2008 financial crisis, the William Blair Bond realized a positive return of 1.7% but lagged the benchmark’s gain of 5.2%. Most of the underperformance can be explained by the team’s preference for spread sectors—corporate bonds and mortgage-backed securities—during a severe flight-to-quality environment. As corporate debt prices declined in the second and third quarters, the team was increasing their exposure, believing they were being well-compensated looking out over the long term. Increasing corporate exposure throughout the second half of 2008 to an overweight (relative to the Barclays Capital Aggregate U.S. Bond Index) hurt performance. In the third quarter of 2008, Treasurys gained 2.3%, while corporates lost 7.8%. But in 2009, the fund gained 11.4% compared to 5.9% for the benchmark. Over the two-year period, the fund’s cumulative return was 13.3% compared to 11.4% for the benchmark.

Litman Gregory Opinion

Our recommendation of William Blair Bond reflects our confidence in the team’s ability to outperform the Barclays Capital U.S. Aggregate Bond Index over a credit cycle.

In a world of increasingly complex investment strategies, we find the team’s approach relatively straightforward. It is a single team focused on a single strategy, uncluttered with material exposure to derivatives, options, currencies, futures, etc. Yet we think there is a sophistication to their simplicity, which we attribute to the team’s collective experience. Our impression is that the team knows who they are, what they are good at, and what their goal is—and they stick to it. A deliberate focus on their expertise minimizes the complexity of their investment process, which we think allows the team to capitalize on the complexity of the bond market.

The team has demonstrated consistency in philosophy as well as decision-making frameworks throughout the investment process, all geared toward the goal of outperforming the benchmark. While taking risks is unavoidable, the team consistently attempts to stack the deck in their favor via bottom-up credit selection within their areas of expertise. Bottom-up analysis is how the team intends to win, and we believe their security-level analysis will be the driver of the team’s longer-term outperformance. It’s difficult for us to see this advantage erode given their intention to always run a relatively concentrated portfolio, where the goal is to thoroughly understand each portfolio holding, the risks associated with each holding, and whether they are being appropriately compensated for those risks. They steer clear of complex, speculative, and/or too-tough-to-call investments, whether it’s at the credit level or based on macroeconomic predictions.

We like that the team intends to preserve their focus on fundamentals and selectivity by limiting assets in the strategy. We applaud the team’s intention to close to new investors at this asset level, which we think is responsible and should allow the team to remain nimble and continue to effectively execute their strategy.

We also like that this is a small team without a bureaucratic structure that can make decisions quickly if necessary. The current team members have been there for several years and our expectation is that the team will be stable. Based on our conversation with firm management, it is clear the fixed-income business is a focus area of growth for the firm, which we think supports team retention.

We do not have any major concerns at this time. While we do not anticipate any departures, we should mention that co-portfolio managers Vincent and Sularz are core to our opinion, and should one of them leave, it would have a materially negative impact on our thesis. Vincent wears many hats including credit selection, managing the team, and overseeing portfolio positioning, while Sularz has deep experience in the mortgage markets.

When considering this fund as part of a core fixed-income exposure in our portfolios, we see a potential diversification benefit. While the William Blair Bond's overall mortgage exposure might appear comparable to other funds, the mortgage portfolios actually differ greatly. For example, while William Blair targets highly liquid specified TBA-eligible agency MBS, DoubleLine Total Return Bond, a Recommended fund in our models, has a broader approach to mortgage assets. These include non-agency MBS, CMBS, collateralized loan obligations, and securities backed by whole-loan (i.e., non-securitized) collateral, among other non-TBA-eligible sectors.

Based on our due diligence, we view the fund as a true core bond holding and expect it to provide ballast to a balanced portfolio should the stock market suffer a material decline. Moreover, we believe that the fund will meet the team’s goal of outperforming the Barclays Aggregate benchmark by 75–100 bps, annualized, over a three- to five-year period.

—Jack Chee and Alistair Savides, CFA

Performance
(8/31/15)
    Calendar Year Returns Trailing Returns*
  YTD 2014 2013 2012 2011 2010 One-Year Three-Year Five-Year Since Inc.
William Blair Bond 0.18% 5.35% -1.28% 8.56% 7.62% 7.89% 0.19% 2.01% 4.03% 5.32%
Vanguard Total Bond Market Index 0.18% 5.76% -2.26% 4.05% 7.55% 6.42% 1.13% 1.24% 2.71% 4.47%
*Inception May-2007.

William Blair Bond Relative Strength Chart

Sector Diversification
(8/31/15)
U.S. Agency Mortgage-Backed Pass Through 44.6%
Developed-Market Credit 34.5%
Emerging Markets 10.5%
U.S. Treasury 6.2%
Asset-Backed Securities 4.0%
Cash 0.2%
Total 100.0%
Credit Quality
(8/31/15)
U.S. Treasury 6.2%
U.S. Agency Mortgage-Backed Pass Through 44.6%
AAA 1.8%
AA 1.7%
A 12.4%
BBB 23.6%
BB 8.1%
B 1.4%
Cash 0.2%
Total 100.0%
Portfolio Characteristics
(8/31/15)
Number of Holdings 252
Average Maturity 8.1
Duration 5.1

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