Fixed Income

Our value-based investment philosophy is built on five guiding principles:

use a business
use a margin
embrace vol
focus price
focus returns

Use a Business Approach

As a bond investor, we believe it is important to research each security on a business basis to ensure we have put the odds in our favor that we are making a good loan. From a quantitative viewpoint, we perform an internal credit analysis where we focus on the quality and strength of the balance sheet, income statement, and statement of cash flows. On a qualitative basis, we examine the viability and reputation of the entity and, most importantly, appraise the entity's ability to repay our loan.

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Use a Margin of Safety

We strive to create a margin of safety that will help us construct favorable reward-to-risk characteristics for the client's fixed income portfolio. To do this, we incorporate one or more of the following: maintain maximum flexibility within the maturity structure of the portfolio, focus on securities that have wide spreads (i.e., discounts) relative to U.S. Treasury securities, and require a minimum real rate of return (i.e., after inflation).

While the margin of safety guidelines do not guarantee the success of an investment or that the price of a security will not go down, it does help to protect against the effects of unforeseen events that are out of our control such as higher interest rates and inflation. By using this principle across a diversified basket of fixed income securities, we believe we are able to put the odds in our favor that, over the long-run, our investment portfolios will be a success.

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Embrace Volatility

We believe securities are not always priced to accurately reflect their true intrinsic values. At the extremes, this price distortion can be irrational. Thus, price is not always the same as value. When investors lose sight of fundamentals and instead trade their debt securities based on emotions, they can cause volatility in the market place. It is during these "manic-depressive swings" when we usually see the greatest disparity between price and value, and therefore, have an opportunity to capitalize on attractively priced securities that can provide solid returns.

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Focus on Price

Paying too much for a security of a great company or highly rated government entity can lead to a poor or mediocre return. However, we believe buying the security of a lesser known company, one with a short-term problem, or a company or government entity whose credit profile is temporarily out of favor for a bargain price can lead to a great return. Furthermore, it has been our experience that investing at a bargain price, or as we like to say a "wholesale" price, helps to reduce risk, increase potential reward, and put time on our side.

After the margin of safety, which helps to safeguard the return of capital, we believe price is the most important consideration as it helps to generate our expected return. The following example highlights the importance of price. Assume you were to invest in a 10-year corporate bond at par, or $1,000. Next, assume this bond has a coupon equal to $60 per year, thus yielding 6%. Last, assume at the end of the 10 years the bond matures and you get your original $1,000 investment back. Your 10-year return on this investment will be 6%, as this is the rate of interest that was paid to you each year before getting your original investment back.

Now, instead of paying par, or $1,000, for this same corporate bond, let's assume we were able to buy it at a discount to par, or in this example $900. This could have occurred because bond spreads widened or for any number of other reasons. While this bond is bought at a discounted price, it still pays the coupon payment of $60 per year. However, because our cost basis is $900 instead of $1,000, this $60 coupon now represents a yield of 6.67%. In addition, assuming the bond reaches maturity, it will also appreciate $100 over this 10-year period as it will mature at par or $1,000. Therefore, when we add the annual coupon received to the appreciation that will take place, we end up with a total compounded return of 7.67% over the life of this investment (6.67% coupon + 1% appreciation = 7.67%). This is a good example of how the price you pay can ultimately determine your return.

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Focus on Absolute Returns

While we offer several investment strategies within our practice, the core focus of our fixed income strategy is to invest where we see the best value and opportunity rather than to manage the portfolio allocation to an index or benchmark. Thus, our focus is on an absolute, not relative, return.

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