We believe that diversification is key to appropriate corporate bond investment. No matter how good the credit analysis or the underlying situation of the issuer, there is the potential for disruption to cash flows that cannot be foreseen. Such a disruption can be disastrous for a weaker or lower quality credit.
Our firm defines risk in terms of absolute capital loss. In our bond portfolios, we use a proprietary system of default risk for our bond holdings called Maximum Loss. This system limits each position according to its potential impact on a portfolio’s long term value-added. Each position is analyzed independently. The higher the trading price of a security compared to its downside potential, the smaller the position allowed. The risk assessment allows the security’s specific features that modify its downside risk to be considered. This includes the priority of the security and nature of the issuer.
Our security selection is not independent of our risk management. Since some of our portfolios allow us to hold AAA to defaulted securities, we frequently invest in distressed names and we are very familiar with the bankruptcy and reorganization process. This helps us recognize the capital risk inherent in many popular issuers that have considerable downside risk despite their published ratings. Portfolio weightings in credit cohorts are established by investment policy statement constraints which reflect client risk tolerances.
Portfolios are diversified by issuer type and industry sector. Positions are then limited individually by the determination of the Maximum Loss potential of each issue.
Compared to commercial credit ratings, Maximum Loss compares the loss potential of a security to its trading value, resulting in limited exposure to bonds trading expensively compared to their potential losses and encouraging the purchase of bonds trading near or below their workout values. This limits the portfolio’s downside risk and creates more upside potential than by using traditional credit rating methodology.