Methodology

Traditional “core” bond management combines corporate bonds with government bonds in an “active” bond mandate. The corporate bonds usually selected are a limited number of higher investment grade issues, which form a portion of the overall bond portfolio at a weight that is typically higher than the corporate bond weight in the market index. Alternatively, a smaller portion of the bond portfolio is allocated to “high yield” management, which is exclusively invested in lower quality bonds.

Our approach allocates a dedicated portion of the client’s bond portfolio to corporate bonds and manages these as its own universe. The result is a diversified and well-structured portfolio of corporate bonds, with each selected on its own individual merits. The credit range of the portfolio includes all investment grade bonds (AAA to BBB) and below investment grade issues, when permitted by the client’s mandate. We believe this latitude frees us from the necessity of trying to mimic index holdings and allows us to accept risks in the portfolios when we are appropriately compensated. Given the risk/return tradeoff, we do not distinguish among bonds by credit rating, but rather on fundamentals. We are opportunistic in our process, moving between bonds as their valuations change; buying unpopular bonds cheaply and selling overvalued, highly sought after bonds into strength. We would rather buy an out-of-favour and cheap “A” bond than a highly sought after and overpriced junk bond.

Our prime focus is on our internal credit research; we do not rely on external research and credit rating agencies. With our large staff of credit professionals we believe we have greater research resources than most other investment managers or Canadian investment dealers. We conduct extensive research on issuers before making an investment and we continue to update our research on an ongoing basis for each issue in the portfolio.

The investment process begins with a thorough fundamental review of the issuer of a security. An internal quality rating is then assigned to the issuer. At this point, the merits of the particular financial security are examined with particular regard to the structure and ranking of the security. Once this is done, the future cash flow stream is identified and the risks associated with it are determined. Extensive fundamental analysis is used to identify the credit risk of an issuer. Our credit analysis is thorough and objective and is independent of the published ratings for the security. Before any security is purchased, the issuer is fully analyzed with respect to financial strength, management capability, and business environment. In addition to analyzing the financial strength of the issuer, the terms and conditions of the security (including covenant package, priority in a default, ability to incur additional debt and make dividend payments) are assessed. If we are comfortable with both the issuer and the security, a risk/return profile is determined.

We keep extensive files on all issues, whether we participate in them or not. As new information becomes available this allows us to move quickly if an opportunity presents itself.

It is easy to buy a bad investment at a low price or securities of an excellent company at very expensive prices. It is very difficult to find a good investment at a reasonable price, which is what we constantly endeavour to do.

Given the wide range of experience and analytical skill of our professional staff, we make it a priority to encourage debate and a complete assessment of all important issues.

As part of our fundamental review, the future cash flow stream from a security is identified and the risks associated with those cash flows are determined. An internal credit rating is then assigned to the issuer and a valuation is established. The portfolio managers make the ultimate buy or sell decision by comparing our valuation to the actual market price of the security.

In order to decide on the appropriate position size, we determine the potential downside of the security from its current market value using our proprietary Maximum Loss analysis. This analysis captures the potential return that will be available to the bondholders and creditors in an insolvency and workout situation. Our experience with distressed debt is invaluable in this regard, as it allows us to fully understand the intrinsic value of a security in a negative scenario.

Weekly meetings are held to assess new information, although decisions are frequently made on an opportunistic basis between meetings. Issuers held in our portfolios are reviewed on at least a quarterly basis. If corporate development arises, the analyst responsible will present their analysis and recommendation to the other team members who provide peer review and input. After the development has been thoroughly reviewed, the portfolio manager makes the investment decision.

Our portfolios reflect our “bottom up” research emphasis. Rather than identifying likely sectors for investment, we select individual securities with regard to their intrinsic risk and return tradeoff. Our portfolios are constructed with little regard for the industry and geographic breakdowns of market indices but our credit limits for individual holdings and ratings categories are always maintained.

Our “buy” or selection process focuses primarily on the absolute price of the issue given the fundamental credit quality of the issuer and the terms and conditions of the specific security. Then we determine the relative value of the prospective issue. If the yield spread is attractive both absolutely and relatively, we will establish a position. When a security becomes overvalued on a peer or absolute basis, we look to sell it and will put the proceeds into Canada bonds if no other attractive investment can be found at that time. If a security deteriorates from an operational or credit point of view, we will sell it on opportunity.

Features such as extension and retraction are valued using proprietary models. We look at these features as changing the duration profile of our overall portfolios and use them to take a credit or term posture. We pay careful attention to the exact terms and conditions of callable bonds, as we desire to have optionality in our favour.

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.

We also recognize that applying the Principles for Responsible Investment (“PRI”) may better align our clients with the broader objectives of society. Effective August 5, 2019, we are a PRI signatory. Although we are a PRI signatory, we will always invest in a manner that is consistent with our fiduciary obligations and responsibilities to our clients.

We believe that it remains difficult to demonstrate, amid the multitude of factors that have a bearing on corporate performance, a discrete causal relationship between ESG factors and credit quality. In our opinion there is rarely a direct or standalone transmission from many ESG factors and long-term profitability. It is also our experience that when companies move to address weakness in corporate practices, including practices related to ESG considerations, these inflection points may represent attractive investment entry points.

Our bottom-up fundamental research process incorporates a variety of factors that impact company cash flows and long-term sustainability. ESG considerations are just a few of these factors. We have always taken a long-term view and when we purchase a bond, we are willing to hold it until maturity. For debt, especially with a long term to maturity, it is essential we have confidence the borrower has a sustainable business model.

We incorporate explicit ESG considerations in our research documentation. At the issuer level, an analysis of each of the ESG factors is separately outlined with a focus on how these factors might affect a company’s cash flows and ultimately a Canso Rating/Recovery.

The PRI suggests signatories actively engage with issuers on ESG related matters. When appropriate we will:

• Engage issuers on ESG factors of concern (e.g., in run-up to issuance);
• Collaborate with other bondholders for more effective engagement, normally through the Canadian Bond Investors Association;
• Engage the company on governance concerns during debt restructurings; and,
• Vote proxies in accordance with Proxy Voting and Corporate Action Policy.