Most fixed income portfolio managers worry about navigating the ebbs and flows of the bond market, but Jeff Klingelhofer also has to contend with some very real headwinds and tailwinds.
Aside from being a Citywire AAA-rated manager on the $5.1 billion Thornburg Limited Term Income fund, Klingelhofer is also a qualified pilot. He regularly flies between Thornburg Investment Management’s headquarters in Santa Fe, New Mexico and his family home in southern California.
Flying was always meant to be more than just a hobby for Klingelhofer (pictured below). He had dreamed of becoming a professional pilot from the age of seven, right up until he learned that he would need 20/20 vision to fly commercially.
However, Klingelhofer did not abandon the professional rigor that flying requires when he moved into asset management. Instead, he has sought to take advantage of some of the surprising overlaps between flying an airplane and running fixed income portfolios.
‘The thing about flying is that you’re not paying the pilot for when things are going right – you’re paying the pilot for when things go wrong. Buying fixed income when the world is humming along, when the economy is doing very well, is actually pretty easy,’ Klingelhofer says.
‘What you want in your fixed income manager is somebody with the fortitude and the ability to provide value when the world isn’t doing so well, because that’s exactly when you want your fixed income portfolio to be the ballast to the rest of your broad asset allocation,’ he explains.
Klingelhofer and his co-managers AA-rated Jason Brady and AAA-rated Lon Erickson have certainly shown those traits over the past three years to the end of October. They have returned 4.5% on the Thornburg Limited Term Income fund over that period, compared with the average fund in the category’s 3.9% and the Bloomberg Barclays Intermediate US Government/Credit Total Return index’s 2.7%.
Fasten your seatbelts
Klingelhofer is no stranger to turbulence, and that’s exactly what the investment grade corporate bond market is going through right now. His Limited Term Income fund has allocated 48.8% to this sector and recently had to contend with one of its giants, General Electric, suffering sell-offs in both the stock and bond markets. The giant conglomerate’s stock price dropped by as much as 10% in a single day, and its bond price has fallen by 8% over the course of 10 weeks.
For some, the company’s debt troubles are a premonition of worse to come in the increasingly fraught corporate bond market. However, as top bond and hedge fund managers sound the alarm, Klingelhofer is seeking to take advantage of this ominous narrative.
‘I do agree that the corporate sector is pretty risky given the fact that leverage in the corporate sector is higher than it has ever been outside of a recession,’ he says. ‘Risk is high, but it’s unfair to paint corporates with a broad brush. Corporations are very different depending on what they are.
‘Because most other investment shops are looking from the top down, that creates an opportunity for us to find differentiation and some relative value in those sectors,’ he adds.
One example of the Thornburg team’s approach was its decision to sell AT&T and Verizon. While Klingelhofer believes that these are fundamentally good businesses, he says that they also have some cyclical characteristics that make them riskier than other similar names.
‘Heading into the last recession, AT&T and Verizon had a profitability adjustment of roughly 12% peak-to-trough, so their Ebitda declined by 12%,’ Klingelhofer explains.
‘If I’m using my phone, both AT&T and the tower operators are going to benefit, but tower operators have long-term contracts with annual 3% escalators in their cash flow,’ he says. ‘So even in a recession when AT&T’s Ebitda declines by 12%, the towers themselves will tend to go up by about 3% every year. They therefore have a very acyclical cash flow profile.’
Klingelhofer believes that the market is not recognizing that difference, so his team is increasingly shifting the portfolio away from cyclical companies to ones with more ‘acyclical-oriented’ cash flows.
Ready for take-off
Focusing on relative value is by no means a knee-jerk reaction to the recent turmoil in the corporate bond market. Rather, it’s a deep-seated part of his team’s fundamental bottom-up investment philosophy.
‘Because of the siloed nature of fixed income, the market is inefficient at assessing risk and reward,’ Klingelhofer says.
He argues that traditionally aligned asset managers are too focused on accessing absolute value within industries, sectors and geographies. Instead, Klingelhofer, his two co-managers and his team of six analysts embrace a bond picking process that looks for ‘three commonalities’ – timing, probability and the quantity of cash flows.
‘When you break the world down to those commonalities, it doesn’t matter whether it has an asset-backed wrapper or an investment grade corporate wrapper or even a mortgage wrapper,’ he says.
Another example of this investment process, playing right into Klingelhofer’s area of expertise, is the team’s decision to invest in American Airlines’ enhanced equipment trust certificate, also known as the ‘double ETC’ – a vehicle which is often used in aircraft finance to take advantage of tax benefits.
Klingelhofer says that while the team favors opportunities in the US consumer sector, particularly the travel industry, buying a double ETC instead of American Airlines’ unsecured corporate paper has helped to limit the fund’s risk exposure.
‘American Airlines and most global carriers don’t actually own aircrafts,’ he explains. ‘They go to Boeing and buy Boeing 730s, but rather than financing it on their own balance sheet, they sell those aircraft to a special purpose vehicle (SPV) and engage in a sale leaseback transaction.’
Klingelhofer adds that both the ETCs and the unsecured corporate paper are ultimately going to live or die by the fortunes of American Airlines, but they could work out very differently in the event of an emergency landing.
‘If American Airlines defaults, you would typically recover 40 to 70 cents on the dollar from unsecured corporate credit,’ he says. ‘With the double ETC though, because you physically own those aircraft, it’s a little bit different. If American Airlines goes bankrupt, it would want to continue being an airline both during its bankruptcy and on the other side of bankruptcy, so it would continue to pay for the right to fly those aircraft, meaning cash flow will be totally uninterrupted.’
For Klingelhofer, the biggest difference between these two vehicles is the fact that the ETC enables investors to own the aircraft. ‘Even if American Airlines chooses not to pay you, you can liquidate the aircraft and get some money to pay back the debt,’ he explains.
‘As such, the risk of owning the double ETC is always lower than the risk of owning the corporate credit. Both are American Airlines, but you’re paid more to own the double ETC,’ he says.
Although Klingelhofer argues that this mispricing of risk and reward is due to the market’s inefficiency in this regard, something else may be at play too. As a pilot, he probably knows the airline industry better than most managers. ‘When you’re investing in the aircraft, you have to understand where they are in the maintenance cycle. Could you learn that if you’re not an airplane pilot? Of course, but I think I have a different appreciation for them.’
Head of investment research, Citywire
Short duration fixed income has been fertile ground for active managers in recent years. Of the largest players in the short-intermediate investment grade category, Jeff Klingelhofer and his team have the best risk/reward profile over the past three years.
They also boast top-quartile standard deviations to match their excellent long-term absolute and risk-adjusted returns. The importance of this amid rising rates cannot be overstated, as it is highly unlikely to be a one-way street for fixed income managers going forward. Limiting downside risk will be the key to success.
However, like much of the category, the fund has a credit-focused portfolio, with half of its assets in corporate bonds and just 11% in Treasurys. This will have benefited returns in recent months, but it could hurt the figures if corporate America starts to show some weakness.