Fixed Income Investment Process
In keeping with our overall investment philosophy, our fixed income management process focuses on identifying the combination of bonds that offers good, competitive, long-term return potential without excessive or undue risk.
Our fixed income management process begins with identifying the risks exclusive to bonds. Changes in interest rates, economic ebbs and flows, and inflation represent some of the key risks for bond investors.
Focus On Credit Quality
Among the major risk factors associated with bonds, we believe the risks posed by credit quality are most important. Credit quality refers to the bond issuer’s ability to repay its debt – the higher the credit quality, the greater the likelihood that the issuer will meet its obligations. Therefore, by maintaining high credit quality within our funds, we believe we are better able to manage the other risks associated with bond investing.
A-Rated Or Better
All of the Cavanal Hill fixed income funds invest only in those securities that are rated A3/A or better at the time of purchase. Although we rely on these major credit ratings services for overall guidance, we delve deeper by conducting our own extensive bond research.
Implementing The Analysis Process
Our fixed income management process is a disciplined five-step methodology
Step 1: Derive Interest Rate Forecast
Interest rates are key “macro” influences on bonds, due to their inverse relationship with bond prices. We evaluate key economic indicators along with Federal Reserve policy and government fiscal strategy to derive a six- to nine-month interest rate forecast. Maintaining this particular time frame helps prevent us from over reacting to short-term fluctuations or from missing out on longer-term movements.
Advantages: Our interest rate forecast takes into account the “big picture” influence of interest rates on bonds. A correct forecast may allow our managers to operate with a key “tail wind”, in which interest rates work in our favor.
Step 2: Manage Duration
We set duration guidelines for our funds based on our interest-rate forecast. Duration refers to a fund’s sensitivity to interest-rate changes. Funds with shorter durations are typically less sensitive, while funds with longer durations are more sensitive.
Advantages: Managing duration may help limit interest rate risk and promote relative share-price stability. If we believe rates may rise, we will take a defensive position and shorten duration to limit any downward share-price movement. Conversely, if we expect rate to decline, we will extend duration to capture potential price appreciation.
Step 3: Determine Sector Weightings
We begin with a hypothetical portfolio consisting entirely of Treasury securities – among the safest securities available – and evaluate the mortgage and corporate sectors on a “value-added” basis. We invest in the corporate and mortgage sectors only when we believe the yield advantages and/or price-appreciation potential are compelling and outweigh the risks.
Advantages: A thorough evaluation of each sector gives us the flexibility to take advantage of what we believe are the most attractive bonds, based on quality, yield and total return potential. Similarly, it enables us to avoid sectors we deem too risky or unattractive.
Step 4: Maximize Yield Curve Opportunities
The yield curve graphically depicts the relationship between bond yields and maturities. Generally, as maturities increase, so do yields, and the curve slopes upward. We evaluate the slope and dynamics of the curve in an attempt to pinpoint the areas that offer the most attractive yields at the best price, while staying within our average maturity guidelines.
Advantages: Monitoring the yield curve helps us identify the most attractive yield and maturity opportunities and adjust our exposure accordingly. For example, we may group our exposure at the long and short ends of the curve, or we may spread out our exposure across the curve, enabling us to maintain our maturity guidelines and capture yield advantages without taking on excessive risk.
Step 5: Invest
The final step involves purchasing securities that fit the criteria derived from the previous steps. We "stress test" each security by performing a multifactor analysis of key characteristics, such as credit quality, cash flow and structure, to identify bonds that we believe offer the best value and present the least investment risk. We also utilize an extensive network of Dealers to uncover, and capitalize on, pricing anomalies and inefficiencies that present themselves in the marketplace.
Advantages: Our extensive Dealer network and multifactor analysis allows us to expose the best bonds trading at the best price, which helps us construct a high-quality portfolio designed to provide attractive, consistent return potential and relative share-price stability.
To understand how we put our investment process to work in our fixed-income portfolios, we invite you to read about our fixed income fund family:
- Cavanal Hill Short-Term Income Fund seeks to maintain an average maturity between one and three years from a mix of Treasuries, agencies, mortgages and high-credit-quality corporate bonds.
- Cavanal Hill Intermediate Bond Fund strives to maintain an average portfolio maturity of three to seven years and invests in Treasuries, agencies, mortgages and high-credit-quality corporate bonds.
- Cavanal Hill Bond Fund generally invests in a portfolio of Treasury, agency, mortgage-backed and high-credit-quality corporate securities with an average maturity of no more than 10 years.
- Cavanal Hill Intermediate Tax Free Fund seeks to maintain an average maturity of seven to 10 years and invests in a broad mix of high-credit-quality municipal securities that provide income exempt from federal income tax.1
1 Income may be subject to state and local taxes. Capital gains are subject to federal income tax.