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The Interview - Andy Seaman, Stratton Street Capital: "It is too early for high yield"

Andy Seaman, a partner and fixed-income portfolio manager at Stratton Street Capital, says the Asia-focused funds he manages with Mark Johns are continuing to hold high-grade sovereign and large corporates in the region, but with proprietary research showing that out it is not until six months after a recession ends that high-yield outperforms government debt.

HW: What is the background to your company?

AS: Stratton Street Capital was founded in August 2000 as a London-based alternative investment advisor specialising in Asian funds. These can be divided into three distinct but complementary styles with separate fund manager teams.

I work with Mark Johns, also a partner and fixed-income portfolio manager, on the fixed-income funds, which consist of the Stratton Street PCC Asian Bond & Currency Fund, launched in December 2004, and with the Stratton Street PCC Renminbi Bond Fund, launched in December 2007. Mark and I also advise the New Capital Total Return Bond Fund managed by EFG Private Bank in London.

We launched the Asian Bond Fund in 2004 as we had noticed there were many credit-related opportunities in Asia, but that the region as a whole slipped through the net with more index-orientated investors and managers. We specialise in investing in sovereign, investment-grade and high-yield debt throughout the region.

Our definition of Asia also includes Turkey, Russia and everything east including Australia and New Zealand. We have now managed money together for over 10 years and have a very strong understanding.

HW: Who are your service providers?

AS: Both funds are set up under our Protected Cell Company structure based in Guernsey. Stratton Street Capital currently has five funds in the structure administered by Northern Trust in Guernsey, legally prepared by Carey Olsen and with KPMG as auditors.

HW: What is the profile of your client base?

AS: We market our funds to institutional investors looking to broaden their exposure into Asia, including a number of wealth managers and funds of funds.

HW: How do you describe your investment process?

AS: We believe that performance is driven by a combination of global macroeconomic factors and country- and company-specific risks. Unlike bottom-up credit managers our process starts at the macro level, and this was critical for us in 2008. Eliminating mistakes and avoiding defaults is one of the main keys to out performance.

Credit spreads must reward you for the risks being taken - something that was clearly (to us) not happening over the past few years. Diversification can reduce the effect of event risk but ultimately may become counterproductive as the overall return of the portfolio can decline.

Our relative value model identifies credits that are either cheap or expensive, both from a regional and global perspective. Our credit-scoring models will then indicate whether the potential candidate is strong or weak from a credit perspective, and we will also cross-reference with our macro view as a reality check.

The overall portfolio duration and beta is adjusted through adding a hedging layer to give us the market exposure we want. We never link our currency decision to our bond position and so we reflect our currency views separately, having first established the bond portfolio. Currently we are short deficit countries against creditor ones.

HW: How do you generate ideas for your fund?

AS: We extensively use models that have now been in place for some 10 years to aid but not dictate our process. These act to establish our current views. For instance, from recent analysis that we have carried out it is not until six months after a recession ends that high-yield outperforms (in general) government debt. Therefore at this stage of the current cycle we are continuing to hold high-grade sovereigns, semi government agencies or large corporates in the region. It is too early for high yield.

HW: What is your approach to managing risk?

AS: We manage an active portfolio that is reviewed daily. Depending on the type of credit we have specific limits and guidelines to follow depending on factors such as the credit rating and quality of the issuer.

We also track and manage risk through a value-at-risk replication model that allows us to call changes in sentiment in the market to allow us to adjust the overall beta component of the fund. In the portfolio we apply a volatility limit of not more than 150 per cent of the volatility of the 10-year US Treasury over an economic cycle.

HW: Has your performance been as per budget and expectations?

AS: Our anticipated annual return has been 10 to 12 per cent since launch of the fund, and as of the end of December we have been achieving 11.56 per cent. We do not expect performance or style to change, but our position in the market will look very different when we begin to see the end of the world recession. Unfortunately for high-yield investors that looks like it will be a long time, and the risk of overall defaults in the region are growing.

HW: What opportunities are you looking at right now?

AS: Emerging market spreads are very tight when compared to high-grade spreads and are currently trading at all-time low levels at present. We believe that some specific high-grade bonds (which yield more than 20 per cent) offer tremendous value and are long high-grade sovereigns and corporates with offsetting shorts in low-grade sovereigns to hedge out the market risk.

This we believe this will pay off well over the year, especially as sovereign issuers return to the market to raise further hard currency debt in markets saturated with credit. Spreads will have to move wider to reflect the supply and demand imbalance.

HW: What events do you expect to see in your sector in the year ahead?

AS: We see increasing defaults globally and in the Asian region, primarily in the sub-investment grade sector. Investment grade bonds should benefit from Fed purchases of high-grade paper, especially purchases of longer-dated US Treasuries.

Despite a clear signal from the Bernanke Fed that they are considering buying US Treasuries, investors are still positioned in the wrong assets. High grade, not high yield is the place to be at present. On the currency front, we see continuing yen and renminbi strength against the US dollar, which will look weak over all against the surplus nations.

HW: How will these developments impact your own portfolio?

AS: We are alert to the trends in the macro picture from outside the region that are likely to drive the markets. For the time being the world economy is clearly slowing rapidly, and this is bad news for weak credits.

HW: What differentiates you from other managers in your sector?

AS: We believe our macro background makes us very different from most other credit managers. This provides us with a unique view on credit in the Asian region, which has certainly offered uncorrelated returns to our investors. We do not use credit default swaps as we felt investors were not being rewarded for owning them.

HW: Do you have any plans for other product launches in the near future?

AS: Not at present, as we believe the Asian Bond Fund has the optimal strategy - long investment grade hedged with emerging market sovereigns.

The introduction of the Renminbi Fund in December 2007 has given us our first absolute return bond fund in the region. We are pleased that after fees on the fund for the year we have more than reflected the return of the currency and bond indices, particularly when most other managers generated negative returns.

We feel it is still much too early for high yield, as we need to let the recession work its way through the system.

We are always looking for good opportunities to launch new funds, and the environment is excellent for macro-biased credit managers like us. So don't be too surprised if we have a new fund up and running soon.

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