This past fall, the Boston Red Sox—perhaps the most embattled team in Major League Baseball in recent times—overcame an exasperating litany of obstacles to finally win their first World Series since 1918. The mavens from Fenway not only resolved such corporeal dilemmas as Curt Schilling’s injured right ankle, but were forced to contend with the supernatural: namely, the curse of the Bambino.
Obstacles—of the tangible variety—have also visited the Boston-based securities firm Putnam Investments, which currently has over $70 billion in fixed-income assets under management. But Kevin Cronin, Putnam’s deputy head and chief investment officer of fixed-income investments, who has a picture of Babe Ruth replete in a Red Sox jersey overlooking his desk, is assured not only of his investment strategies, but that he has the right team in place to overcome those obstacles and to navigate the continually choppy waters of the global marketplace.
The seedlings for Putnam, before it became one of the largest mutual fund companies in the world, sprang in the early nineteenth century when Samuel Putnam, a Massachusetts-born and Harvard-trained lawyer joined the supreme court of Massachusetts, and coined The Prudent Man Rule, which would set the foundation for professional money management. This doctrine, as stated by Judge Putnam in 1830, said, “Those with responsibility to invest money for others should act with prudence, discretion, intelligence, and regard for the safety of capital as well as income.”
In 1937, Samuel Putnam’s great great grandson, George Putnam, created one of the first balanced portfolios of stocks and bonds, the George Putnam Fund of Boston. This was to set the stage for the $209 billion behemoth that is now run by president and chief executive Charles ‘Ed’ Haldeman Jr.
When speaking to the head of the fixed-income group, Kevin Cronin, one is quick to realize that his investment philosophy has its grounding in the firm belief that his management team comprises the most talented individuals in their fields and that they have achieved an unusual level of specialization, sufficient to allow them to outperform in a variety of market conditions and over the long haul.
Cronin’s career at Putnam began in 1997, when he was hired to head up the fixed-income group’s mortgage team. Before his arrival at the firm, he worked as a portfolio manager at both MFS Investment Management and Liberty Mutual Insurance Company.
So how would Cronin describe his team’s strategy, in a nutshell? “The markets are inherently inefficient,” he says. “There are people in the markets who create dislocations and inefficiencies and we want to exploit those. We want to generate excellent long-term results by leveraging our valuation framework, our risk management framework and our portfolio construction framework and we think the way that you do that is to have talented people working together in teams.”
The notion of teamwork is clearly important to Cronin, as he adds, “Talented people working together can cover a broader array of opportunities and bring together a diversity of skill sets that makes them more powerful as a team than working alone.” An important ingredient for success, believes Cronin, is consistency. “We think the key to delivering long-term performance is by consistently outperforming month in month out, quarter in quarter out, year in year out. So we’re not looking for the periods of feast or famine where we wildly outperform and then give it all back.”
From a historical context, Putnam saw a paradigm shift in the marketplace in 1997, a shift that forced management to restructure its team and refocus its goals. At this pivotal moment in the global markets, Wall Street firms were beginning to look upon proprietary trading operations as anathema, which happened in conjunction with a general decrease of liquidity in the marketplace.
The fixed-income group felt that it could gain a competitive advantage in the marketplace by increasing the level of specialization inherent in its core structure. The new structure was based on sector teams, which would consist of specialists close to their respective markets. Cronin emphasizes that the individuals that make up these teams, experts in their own niches, are able to give Putnam’s overall group a discrete advantage when allocating money within, and between, the sectors.
Speaking of the fixed-income group at Putnam, Scott Berry, an analyst at the Chicago-based fund tracker Morningstar, believes its new investment approach is a little more conservative. “They are more aware of the size of their bets and are trying to hit more singles than doubles and home runs,” says Berry. “They’ve paid closer attention to risk and use more research-intensive methods.”
The debt group is made up of five main sector teams. Stephen Peacher, who is the chief investment officer on the core fixed-income high-yield team, joined Putnam in 1990 after working at Dean Witter Reynolds in the late 1980s. Rob Bloemker, formerly at Salomon Brothers and Lehman Brothers, joined Putnam in 1999 and is the team leader of the mortgage-backed securities/asset-backed securities/government group, and is responsible for developing themes and strategies within that sector.
Kevin Murphy also joined Putnam in 1999, formerly working at BancBoston Robertson Stephens and ING Barings. Murphy was originally hired within the newly formed derivatives group, which was set up with the mandate to show all the fixed-income accounts how to use credit derivatives in general and how derivatives could be used in Putnam’s separate portfolios. The idea was to let the group dissolve, and those people who were central to the derivatives team would then move on to become portfolio managers or to function in some other capacity within the funds themselves. Now Murphy is the team leader of high-grade corporate debt and develops strategies for the institutional and mutual fund portfolios within that arena.
Rounding out the sector teams are Jeffrey Kaufman and David Hamlin, who are the team leaders in charge of the emerging markets group and the tax-exempt fixed-income group respectively.
A sixth team within the fixed-income group, the portfolio construction team, was developed in 1998, and was designed to receive the strategy ideas from all the various sector teams and makes decisions on sector allocation and risk management. David Waldman, who is also the director of core quantitative research, heads up the portfolio construction team.
The organization and specialization of the fixed-income team exudes the basic philosophy of the group, and the manner in which they approach their investment strategies. “Since 1997 we’ve been in a period of heightened market volatility,” says Cronin. “We had persistently higher volatility which we think placed a greater premium on being able to quickly identify ideas and then being able to understand the risks associated with them and the correlation of those risks which is why we spent so much time building our risk management platform.”
In fact, when talking about Putnam’s investment strategies, 1997 is inevitably used as a starting point in the discussion of the team’s core philosophies and its views on macro market trends. And the lessons learned from that transitional point in the history of the bond market seem to serve as the guiding principles in managing their funds to meet the needs of an ever-cyclical market environment.
“We think a lot about 1998,” says Rob Bloemker. “If you look at today’s environment, we are most like 1997. Spreads are near all-time tights, volatility is very low, default rates are very low, leverage has entered the market. The question is: are we one year away from 1998, or are we three? It’s going to happen.”
In 1997, Baa spreads averaged 117 basis points over Treasuries, according to data provided by Moody’s Investors Service. Most recently, Baa spreads, while not quite as tight as they were seven years ago, have come in to 135bp over Treasuries. Alternately, during the month of May 2000, Baa spreads reached their widest level during the interim time period of 279bp.
Additionally, the most recent issuer default rate for US speculative-grade debt was only 2.9%, according to Moody’s. In 1997, the average was 2.11%, a far cry from the highest level reached in the interim, which was 11.6% in January of 2002.
The credit cycle peaked in 1997, explains Kamalesh Rao, an economist at Moody’s. “We are at the beginning of an upswing where there is a narrowing of upgrades versus downgrades.” Rao also explains that in 1997, the number of upgrades had eclipsed downgrades for a sustained duration, while now that trend appears to be in its initial stages. “But spreads look really narrow, so it isn’t really clear what the bond market thinks is going on,” adds Rao.
This dilemma illustrates the crux of the job that lies ahead for Putnam and all fixed-income money managers. According to Murphy, market participants are trying to assess whether or not technical factors have pushed spreads into levels that the fundamentals no longer support. He notes that while some people believe that fundamentals could get to the point where they are commensurate with their analogous spreads, at the moment they are not.
Synthetic CDO structuring, foreign entities purchasing dollar-denominated corporate bonds and the demand created by the credit derivatives market—which has attracted hedge funds, private banks and other investors not normally seen in the debt market—have all contributed to a technical environment that is ripe for mishap.
“Once you start looking at the fundamental side, then you start putting together your ‘wall of worry’,” says Murphy. “Oil is going up, which is going to be some sort of a tax on the economy no matter how you look at it, interest rates sure aren’t going down from here, they’re going up so that’s an added cost. We’re looking at below-trend growth for the next few years, so that’s not phenomenal for corporates. We’re looking at a period where we’ve done incredible amounts of margin expansion through cost cutting, the companies that we’ve got now are very efficient at turning a dollar of revenue into the bottom line but that’s starting to reach its end. This is the ‘wall of worry’.”
“Things that in a normal market would be causing all markets to be pausing—and you are seeing that in the equity side—you don’t see that in credit. Credit continues to march in and it’s because of these technicals,” adds Murphy.
Money managers are now in a position where they have to anticipate when the peak will arrive in the current credit cycle. While fundamentals are continuing to improve overall, few believe that spreads can grind tighter for too much longer. This drives the way in which Peacher approaches the management of the high-yield segment of Putnam’s funds. He stresses diversification, saying that his basic tenet is that he refuses to allow one bond to kill them and, conversely, that no one bond is going to make them. They intend to accomplish this end by merging a top-down view of their portfolios—in which they have a defined portfolio strategy and the proper tools to measure if the actual portfolio is commensurate with that strategy—with an analytical approach where they study each of the building blocks that go into the portfolios.
In response to the many factors that could send shockwaves through the debt markets, Putnam has taken risk off of its books, waiting for the next big surprise. “We think on the investment-grade side, it’s priced to perfection, reflecting continued strong economic growth,” says Cronin. “We’re concerned that if you get a credit event or if the economy is slower than predicted that some of this leverage will begin to unwind and we still haven’t solved the structural liquidity issue that pervades the marketplace. So we think that we’re likely to see a yield like 2002 where spreads widened fairly dramatically. We’re underweight our exposure to credit generally but particularly investment-grade corporates, waiting for that dislocation so that we can come back in.”
On October 14, Eliot Spitzer filed a lawsuit against Putnam’s parent company, Marsh & McLennan, the largest insurance brokerage in the world. The suit alleges that the firm steered clients to insurers with whom it had lucrative payoff agreements and that it had also solicited rigged bids for insurance contracts. Spitzer’s lawsuit also implicated insurance companies American International Group (AIG), Ace, The Hartford, and Munich American Risk Partners.
Putnam is emphatic, however, that it has avoided any backlash from the woes of Marsh & McLennan. This past November, Haldeman told Reuters, “So far, we have been relatively insulated,” and outlined several large mandates that the company has earned since Spitzer filed the suit. Morningstar’s Berry concurs, saying that Marsh & McLennan’s problems “won’t have a huge impact on the bond group. Obviously those are distractions, but the bond funds have shown continued results despite these distractions.”
The suit focuses on two distinct practices allegedly undertaken by Marsh & McLennan: bid rigging and the payment of so-called contingent commissions, which are special payments from insurance companies for underwriting business that are above and beyond normal sales commissions.
Although contingent commissions are legal and widely used by the insurance industry, Spitzer argues that Marsh’s failure to disclose the true nature of the payments has taken advantage of customers by distorting and raising the price of insurance for policyholders. Spitzer is leveling a punitive suit against the company and is seeking profit disgorgements from contingent commissions dating back to the late 1990s.
Cronin is keen to emphasize the insularity of Putnam and his fixed-income department from the investigation. “This hasn’t had any impact on the fixed-income business here to date,” he says, “and I wouldn’t expect it to have any impact on the fixed-income business. There’s a loose confederation of professional services firms but the overlap between our business and Marsh’s business and Mercer’s [Marsh’s pensions consulting arm] business is not that great.”
Even though the fixed-income group will not directly suffer from the attorney general’s lawsuit, the investment firm as a whole has not dodged the bullet quite yet. According to Marsh & McLennan’s third-quarter results, Putnam’s average assets under management fell 23% to $209 billion.
Separately, Marsh & McLennan’s earnings report also states that the mutual fund company, in principle, came to a $40 million settlement agreement with the Securities and Exchange Commission (SEC) concerning its disclosure of brokerage allocation practices prior to 2004, the amount of which will be distributed to Putnam’s mutual funds. But Putnam has shown a tenacious adeptness at weathering such storms in the past. Last fall, Putnam was the first mutual fund company to settle with federal regulators over the market timing scandal that swept the industry. Putnam agreed with the SEC to pay $110 million, a relatively small sum that the SEC said was commensurate with the benefit the company received and the damage done to investors.
Overall, the effects of the market timing scandal on the firm were dramatic. Within a week, around $10 billion had been pulled out of Putnam and by the time the fourth quarter had ended, that number was nearly $54 billion. But again, the fixed-income department seemed to emerge relatively unscathed, but still suffered the loss of one portfolio manager who illegally traded in his deferred compensation account, says Cronin.
“On the fixed-income side, where performance was generally quite strong, people continued to stay with it,” says Cronin. “We didn’t lose any institutional fixed-income only clients. We actually received a number of mandates on the institutional side in the December to February period where people won new mandates and people who had existing mandates either added to them in terms of adding assets to the mandates that they had or gave us new mandates in new areas within fixed income.”
Despite these concerns, which in the end are at most tangential to the primary focus of Putnam’s debt operation, this group has a clear vision of its strategy going into 2005, and despite the colossal amount of money the managers wield in their portfolios, they seem to have kept things in perspective.
“Bonds are not exciting,” admits Bloemker. “We’re here to make 50 to 100bp a year. When you get on the money management side, reputations are made over five to 10 years,” adding with a touch of irony, “You don’t want to be in magazines.”