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Mutual Fund Q&A: 
Relative Global Value
Morgan Stanley Global Fixed Income Opportunities Fund
Management: Michael Kushma

Author: Manish Shah
Last Update: 10:55 AM ET March 30 2012

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Beneath the seemingly stable returns of fixed income securities lies a serious amount of volatility. At Morgan Stanley Investment Management’s Global Fixed Income Group, Michael Kushma and his team maintain a disciplined approach to their valuation and sell process to seek to transform imbalances in valuations into consistent returns.

Q:  Would you provide a brief overview of the Morgan Stanley Global Fixed Income Opportunities Fund?

A : The Morgan Stanley Investment Management Global Fixed Income Group has worldwide focus, and our investment expertise ranges from sovereign bonds and emerging markets, to government agency bonds, asset-backed and convertible securities, and corporate bonds.

Our investment teams in Tokyo, London and New York search and evaluate various investment opportunities, and we invest in diverse products, including interest rate and currency products, credit products, derivatives and commodities-related securities.

As Chief Investment Officer of the Global Fixed Income Group, I oversee all fixed income strategies.

Q:  What investment beliefs drive your philosophy?

A :
We have built the investment philosophy for the Morgan Stanley Global Fixed Income Opportunities Fund around several fundamental points of view.

First, we strongly believe in mean reversion and that undervalued fixed income securities appreciate to their fair value. We consider ourselves value investors, meaning that we seek to maintain a diversified portfolio of bonds trading below their intrinsic value.

Second, we have a disciplined sell process. When bonds become fully valued we undertake a rigorous review of the fundamentals. If fundamentals have not changed, we will likely sell the bond.

As part of this philosophy, asset allocation is just as important as picking the right security and following a disciplined approach to investing. Divergences in returns between sectors can be dramatic. Applying a top-down macro approach to sector selection complements quite nicely our bottom-up process of attempting to find the most attractive bonds within a sector. For example, we have identified certain investment environments that typically benefit corporate debt. We use this analysis to decide our total credit exposure, and then our credit team will work to try to find the best bonds to meet our asset allocation targets.

In addition, we are convinced that generating positive returns over a medium-term horizon in our funds is more important than just beating the benchmarks. The philosophy behind this fund – rather than to think solely in benchmark terms – is to be opportunistic and give higher priority to absolute return investing and bonds that have attractive returns. Our viewpoint drives us to seek out better investments among various bonds while managing downside risk.

Since the onset of the financial crisis in 2008, yields have fallen to very low levels. This has created an investment dilemma for clients who want to earn a certain income from their fixed income portfolio but are getting less now than they were several years ago. We want to help investors sort out this problem.

Q:  What is your investment process?

A :
In many ways it is quite simple: buy undervalued bonds and sell overvalued ones. The challenge is doing the analysis to identify in which camp a bond falls. We have investment teams of specialists who focus on government, emerging market and corporate bonds. Analyzing bonds in their individual areas, the members of the different teams develop domain knowledge that helps them select bonds they believe offer a better risk reward profile.

For example, the mortgage research team analyzes agency and non-agency mortgage securities, asset-backed securities and commercial mortgage-backed securities among many other varieties. They have a deep understanding of historic behaviors of the asset class, and their analysis includes both top-down and bottom-up views to find sectors, asset classes and individual bonds that meet our investment criteria.

Another example is our emerging market team that analyzes specific countries and the global economic and demographic trends driving these economies. The team reviews bonds using a subjective analysis of the individual country and of its prospects on the economic and political front. The team also employs a strong set of proprietary quantitative models that consider inflation, growth and other variables that go into measuring and identifying fair value for government bonds. Their expertise helps the entire group in understanding the relative merits of different regions across the world.

Additionally, we have a team of professionals who focus on macroeconomic developments to guide us in our thinking on whether and how much interest rate risk we should take. What is more, their analysis seeks to identify which part of the yield curve, country or currencies to invest in or which currencies to avoid.

Each individual research team analyzes specific sectors and securities, and our investment process relies on the research ideas generated by this analysis. That said, our investment strategy is highly dependent on buying into multiple sectors of the fixed income universe – from mortgages to corporate credit and interest rates – so our ability to put this all together is critical in determining our final success. To that end, we have a highly structured approach that facilitates continuous interaction between the teams and relies on a collective decision making process. We have a formal asset allocation meeting regularly to discuss cross sector opportunities as well as to decide on aggregate risk targets for the entire portfolio. All investment team leaders participate in this discussion.

Throughout, the fund relies on proprietary models to analyze yield curves and movements in currencies. We also have credit models that provide assistance with fair value spreads.

A very important aspect of our investment process is that we have a strict discipline and we adhere to it.

Q:  Could you give a couple of examples to better illustrate your research process?

A :
One of our specialist teams focuses on corporate credit. Our belief is that there should be one single credit research effort. We think that individual analysts that cover both investment grade and non-investment grade companies are best positioned to understand the dynamics of that particular sector. They need to know the competitive positions of all companies in their sector – investment grade and non-investment grade.

A good example of this is our team’s coverage of financials, where we tend to be overweight in bonds issued by banks. The reason is straightforward. We looked at the valuation of these companies and came to the conclusion that they were further away from fair value than our models suggested, especially relative to risk, and more undervalued than other corporate securities.

Our analysts work hard to understand company dynamics – profitability, levels of risk, management intentions, and prospects for banks going forward in the current competitive universe – before they come up with an assessment if a particular company is going to succeed or fail.

Our overweight focuses on banks that we view are national champions. Every country needs a banking sector, at least any capitalist economy needs a well functioning banking sector to take deposits, make loans and manage the payment system.

We tend to like such banks because they are viewed as indispensable. They are systematically important institutions that we believe are priced at a discount to intrinsic value. We will buy the senior debt of those banks, because they are attractively priced relative to the set of fundamentals, even though banks have been under a lot of stress in the past couple of years due to all the dislocations in the economy and financial markets.
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