# Baillie Gifford Proposal

### Scope of Document
This document presents the proposed investment strategies made by Baillie Gifford ("BG") to Maker under Clydesdale.

## Baillie Gifford Mandate Options
BG propose engaging in a investment mandate with Maker, that can be broad or narrow - and varied according to circumstances and strategy.

The proposed mandate elements are:

* A short-term investment grade alpha-generating clean money aligned **Corporate Bond Mandate** with potentially a sub-investment grade element to add further.

* A **Government Bond Mandate** focused on US short-term treasuries following an index with a potential 30% allocation towards global government bonds for some alpha generation.

## 1. The Corporate Bonds Mandate
In BG credit team’s own words:

>“...Our strength in credit investing lies in the ability to identify the relatively small number of corporate bonds that will outperform the market over a long-term investment horizon. We believe that, over the long term, an issuer’s fundamental resilience will be reflected in the performance of its bonds and will prevail over shorter-term or sentiment-driven market fluctuations. Our in-depth analysis focuses on building a comprehensive understanding of a company’s long-term prospects and genuine diversity, based on deep knowledge of individual companies, allows for thoughtful risk taking. We have various strategies with long-term track records which demonstrate this ability to add value through individual bond selection.” <br>
“...We believe our strengths align very well with the aims of MakerDAO and include, as a core of our proposal, and actively managed long-term credit strategy. This relatively short-dated and high-quality portfolio would deliver attractive levels of yield to compensate for some mark-to-market volatility.”<br>
“...An actively managed portfolio representing our best ideas across global corporate bond markets. A relatively short-dated investment grade portfolio provides a balance of liquidity and low-probability of loss while still offering potential to add value through active credit selection. The current yield of this universe is around 3.5% with a spread above US treasuries of around 1%.”

BG proposes the following two strategy options based upon the long-term active bond selection principles above. The difference lies in the credit universe accessed and results in two different index overperformance targets.

* **Option IG** is focused purely on investment grade bonds (including unrated bonds with an investment grade equivalent internal rating) and has a target of +0.5% over index performance target.

* **Option IG+** adds a 20% budget for sub-investment grade bonds that are rated minimum BB- or equivalent and has a target of +1% over index performance target.

The BG credit team’s research, and practical investment experience, has shown that the ‘cross-over’ space between investment grade and high yield (BBB to BB-) is where it observes most inefficiencies, creating substantive alpha generating opportunities for active bond selectors. The BG team’s philosophy is to focus on lending to resilient issuers and therefore it tends to select higher quality high yield bonds, often where in-house fundamental research has identified companies which are likely to improve credit quality over time.

BG also observes that the divide between investment grade and high yield can be arbitrary, as, for example, a 1-year BB rated bond would carry lower default risk than a 5-year BBB rated bond.

In short, the 20% budget in option B provides a level of flexibility that enables a meaningfully higher level of performance to be targeted, without lifting risk in any material way.

### 1a. Corporate Bond Mandate Parameter Proposal

|Parameter|Value|
| --- | --- |
|Benchmark|ICE BoFa 1-5yr US Corp Index|
|Target|**Option IG**: +0.5%, gross of fees, over rolling 3 year period <br> **Option IG+**: +1%, gross of fees, over rolling 3yr period|
|Universe|Global, fully-hedged to USD|
|Credit Quality|**Option IG**:Wholly investment grade rated bonds (including unrated bonds with an equivalent internal rating) <br> **Option IG+**: Average portfolio rating investment grade. Universe predominantly investment grade (including unrated bonds with an equivalent internal rating), with 20% budget for sub-investment grade bonds (minimum rating BB- or equivalent)|
|Maturity Profile|Predominantly short-dated, c.20% budget for > 5 years|
|Duration flexibility|Benchmark -/+ 1 years|
|Guideline Holdings|< 100 issuers|
|Derivatives|Credit Default Swaps, interest rate swaps, futures|
|Accumulating or Income|Accumulating|
|Fee|**Option IG**: TBC, but slightly less than Option IG+ <br> **Option IG+**: Base fee 0.35% with sliding fee scale dependent on mandate size. Further details available once allocation size determined|
|Investment Mode|Segregated Account/Custodian|

### 1b. Individual Manager for Corporate Bond Mandate

BG operates with a team-based structure and the whole credit team carries out investment analysis that will contribute to the portfolio.

However for this Corporate Bond Mandate, Paul Dilworth, would be lead portfolio manager (bio below) with another experienced investment manager to assist in decision-making (to be confirmed in due course).

**Paul Dilworth - Investment Manager**
>“...Paul is an investment manager in the Credit Team and manages our investment grade bond funds. Before joining Baillie Gifford in 2019, he worked for almost 13 years at Kames Capital where he was responsible for managing a broad range of fixed income mandates, including Global Financial Credit, Global Absolute Return and Investment Grade Credit. Paul graduated BSc (Hons) in Mathematics from Heriot-Watt University in 2006 and is a CFA Charterholder.”

### 1c. Corporate Bond Manager Historical Performance

These fund options are customised for Maker to create a balance between being on the side of security, whilst making room for alpha from bond selection and market distortions in the public market investment grade ratings. As such there is no direct comparable fund today delivered by BG to the public.

However, two BG public funds appear relevant:

1. “Baillie Gifford Investment Grade Bond Fund” (“BGIG”) seems the most relevant fund available for analysis of Option IG. This has a sterling investment grade benchmark with relatively little flexibility to invest in HY. It does have the challenge of being UK focused.

2. “Baillie Gifford Worldwide Global Strategic Bond Fund” (“BGWW”)seems the most relevant fund available for analysis of Option IG+. It has an allocation towards high-yield bonds without a BB- constraint, which the Maker Option IG+ Bond Strategy does not. Because of this, the fund also has a more aggressive mixed benchmark of 70% ICE Bofa Global Corp + 30% ICE Bofa Global HY.

#### Direct Performance

We see appropriate overperformance of the two relevant funds over the past 10 years in-line with their proposed alpha targets.

|BG Fund | Return | Benchmark| Alpha|
|:---|:---:|:---:|:---:|
|Strategic Bond Fund| 5.7 |3.9| 1.8|
|Investment Grade Bond Fund |4.9 |4.4 |0.5|
|High Yield Bond Fund |5.8 |4.4 |1.4|
|World Wide Global Strategic Bond Fund| 5.5| 3.8| 1.7|

#### Comparable Performance

BGWW is best compared to the Morningstar Global Flexible Bond Sector of funds. Within this, BGWW has been in the top percentile since its inception in 2012. BGIG has a more mid-tier rating.

Overall, as Manager, BG appears a high-quality choice. BG does appear to, relatively speaking, perform better when allowed broader freedoms as under Option B and can use their skills in identifying and exploiting inefficiencies from doing fundamental company research.

#### Projected performance

Over a 10-year period the best practical indicator of return for an investment grade portfolio is generally considered to be the current market yield. Therefore, if the performance targets above are achieved, the net return should be in the region of **3.75% - 4.25%** per annum.

BG believes this is a reasonable expectation of return in the medium term given the current starting point – inflation has quite likely peaked and much central bank reaction is already priced in.

Further, this relatively short-dated portfolio will be frequently re-invested at prevailing yields.

#### Liquidation Analysis

BG has run the model portfolio for Option IG+ (as Option IG would just be a slightly better version in respect of liquidity) through their liquidity systems and engaged with dealers to give a liquidity view based upon current conditions. It would rate as a highly liquid portfolio.

The primary liquidity monitoring tool is the ICE Vantage system, and BG typically test their credit portfolios assuming 40% market capture with a price tolerance of no more than 1% above current mid-bid spreads. The results thereof - including the impact of tightening the price tolerance to 0.25% - in current market condition are as follows with a USD 500M portfolio size:

|Price Impact|Portfolio % Liquidated within x days|
| :---: | :---: |
|1%|97% within 1 day|
|0.25%|67% within 1 day <br> 83% within 3 days|

The mid-bid spread on BG’s general credit portfolios is currently in the region of 0.25-0.40%.

At lower volume (<500M), such as the recommended allocation level of 100M, the portfolio becomes even more liquid.

Should it be requested, BG can incorporate further liquidity requirements into the mandate such as limiting the individual size of issue in which BG invests.

#### Market-Value Variation Analysis


The chart above shows rolling volatility (averaged over 1, 3 and 5 year periods) of the ICE BofA 1-5 Years US Corporate Index. The long-term average annualised volatility of this index is 2.9%.

### 1d. Clean Money Credentials for Corporate Bonds
Asset managers today score all bonds on ESG - and you can essentially, as investor, decide a scoring threshold for what bonds you are willing to invest in. Equally, we think, we all know that there are material issues with scoring standardisation and the quality/meaningfulness of the scoring. One might go as far as to say that certain asset managers are essentially check-boxing their way through a green-washing of their portfolio. This type of behaviour, of course, Maker has zero interest in supporting whatsoever.

BG have taken a different approach - an approach we think might have some merit. We will summarise it here via quotes and explain why it might work for Maker, but I will encourage reading this thoughtful piece from BG on their approach: [Actual ESG](https://www.bailliegifford.com/en/uk/about-us/actual-investors/ic-document/2021-q1-actual-investing-actual-esg-all-ar-0155/).

BG is an active, long-term investor, using fundamental company analysis to drive its bond selection. That starting point means sustainability/Clean Money becomes an integral part of company and bond analysis:

>“**Sustainability in our philosophy and process**
A detailed understanding of the factors driving the fortunes of the companies in which we invest is crucial to our success. We choose to focus on resilience as the key to companies’ likely success or failure over the long term. Resilience ensures that companies can adapt as technologies and societies change and as economies wax and wane. Sustainability is one of the three key factors we use to assess resilience alongside company prospects and capital structure. Our goal is to establish if the company is compatible with a sustainable economy.
>
>In our view, the transition to a sustainable economy, one which achieves a balance between economic, environmental and social needs, has begun. We believe this is a material shift that will affect all companies, creating long-term investment opportunities as well as risks. In our view, capital will be reallocated towards businesses that appropriately manage their impacts on society and the environment. Furthermore, we believe that corporate bond prices do not fully reflect sustainability-related risks.
>
>Sustainability analysis is, therefore, a core element of our company research framework because we believe this factor is fundamental to long-term returns. By assessing whether each investment is compatible with a sustainable economy, we believe we are building more resilient corporate bond portfolios for our clients. Given the importance of this factor, we explicitly exclude companies that our analysts deem to be unsustainable.”

In practice, the BG ESG team have built a quantitative resilience score and perform a qualitative assessment slotting the potential company/issuer into the following sustainability archetypes:

>“**Enabler** – the company is enabling the transition to a sustainable economy and has a low-risk sustainability profile. An enabler may offer an investment opportunity as capital is allocated to companies that provide solutions to sustainability issues.
>
>**Leader** – the company is actively neutralising sustainability shortfalls and/or developing positive sustainability features. The company is compatible with a sustainable economy and has a low-risk sustainability profile. A leader may offer an investment opportunity as capital is allocated to companies with positive sustainability characteristics.
>
>**Neutral** – The company is compatible with a sustainable economy and has a low-risk sustainability profile.
>
>**Adapting** - the company has a weak sustainability profile but has outlined clear commitments to improve. The company is therefore compatible with a sustainable economy but is medium to high risk. The company will be set specific sustainability-related investment milestones and will be monitored closely. Failure to achieve milestones may lead to divestment.
>
>**Unsustainable** – the company has a negative sustainability profile with no commitments to improve. The company is not compatible with a sustainable economy and is uninvestable. “

As the bonds considered by BG are generally traditional rather than sustainability linked, the primary means of ESG advancement within the company/issuer is through company engagement:

>“**Company engagement**
Engaging with and monitoring our companies on an ongoing basis is a fundamental part of our investment process and how we discharge our stewardship duties. We expect our dialogue with issuers to be supportive or challenging, but always constructive and approached from a long-term perspective. We maintain an audit trail of our dialogue with issuers by recording engagements in our in-house systems. This enables us to monitor and report on the effectiveness of our engagements and set future priorities. As part of our monitoring process, we may set ESG investment milestones allowing us to track the progress of the engagement objective over a defined timeframe.”

So here comes our thought process on a potential fit on this approach with Maker Clean Money:

1. Just like we have set thresholds for rating we can agree on thresholds with BG on resilience score and sustainability archetype. (for instance focus on Leaders and Enablers plus a certain higher sustainability score). This way we can reasonably ensure that Maker indeed only provides capital to companies who are expected to be part of a Green/Sustainable/Clean Money future.

2. It would allow Maker one mode of access to the vast traditional corporate bond universe, without compromising the Clean Money vision that seems anchored well in proper, prospective company analysis rather than “box checking”. We think this access has substantial investment and “advancing corporate change” merit in the short to medium term, as the sustainable/green bond market grows and matures.

## 2. The Government Bond Mandate
Contingent on a Corporate Bond Mandate, BG also offers to provide an index following strategy for US Treasuries on competitive cost terms to an ETF alternative and the option to add-on a component for a potential allocation towards global government bonds from developed economies for added yield generation and diversification.

* Option **UST** : Passive mandate following reference US Treasury indices
* Option **UST+** : Same as Option UST, but adds the ability to allocate up to 30% into global government bonds within AA rated economies

#### Benefits of allocating US Treasury to mandate vs ETF for same
* Potentially more cost efficient portfolio management as bonds held in a single mandate, can minimise transactions costs (ETF's must sell and buy bonds as they cross over 1-year threshold between 0-1y and 1-3y ETF funds)
* Easy to change parameters within existing mandate, e.g. if Maker wishes to invest in longer-duration bonds in future or such (would in ETF world mean allocating between ETF's and incurring exit/entry costs)
* Potential to shorten settlement cycle, standard settlement is T+1 but typically able to settle T+0 dependent on market conditions (and subject to intra-day cut-off)

#### Benefits of adding global government bond allocation
* It provides potential for enhancing yield by allocating to higher yielding positions.
* Essentially this involves monitoring interest-rate differentials and yield curves across global markets and benefiting from hedging back into USD. These returns can be ‘locked-in’ for a period of time by using currency forwards, but are not necessarily consistent across countries so positions will vary over time. This does not involve taking on additional sovereign credit risk (as countries considered would be similarly rated to US) or adding duration.
* As a low risk strategy a modest outperformance target is achievable, e.g. c.25bps
* A higher return could be sought by giving further flexibility to include positions based on BG’s fundamental research process, i.e. actively allocating across global markets with greater duration flexibility. But we leave this option for the future.

### 2a. Government Bond Mandate Parameter Proposal

US Treasury Mandate Parameter Proposal
|Parameter|Value|
|---|---|
|Benchmark| 50% ICE BoFa 0-1 year US Treasury Index, 50% ICE BofA 1-3 year US Treasury Index|
|Target| **Option UST**: Passive mandate in line with index <br> **Option UST+**: +0.25% p.a., gross of fees, over rolling 3yr period|
|Universe| Global government bonds issued by nations with G10 currencies and minimum AA rating, fully-hedged to USD|
|Allocation| **Option UST**: Wholly invested in short-dated US Treasuries in line with reference benchmark index <br> **Option UST+**: Up to 30% invested in high quality global government bonds to enhance yield|
|Maturity Profile| **Option UST**: sub 3-year bonds in line with index <br> **Option UST+**: maximum average duration of 3 years, maximum individual maturity 5 years|
|Derivatives| Currency forwards|
|Accumulating or Income| Accumulating|
|Fee| TBC (~0.1%)|
|Investment Mode|Segregated Account/Custodian|

### 2b. Individual Investment Managers

This mandate would be managed by BG’s Global Rates & Currencies team with lead portfolio managers Phil Annen and Stuart Kelly, bios as follows:

**Phil Annen - Investment Manager**
>"...Phil is an Investment Manager in the Global Rates & Currencies Team and has been managing global bond funds and currency overlays since 2003. He joined Baillie Gifford in 1999 and worked in the Risk Department before becoming a Fixed Income Investment Manager in 2002. Phil graduated MSc in Physics from the University of Bern in 1997 and MSc in Financial Maths from the University of Edinburgh in 1998..."

**Stuart Kelly - Investment Manager**
>"...Stuart joined Baillie Gifford in 2012 and is an Investment Manager in the Rates and Currencies Team. Prior to joining Baillie Gifford, he worked as an Emerging Markets Bond and Currency Trader for ING Barings and Bank of America, before working for the Bank of England as an Economist. Stuart graduated MA in Economics and Accounting from the University of Edinburgh in 1995..."

#### Historical performance
This is purely a follow index strategy, so no particular relevant manager performance to assess. We can, however, clearly identify that following a mixed index of 0-3y US Treasuries is possible withou

#### Liquidation Analysis
As these are US Treasuries (and potentially G10 economy government bonds), these instruments are as liquid as it is market possible.

#### Market-Value Variation Analysis
Will follow the same market-value variation as described under Blackrock/Sygnum proposal, as it is the same underlying US treasury mix.

## 3. Reporting
BG provides a quarterly investment analysis report (sample from BGWW [here](https://drive.google.com/file/d/1a9cC3ixfquTLF8OZDjmqLO2l4S_lpIah/view?usp=sharing) and detailed monthly accounting reports for the mandate. Should Maker require it, additional reporting can be provided.

## 4. Legal
The trust structure will have to undergo KYC/AML checks from BG (has not yet been completed). Given this in place, the investment mandate is simply controlled through an Investment Mandate Agreement between BG and the trust structure.

## 5. AMA of Portfolio Manager

[AMA Recording](https://forum.makerdao.com/t/mip65-bond-allocation-review-vote-baillie-gifford/14865/21?u=allan_pedersen)

## 6. Portfolio Projections
The BG team have modeled the options above - resulting in the following numbers. Important to note that these numbers are without any alpha added - i.e. realistically some bps should be added to all B options (and sharpe be slightly better)

**Stand-alone**
|Gov Bond|Corp Bond|Risk|Return|Sharpe|
|:---:|:---:|:---:|:---:|:---:|
|UST|-|0.87%|2.03%|138%|
|UST+|-|1.12%|2.32%|133%|
|-|IG|3.16%|3.52%|85%|
|-|IG+|3.80%|3.77%|77%|

**10% to Corp Bonds**
|Gov Bond|Corp Bond|Risk|Return|Sharpe|
|:---:|:---:|:---:|:---:|:---:|
|UST|IG|0.91%|2.18%|148%|
|UST|IG+|0.90%|2.20%|153%|
|UST+|IG|1.15%|2.44%|140%|
|UST+|IG+|1.14%|2.47%|144%|

**20% to Corp Bonds**
|Gov Bond|Corp Bond|Risk|Return|Sharpe|
|:---:|:---:|:---:|:---:|:---:|
|UST|IG|1.05%|2.33%|143%|
|UST|IG+|1.14%|2.38%|136%|
|UST+|IG|1.09%|2.44%|148%|
|UST+|IG+|1.18%|2.49%|141%|