Below, we reprint the lead article from the December issue of our Bond Fund Intelligence newsletter. Entitled, "USAA Short-Term Bond's Bass Has Focus on Yields," it says: This month, Bond Fund Intelligence interviews Julianne Bass, Assistant V.P. & Portfolio Manager at USAA Investment Management, who co-manages USAA Short-Term Bond Fund, and several other bond funds for the San Antonio-based, military alumnus-affiliated manager. We discuss their funds and their focus on attractive yields. Our Q&A follows.

BFI: How long has USAA been involved in running short-term bond funds? How long have you been involved? Bass: USAA Short-Term Bond Fund has been an existence since 1993.... The Ultra-Short Bond Fund has a shorter history, about six years. We also have USAA Income Fund that's been around since the 1970's, and an Intermediate Term Bond Fund.... I've been at USAA for 17 years. I started as an analyst, and for the past 10 years I've been the co-manager on the Short-Term Bond Fund, Intermediate-Term Bond Fund, and the High Income Fund. I've also been the co-manager on the Income Fund for the past four years.... Brian Smith is my co-manager on the Short-Term Bond Fund.

BFI: Tell us about the Short-Term Bond Fund and other bond fund offerings. Bass: They all focus on spread product, and, with all of our funds, we're looking for an attractive yield for an acceptable level of risk. So we focus on yields, and over time that's what has worked for us. The Short-Term Bond Fund has to have a weighted average maturity of three years or under.... So it's much shorter duration. All three of the investment grade funds have corporate, asset-backed securities, commercial mortgage-backed securities, and various loans and some high yield. They're typically underweight Treasurys and mortgage-backed securities, with a focus on heavy spread pickup.

The Intermediate-Term Bond Fund has to have an average life of between three and 10 years. The Income Fund can have any duration, but it's typically a longer fund than the Intermediate Fund. The duration is around 5.3 years for the Intermediate Term Bond Fund. Typically, the duration positioning is shortest in the Short-Term Bond Fund.

BFI: What's the biggest challenge for these funds today? Bass: The biggest challenge for Short-Term Bond Fund is that is has a short duration, currently 1.8 years. Short-term bond funds constantly have a lot of maturities coming through, so you're constantly reinvesting. The challenge always is just finding attractive things to invest in.... But the duration is short, so that's the fund that will have the least impact as rates go up. Since [the portfolio] is very quickly running off all the time, it will be a good opportunity to invest at higher rates.

BFI: What kinds of investment strategies can and can't you use? Bass: In the Short-Term Bond and Intermediate-Term Bond, we can buy basically anything that's in the fixed income sector. But we have limits on how much high yield we can hold in the investment grade funds, so we can hold that up to ten percent. In the Short-Term and Intermediate-Term, we cannot buy common equity. But we can buy common equity in the Income Fund, but it will never be a meaningful part of the portfolio. We also don't do very much with derivatives, and we don't buy CDS.

BFI: Are there any diversity or concentration limits on these funds? Do financials play a big role? Bass: We have limits. We can only have up to 25 percent in one industry, [and normally] we don't go anywhere near that. Then there are also some limits on individual obligors -- the general rule is five percent. But these are diversified portfolios, and typically every issuer excluding the U.S. government is under one percent. So one percent is a large issuer for these funds.

Financials are a pretty big part of investment grade issuance. So we're involved in that. Other types of securities we buy are other corporate bonds, asset-backed securities and commercial mortgage-backed securities. We have bought MBS in the past and we probably will again when that market is free of the government, and then we buy Treasurys.... On the number of issuers, we have 381 [as of October 2016] ... it's much more [in] individual securities, usually around 500. We have 20 credit analysts.... We actually buy municipal bonds as well, taxable munis. So we have a group of municipal analysts, that specializes by state and then we have our corporate analysts that specialize by industry.

BFI: Have you taken advantage of any of the LIBOR or SIFMA spikes in the money market space? Bass: The Short-Term Bond Fund did a little bit in variable rate demand notes, but that trade has moved away and it's not something that's been actively pursued right now. A little bit of that's been done.

BFI: Does USAA manage separate accounts, ETFs or other pools? Bass: USAA does have custom managed portfolios. Our analysts also work on our internal money -- our life portfolio, and our property and casualty portfolio.... Our life portfolio is very similar to an intermediate-term bond fund and our P&C portfolio is more conservative. It's typically much shorter.... Overall, USAA has been a conservative firm and it has a very high credit rating (Aa1/AA). We have $16 billion in the taxable fixed income funds, total mutual fund assets are $70 billion, and total assets under management including the insurance affiliates are $150 billion.

BFI: Tell us about your distribution, investors and flows. Bass: We do have a new, third party distribution effort. I've seen the numbers of that amount of money and it's manageable, it's not a very large percentage of the fund. We cater to the military, and we have sticky retail investors in our funds. So we don't see drastic inflows and outflows [like] some other fund companies.... On occasion, there might be an internal rebalancing because our private wealth management area uses some of our funds and they might rebalance one of their models. That would be the largest kind of swing we've seen. We know about [these though] and they've actually allowed us to match our cash flows to their movement.

BFI: What is your outlook for the Fed and for the coming year? Bass: We don't predict interest rates here. All of our funds are duration neutral to their peer groups. What we focus on is finding attractive yields bond-by-bond. So our analysts look at every single bond we have in our portfolio, and we're looking for attractive yield pickup for risk. I'll just use the example of our Income Fund. Over the past 10 years its average annual return has been 4.9 percent, and 4.4 percent of that was from the yield and 0.5 percent was from the NAV movement. So we really focus on finding attractive yield pickups and holding to maturity. It's very low turnover.

BFI: Any thoughts on the recent spike in bond yields? Have you seen flows impacted by this? Bass: Personally, no, and it's not something that we're being asked about very much yet. Since we're involved mainly in spread product, our rates have gone up but spreads have stayed steady or tightened a little bit. So we haven't really seen that much of a difference in all-in yields.

BFI: How fast does the portfolio adjust to new higher yield levels? Bass: About 15 percent of the fund is cash and floaters and that will quickly adjust to higher rates. The duration is 1.8 years, so prices in the underlying bonds won't change as much as funds with longer durations which are more sensitive to interest rate changes. So the yield will adjust more slowly than for the longer duration funds. As the fund reinvests it will be at higher rates.

BFI: Any thoughts on the future of short-term bond funds? Bass: I don't really see any change for short term bond funds going forward. They're in a place to get a yield pickup over money markets or ultra-short funds, and you can write checks on them. The net asset value does fluctuate some, but I think they'll still have an attractive place.

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