Baird Advisors Chief Investment Officer Stanek Offers Bond Outlook

The “super sale” on high quality bonds is over; need to be selective going forward.

In a recent speech to institutional investors, Baird Advisors Chief Investment Officer Mary Ellen Stanek offered her outlook on the bond markets. Baird Advisors is the fixed income asset management unit of Baird, an employee-owned global capital markets, private equity, wealth and asset management firm. Stanek spoke at Baird Advisor’s 10th Annual Institutional Investment Conference.

Mary Ellen Stanek, CFA
Managing Director
Chief Investment Officer

Looking back over the past 12 months, we’ve seen unprecedented stresses in the financial system and the economy. Last September, we entered the completely uncharted waters of a full blown financial panic not seen in our lifetime. The roots of this panic can be found in the complete breakdown of the credit markets after a long period of unsustainable debt growth that created a “bubble” that burst. The “shadow banking system” of securitizing consumer and business loans and selling them as bonds was a primary driver of the unsustainable increase in private sector debt over the last decade. And much of the securitization was in residential home loans that clearly contributed to the unsustainable rise in housing prices in the first half of this decade.

Once we entered the crisis, deleveraging resulted in widespread and severe price declines – even on high quality assets. Nowhere was this deleveraging more evident than on Wall Street where it was almost immediate and very violent. And as is often the case, the severe challenges in the credit markets also affected the stock market.

While these challenges facing the financial markets and economy were colossal, so was the government’s response. This policy response, which included the Fed pushing the Fed Funds target rate to zero in December, was necessary and in many respects it worked – credit spreads tightened almost immediately and overall market conditions began to stabilize. The resulting improvement in the bond market has been encouraging.

But what about the economy? The decline in home prices and the drop in stocks have taken a toll on household net worth. Like it or not, Wall Street and Main Street are linked. The drop in consumer confidence caused by the huge drop in household net worth has had a negative effect on the economy in the near term as consumers held off making purchases. But the change in attitude toward debt and savings is, in our opinion, better for the economy in the long term. Personal savings rates have risen substantially to 4.2%.

While the government response to stimulate the economy – including multiple bailouts – has led to temporary “boosts” to the economy that will probably get us temporarily out of recession, we wonder whether the growth is sustainable and think the short-term economic stimulus is almost like a quick “sugar high.”

We expect a slow improvement in the jobs market and for the unemployment rate to remain stubbornly high for some time. In fact, we think the unemployment rate will continue to rise to over 10% in the next couple of quarters. We also believe we are still in a disinflationary wage environment that will keep broad inflation measures contained for some time.

Though in the short term there are still disinflationary and deflationary concerns, we all recognize that we are swimming in a huge pool of liquidity created by the Fed and higher inflation is a long term risk. Inflation is a key building block to where rates are headed. The market is also concerned about the huge increase in the Federal budget deficit that has resulted as part of the massive government response to the current crisis and the significant amount of Treasury supply coming over the next several years. So far, the huge supply has been absorbed by greater domestic demand and foreign demand remaining fairly stable. But this significantly increased financing burden could also put upward pressure on interest rates, posing a challenge to economic growth.

So here is our fearless forecast:

• An historically weak and uneven recovery – We believe a ‘V-shaped’ recovery is unlikely and further deleveraging, increased regulation and taxes will create headwinds for the U.S. economy.
   
• Modestly higher inflation – a weak recovery coupled with a significant global output gap should give the Fed time to reverse highly stimulative monetary policy.
   
• Bottoming housing market – home prices nationally have begun to rise over the last couple months and we believe a bottom will be evident by year-end 2009.
   
• Financial markets are fairly valued – Attractive value can be selectively found in stocks and bonds, but the “super sale” is over.

That leads us to the investment implications of this forecast. We like diversified exposure to corporate credits – emphasizing financials on a selective basis. We also like some selective exposure to senior class non-agency mortgage backed securities that are currently paying down principal at par (100). The historically strong relationship between non-agency mortgage-backed securities and agency securities broke down in the market crisis in part due to the dramatic actions taken by the ratings agencies. The number of downgrades of non-agency mortgages skyrocketed. While our exposure to this sector is modest, we are now seeing signs of price recovery and expect it to continue. We would emphasize senior structures and high quality fixed-rate collateral. Current pricing doesn’t reflect the fundamental value of many of these securities. As the unprecedented market volatility and dislocation subsides, we think patience will be rewarded as market prices rise to reflect true intrinsic value of these securities.

About Mary Ellen Stanek, CFA
Mary Ellen has over 30 years of investment experience managing various types of fixed income portfolios. Prior to joining Baird Advisors, Mary Ellen was President and Chief Executive Officer of Firstar Investment Research and Management Company (FIRMCO) and was Director of Fixed Income. She is responsible for the formulation of fixed income strategy as well as the development and portfolio management of all fixed income services. Baird Advisors manages $15 billion in fixed-income assets.

About Baird
Baird is an employee-owned, international wealth management, capital markets, private equity and asset management firm with offices in the United States, Europe and Asia. Established in 1919, Baird has more than 2,400 associates serving the needs of individual, corporate, institutional and municipal clients. Baird oversees and manages client assets of more than $66 billion. Committed to being a great place to work, Baird ranked 14th on FORTUNE’s “100 Best Companies to Work For” in 2009 – its sixth consecutive year on the list. Baird’s principal operating subsidiaries are Robert W. Baird & Co. in the United States and Robert W. Baird Group Ltd. in Europe. Baird also has operating subsidiaries in Asia supporting Baird’s private equity and investment banking operations. For more information, visit Baird’s Web site at www.rwbaird.com.