Q&A: Decent Returns Still Available In High Quality Bonds

Baird Chief Investment Officer Mary Ellen Stanek believes it is not the time to stretch for yield

 
MILWAUKEE, May 31, 2011

With Federal Reserve Quantitative Easing (QE2) coming to an end and fearsf rising inflation widespread, investors are concerned about risks in bonds. Baird Advisors Chief Investment Officer Mary Ellen Stanek, lead manager of Baird Core-Plus Bond Fund, believes now is not the time to abandon bonds. She recently shared her thoughts on what lies ahead.

How have you positioned the fund to protect against the threat of growing inflation?
We are not seeing signs of worrisome inflation and, consistent with what the Fed has signaled, survey and market-based measures of inflation expectations suggest inflation continues to be well-anchored. While there are visible signs of inflation in food and energy, these pockets of inflation have not become imbedded more broadly into wages or worked their way into longer term inflation expectations in a meaningful way. So far, higher food and energy prices have acted more as additional headwinds to an already modest economic recovery than as catalysts of more pervasive inflation. Significant slack in the labor market, moderate growth, excess global capacity, and now supply chain disruptions in Japan continue to act as counterweights against broad inflationary pressures.

We have said for a long time that interest rates and inflation could stay lower longer than many expected. As a result, we believe the Federal Reserve will have more time than people expect to unwind the extraordinary monetary stimulus they put in place.

We are a duration-neutral manager and the hallmark of our approach is to keep the Funds’ duration equal to that of its benchmark at all times. We believe that strategy continues to serve the Funds well and, with the historically steep yield curve, shortening duration in anticipation of rising rates has been a costly defensive move that many investors have made over the past couple years. Having said that, we are doing other things in the portfolio to protect against the threat of higher inflation and rising interest rates. One, the fund holds primarily short- and intermediate-term bonds with effective maturities of 10 years or less. Two, the fund’s significant underweight to the U.S. Treasury sector and overweight to “spread sectors” such as corporates will dampen the impact of higher rates. We believe spread sectors are likely to outperform U.S Treasuries in a rising rate environment associated with stronger economic growth and rising inflation. Third, the positive impact of roll-down* along the historically steep yield curve could offset some of the price declines caused by rising rates Finally, we are underweighting issues and sectors (e.g. callable bonds, mortgage pass-throughs) which are more likely to extend in duration and experience larger than average principal declines as interest rates rise.

* Yield curve roll-down returns occur when each bond in a fund rolls down an upward sloping yield curve and is valued at a lower yield/higher price simply due to the passage of time. For example, a 5yr bond today with a yield of 2.5%, coupon of 2.5% priced at $100 would be valued as a 4yr bond at a yield of 2.0% a year from now if nothing changes. This would increase the price to approximately $102 for this now 4yr bond with a 2.5% coupon. The yield curve roll-down in this example adds 2% to the return of the bond over a one year period in addition to the 2.5% earned in coupon interest. Decades of low inflation and declining interest rates created a golden age for bonds. Will fixed-income investors have to accept lower returns in the years ahead?
The risk/reward tradeoff in non-Treasury bonds is clearly not as attractive today as it on the heels of the financial crisis early in 2009. We believe there could be a year or two of below average returns for bonds when rates turn and start to rise. However, we believe there is an equally likely possibility that other asset classes, including equities, may experience a similar period of lower than average returns. The impact for investors will vary depending on their overall asset allocation.

It is important to point out that many people expected the turn in bonds to happen a year and a half ago. Instead, bond returns have continued to remain strong, and interest rates could persist at current levels for some time before making a turn. When the turn happens, bond returns will be lower, but much of the advice in the marketplace right now is extreme. Either investors are told they don’t need to own bonds at all or they are told they should take currency risk by investing in international bonds to add income to their portfolio. While we wouldn’t advise overweighting bonds at this juncture of the cycle, neither do we recommend that investors simply abandon bonds altogether.

Bonds continue to provide an important risk control element to portfolios and an allocation to high quality bonds is prudent. We believe there are still decent returns available in high quality bonds but caution that now is not the time for bond investors to stretch for higher returns by going out too far out the yield curve or too far down in quality.

Where are you looking for yield today?
We are not particularly enthused with the relative return prospects for Treasuries, so we are focusing more on opportunities in non-Treasury sectors. Yield spreads in these sectors have tightened pretty dramatically over the past couple years and as we mentioned, this is not a good time to stretch too far for yield. That said, on a selective basis we see value in high quality spread sectors—corporates, asset backs, CMBS—but we are more selective today than a year ago. Our focus is on risk control and we try to buy defensively, taking more of our “spread” exposure on the shorter end of the yield curve to mitigate the impact of spread widening should it occur.

With Core Plus we can invest a portion of the portfolio in what we view as a very attractive segment, the slice of the corporate bond market just below investment grades where bonds are rated BB instead of BBB. Investment grade funds generally cannot buy these securities and high yield funds tend to focus further down in quality in their search for higher yields. We also find some very select opportunities in senior class non-agency mortgage-backed securities with fixed -rate collateral. We believe both the BB corporate bonds and the non-agency mortgages offer attractive risk adjusted return potential and we take this exposure in moderation—just 12 to 16% of the portfolio falls into this below investment grade and non agency mortgage segment in total.

One other factor on which we focus intently in our sector and security selection decisions is roll-down. While not explicitly captured in yield calculations, roll-down is a very important component of total return, particularly now, where nominal yields are very low and the yield curve is historically steep. As a bond “rolls down” the yield curve over time to a lower yield, it experiences a certain amount of associated price appreciation. The magnitude of the price increase depends upon the duration of the security and the steepness of the region of yield curve over which it rolls. Not all bonds roll alike, and the key is avoiding bonds with less well-defined cash flow characteristics that can extend (e.g. callable bonds, mortgage pass-throughs) and miss out of roll-down. Bonds with significant extension risk even have the potential to roll up and out the yield curve to higher yields and lower prices – this can be particularly painful when the yield curve is as steep as it is right now.

Last year, roll-down on many intermediate maturities significantly boosted total returns return. As long as the yield curve remains steep, roll-down will be a powerful component of fixed income returns and can also help mitigate the effects of rising interest rates if and when they occur.

Are you concerned about S&P’s negative outlook on the U.S.’ credit rating? Have you made any adjustments to your portfolio to compensate for additional credit risk?
We are not terribly concerned. While we are not excited about the total return prospect for Treasuries given unfavorable supply and demand dynamics (we have a significant underweight), we believe the risk of default is negligible. A downgrade would likely reduce the superior liquidity that the Treasury market has always enjoyed, but liquidity in Treasuries would likely still remain superior to that in other sectors.

How do you think the Treasury market will react to the end of quantitative easing? Do you think the Fed would consider a third round of easing?
The supply/demand equation continues to be unattractive. It is hard to justify current Treasury yields with such huge supply. Once the Fed stops buying, we expect a modest increase in Treasury yields, but not the big adjustment some expect. High quality spread sectors, on the other hand, could experience a smaller increase in yields and we believe these spread sectors could outperform Treasuries once QE2 is complete.

Eventually, the shape of the yield curve will flatten. The steep yield curve has helped financial institutions; the positive carry has helped their balance sheets and is part of the reason the Fed has kept the yield curve steep. Once the yield curve starts to flatten, we anticipate the potential for a more pronounced rise in yields as financial institutions unwind some of their Treasury positions.

Regarding a third round of easing, we think it is highly unlikely. There would need to be a clear and imminent danger of the economy moving into negative growth or a double dip recession. This is an extremely high hurdle for the Fed to consider a third round of quantitative easing (QE3).

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 2,600 associates serving the needs of individual, corporate, institutional and municipal clients. Baird oversees and manages client assets of nearly $82 billion. Committed to being a great place to work, Baird ranked number 14 on FORTUNE’s 100 Best Companies to Work For® in 2011 – its eighth 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 an operating subsidiary in Asia supporting Baird’s private equity operations. For more information, please visit Baird’s Web site at rwbaird.com.

 

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In a rising interest rate environment, the value of fixed-income securities generally declines and conversely, in a falling interest rate environment, the value of fixed-income securities generally increases. While individual bonds can be held to maturity with the intention of delivering par value, investment return and principal value of an investment in bond funds will fluctuate so that an investor's shares when redeemed, may be worth more or less than their original cost.

Diversification does not endure against loss.

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.