The Biggest Risk to Bonds

Harry Milling: Hi, I'm Harry Milling, mutual fund analyst with Morningstar, and I'm here with Joe Balestrino. He's the manager for Federated Total Return Bond Fund. Welcome, Joe. Joseph Balestrino: Thanks, Harry. Harry Milling: The bond world or at least the diversified bond fund world is divided into two camps. One camp is very weary of interest rate risk, and they are moving toward corporate bonds. Then the other camp is a little concerned about this economic recovery still. They're concerned about credit risk, and they're begrudgingly putting the money in Treasuries. You're more toward the camp of interest rate risk, and so you have been gravitating toward corporate bonds. Tell me about that. Why is that? Joseph Balestrino: You're right, Harry. The market has changed, and obviously, over the past couple of years we've seen it all. Two years ago, our focus was on the interest rate side. Interest rate exposure was a good thing to have as rates were coming down in the crisis days. Today there are a lot of hiccups, certainly, and Greece is a quick reminder. But we believe that the world is on the mend to include the United States. So in that world, one of the best protections against the prospect of rising rates is to add yield, add economic sensitivity. So we like the economic pieces of the corporate bond market, the high-yield market, even the emerging debt markets. Harry Milling: What do you like in the corporate bond and high-yield market? Joseph Balestrino: Two things. I would say number one, we've increased our cyclical industrial exposure, and that's simply a macro call that says we're out of the woods. It took us a long time to come to that conclusion. But out of the woods I'll define as, we can sustain economic recovery and earnings growth without government support. It took us a while to come to that conclusion. So, we like the industrial sector on the cyclical side. Then, probably a little more controversial, we like the biggest of the big banks and brokers, dare I say, the too-big-to-fail segment, so the J.P. Morgans, the Goldman Sachses, the Morgan Stanleys. Yes, the Goldman Sachses are included in that, because if for no other reason, bank regulation. What's going on in D.C. right now we think will ultimately play out in more regulation, less leverage, less risk taking. All of that sounds not so good on the equity side. Bond holders like those types of certainty words. Harry Milling: In high yield, you talked about default risk, which was very present in 2008 and into 2009, has been replaced with event risk. What do you mean by that, and how are you playing that in the high-yield space? Joseph Balestrino: Event risk is really merger and acquisition related. Company A buys Company B with debt, and hence the event. So if you're the investment-grade company that gets acquired, worst case, by the high-yield company with debt, with leverage, and maybe it's even with your cash that you already have on the books, overnight, you can become a BB company from a single A company. On the flip side, if you're the high-yield credit and you're merging in with a high-quality credit, your finances look better. That is early in the development, but early, it's a scary thing. We just had CenturyTel potentially acquiring Quest: CenturyTel, BBB-, investment grade; Quest, BB, high yield. They may literally change places. So for a couple years, in a recession, in the negative earnings environment, you love cash. It's your safety net. Cash over the next couple of years could be used against you. Today we want to buy companies that have good businesses that are growing earnings organically and maybe without that safety cushion. We don't think we need it. You actually started your question with the key word, the key word being "risk." I define risk very simply: The likelihood of losing money. I think the likelihood of losing money in bonds tomorrow versus yesterday is rates going up, not defaults going up. Defaults are plummeting this year. But event risk is a big deal in the investment-grade side, or will be soon. Harry Milling: One thing hasn't changed in the bond world, and that is there are players that still like to use leverage and like to use derivatives. Certainly, there's a very big player that uses derivatives. I won't mention the name, but it begins with "P", ends with "O". Federated, though, generally speaking, doesn't use leverage, and eschews derivatives. What are some of the advantages of that? Joseph Balestrino: Very sparingly, we use them, and we use them for efficiency purposes. For example, if we want to adjust the ration or yield current strategy, we'll simply go into the Treasury futures market, go long a piece, go short a piece. We'll also adjust our credit exposure, very quickly, up or down by going long or shorting the CDX index baskets, and that's it. Those are temporary things. We try to add a lot of alpha in our process via security selection, so we may go long in the index but then immediately replace it with cash bonds. A PIMCO—to use that word, I know that was a big shock to get there. They use leverage quite a bit more. Their style is more return with more volatility. Our style is more return with less volatility. I won't say one's better than the other. They're different ways of managing fixed income. Frankly, while I don't hear them talk about it too often, using derivatives is in part, required on their part. They've been so successful, and they're so large that they really can't access certain parts of the cash market in the size that they need. The derivatives market they can take exposure there. So part of it is style, part of it is required. Harry Milling: I would imagine too that it depends on what kind of investor you are. Certainly, it's easier to understand a Federated bond fund than it is a PIMCO bond fund. Joseph Balestrino: No question. Harry Milling: So, if you're an investor that is attracted toward more plain vanilla style, not necessarily easier, but plain vanilla style investing, Federated may be more your cup of tea. Joseph Balestrino: That's right. There's no doubt when you and I talk on the phone pretty frequently you immediately know what we're doing and probably without even having the conversation. But it gets you more detail. With PIMCO, your job's definitely a little tougher. There are a lot more moving parts going on in there. Again, that's not a positive or negative. It's a different way of running the money. Harry Milling: Right. Certainly, your funds have been very successful, so plain vanilla works. Joseph Balestrino: Yes. Harry Milling: I think we'll leave it there.