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By Greg Carlson | 08-22-2013 11:00 AM

Giroux: Time to Put Bonds Back on the Radar

The fact that everybody is so nervous about bonds today actually makes us a little more positive, says 2012 Morningstar Allocation Fund Manager of the Year David Giroux.

Greg Carlson: Let's turn to the fund's bond portfolio. There have been some significant changes there. Leveraged loans have been the biggest piece of that pie, perhaps, in some ways, and that weighting has come down a bit. Meanwhile, you've bought some shorter-term, more traditional bonds.

David Giroux: I think one of the things we've had in the fixed-income portfolio is a real bet that rates were going to rise someday. We didn't know that they were going to happen this year, but we've had a big pretty bet on the portfolio. That manifests itself in a very short duration. Our duration of our fixed-income portfolio is about 1.7 years. Over half of the portfolio in our fixed income was floating rate.

So specifically on leveraged loans, we did … cut back the … exposure a little bit earlier this year. You saw a lot of the leveraged loans trading above par, above 101; valuations were a little bit less compelling. We're seeing a lot more issuance being covenant-lite, so leveraged loans have come back a little bit.

Carlson: When you say covenant-lite …

Giroux: Covenant-lite means that you don't have a limitation on the amount of leverage that the company can go up to. … As a leveraged loan holder, we like to have covenants that protect us in a downturn, that … make sure there is not new debt put on top of us or beside us or in front of us, which is what happened a lot in 2009 in the downturn. So we want to make sure that we're protected, so having covenants really protects us.

I think the leveraged loan market has a very short memory of what happened to those loans in 2009, and we have a very long memory. So, for the most part, we don't buy covenant-lite loans, and most of the new-issue market in leveraged loans today are covenant-lite.

So our leveraged loan exposure has gone from 8.5% to 6% of the portfolio. What we did do in the first half of the year and the second half of last year is, we had a pretty big cash position. We took some of that cash and invested it in very high-quality, short-duration, investment-grade bonds, where you didn't have a lot of credit risk or interest rate risk, … because you were earning very little on cash, but you were earning potentially 1% on short-duration investment-grade paper.

Carlson: So basically better than nothing.

Giroux: Better than nothing. That's actually very, very fair.

I think the point where we are now is, having had the 10-year Treasury go from 1.46% to 2.9% today, we may need to moderate that bet a little bit and may need to take duration up as rates rise.

We've always said that we think fair value for the 10-year is about 4%, sort of 2% inflation, 2% GDP growth, 2% real yield, 2% inflation. We get to about a 4% real yield. I think as rates get close to that level, we think we would want to probably be adding to our duration and moderating the really negative bet we had on rates.

Carlson: Just to be clear, the fund … doesn't own Treasuries now and hasn't for several years, I think.

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