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Stanek: Don't Write Off Bonds Altogether

Now is not the time for investors to overstretch themselves in fixed income, but decent returns are still available in high-quality bonds, says Baird's Mary Ellen Stanek.

Liana Madura, Assistant Site Editor, 05/24/2011

Mary Ellen Stanek, managing director and chief investment officer with Robert W. Baird, recently participated again in our manager Q&A. As a manager of Baird Core Plus Bond BCOSX, she answered our questions on how the fund is cushioning itself against increasing inflation concerns and what the picture may look like for fixed-income investors in the years ahead.

She also discussed where management was looking for yield today and whether she is concerned about additional credit risk because of the negative outlook on U.S. credit ratings. Finally, she commented on how the Treasury market will react to the end of quantitative easing and whether there will be a third round to come.

1. 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 Federal Reserve has signaled, survey and market-based measures of inflation expectations suggest inflation continues to be well-anchored. Although 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 a counterweight 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 it put in place.

We are a duration-neutral manager, and the hallmark of our approach is to keep the fund's duration equal to that of its benchmark at all times. We believe that strategy continues to serve the fund 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 during the past couple of 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 so-called spread sectors, such as corporates, will damp 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. Three, 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 (for example, callable bonds and mortgage pass-throughs) which are more likely to extend in duration and experience larger-than-average principal declines as interest rates rise.

2. 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 trade-off 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. Although 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 we 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.

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