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By Eric Jacobson | 06-21-2012 03:30 PM

Today's Risks Not Lost on the Bond Markets

Risk markets are fairly to cheaply priced today because they are aware of the global uncertainties investors' face, says Western Asset's Steve Walsh.

Eric Jacobson: Hi, I'm Eric Jacobson. I'm director of fixed-income research for Morningstar.

We're here today at the Morningstar Investment Conference, and we're pleased to have Steve Walsh, the chief investment officer of Western Asset Management with us.

Thank you so much, Steve.

Steve Walsh: You're welcome, Eric. Happy to be here.

Jacobson: We're really glad to have you. So, one of the things that I just wanted to start off by asking you is, there are so many things going on, on the world stage especially, where do you perceive some of the greatest areas of risk for bond investors right now?

Walsh: I think the two big macro factors that seem to be really having investors so anxious are, first of all, Europe, and that's been front and center for quite some time. And secondly, and this has certainly been picking up over the course of the last 45 days, the real question is about the state of global growth across the world, not just the sustainability of the U.S., which the data has turned down certainly recently, but also what's going on in China. We've certainly seen a marked downturn in their economic data over the course of last couple of months.

So the combination of this big European issue that I think investors have really a tough time getting their arms around, and then on top of it having questions about, oh my gosh, we might be heading into a period of much, much slower growth. Those are the the macro issues that I think have investors pretty worried today.

A third kind of satellite out there might be politics, just that general issue, given both the transition of power in China as well as our own election coming up this November, and obviously in the last 45 days, politics was a big issue, given the votes in Greece and even in France.

Jacobson: So, slowing global growth being a worry, I take it, then, that inflation is less on your mind now than it might have otherwise been?

Walsh: Yes, it is. For the foreseeable future, we see pretty benign inflation. You can't help think about it a little bit, just given the extraordinary nature of monetary policy. I mean you've got the central banks around the world building up balance sheets at a rate that we have never seen historically. That could potentially be the kindling for inflation down the road if they don't remove that policy appropriately.

But I think we feel we're going to go through a period of fairly sub-trend growth across the developed world for the foreseeable future, which ought to mute general price level changes to something in that kind of 1% [range], maybe in a bad case, 3%.

Jacobson: What is that outlook translating to right now in the way that you're positioning portfolios?

Walsh: Given that you could argue [there is a] big amount of uncertainty, like what happens in Europe and where is the state of growth, that might have you say let's not take risk. That might have you say, you know what, maybe staying away from the riskier sides of fixed income might make sense.

But we think that's not lost on markets. We would actually argue that risk markets are fairly to cheaply priced today because they are aware of that uncertainty. You look at high-yield bonds today at spreads almost 700 over Treasuries or almost an 8% yield. We think that's factoring in a lot of bad or negative outcomes on both the growth and European scenario.

So, developed government bond markets we think are a little stretched. They reflect that anxiety because people want to hold on to something that may mature for them. On the other side of that, within the credit space, we do see in the spread markets some good opportunities in high yield and senior bank debt and emerging-market local currency.

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