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By Dan Culloton | 05-08-2012 10:00 AM

A Word of Caution When Stretching for Yield

Osterweis' Carl Kaufman says if bond investors can't find the yields they seek, there must be a reason, and that might be a sign for them to preserve capital.

Dan Culloton: We see a lot of investor flows going to funds that have high-yields, and there seems to be a lot of investors chasing yield right now. What should investors be concerned about? What risk should they be cognizant of when they're seeking higher yields?

Carl Kaufman: Well, as you know, when you're looking for yield, some people will stretch for yield. They keep a certain dividend payment, or they require an income stream that is not compatible with the current markets. Being aware of what your manager is actually buying, or if you're buying individual bonds what you're buying, I've never felt it appropriate to stretch either your quality standards or your duration standards to just get an absolute yield.

If the market is not offering [the yield], there must be a reason. I think that investors should be aware that sometimes the art of the possible is not the yield they have in their head, and sometimes it's best to take a lower yield for a period of time in order to preserve capital when an accident does happen or an unforeseen macro event does happen. You'll preserve capital and be able to reinvest that capital at a much higher yield during or after that slowdown or correction. We've always believed in preserving capital in down markets because then you compound a higher rate.

Culloton: What are your major concerns as an investor and a portfolio manager right now?

Kaufman: Well, obviously, Europe is an evolving situation. I think that what we're seeing now is that the populous is tired of austerity. It's been two years already, come on. But the problem is [the countries] have a lot of debt. There is no obvious way to grow. I mean they're talking growth. There is no obvious solution to that right now because typically when a country or region has gotten into trouble, you devalue the currency.

In the euro that tool is not available to most countries now. If Europe as a central bank or as a central authority wants to devalue the euro, that would be an interesting solution. I don't know if that's possible given the strength of Germany or the debt that [the eurozone has] at this point. It would be interesting to see how [the countries] work their way out of it, but that's a worry to see that because any more weakness there does affect trade in the rest of the world. It affects trade in China. It affects trade in the United States. [Europe] is a big trading partner of ours.

Companies that have operations there you have to watch fairly closely because usually strength in the euro will translate into much positive earnings here, but if you end up with a devaluation then there are much weaker earnings here. I've always used currency as kind of self-correcting over time. So I don't pay too much attention, but you could go through a period where you do have weaker earnings because of that translation, and that does worry me. I think the political impedance that we're seeing around the world, [with politicians] just not being able to act, has gotten very partisan not only in the U.S. but everywhere else. I mean the Greeks can't come to a coalition.

I think people are looking for something different, but I don't know whether you know going a more socialist route in France is the right answer. I don't know [if French president Francois Hollande] is going to be able to fulfill many of his promises. Elections are elections the world over. You make promises you sometimes can't keep. So, I don't think that's as bad as people make it out to be, but I think eventually they will stumble on the right answer. Those are things that I keep in the back of my mind.

Also, low interest rates, low yields, and deflation are [all things] you have to worry about as a bond investor because deflation is not very good for bond investors because you keep on paying your interest in more expensive dollars. So, your yields will tend to come down more. We could be facing a Japanlike situation, where it takes years to get out of this debt delever because a deleveraging recession takes time.

Culloton: For a portfolio manager like you who really focuses on individual credits, almost in some case picking bonds like a stock-picker likes stocks, how do these macro concerns translate into how you're constructing the portfolio right now?

Kaufman: Well, I think the way it translates for me is, if you don't have a real growth trajectory that you can see for the next three to five years, you're not going to lend money out for that period of time because rates could change dramatically during that time period. It does tend to compress by duration and my unwillingness to go out on the curve, so to speak. So, that's really how it affects me. You also want to look at the result, such as when does it start affecting individual company results. It hasn't really so far. I'm kind of amazed that it hasn't, but growth rates seem to have slowed, but they're still positive in the U.S. So we're still OK.

Culloton: All right, Carl. Thank you very much for your time today.

Kaufman: Thank you very much for having me.

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