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By Karin Anderson | 06-25-2015 11:30 AM

Landmann: Tread Carefully in Today's Bond Market

Uncertainty over interest rates, frothiness among higher-yielding issues, and liquidity risk are reasons to be cautious, says MetWest's Laird Landmann.

Karin Anderson: Hi, I'm Karin Anderson, a senior analyst with Morningstar. I'm joined today by Laird Landmann, who is co-director of fixed income at MetWest TCW and one of the managers on Metropolitan West Total Return Bond (MWTRX).

Hi, Laird--how are you today?

Laird Landmann: Very well. Thank you for having us here at the Morningstar Conference.

Anderson: Thanks very much for coming. We've seen a lot of volatility in the global bond markets so far this year. What are the potential risks you see if and when the Fed starts hiking rates later this year?

Landmann: Well, I think you touched on the first one: volatility. If you think about it from a theoretical perspective, if the Federal Reserve and other central banks promise to keep short-term rates at zero or close to zero, they're in effect milking all of the volatility out of the system--since volatility, up and down the yield curve, really starts with short-term interest rates. So, I think the market is trying to adjust to the idea that this is no longer going to be the policy and what the unintended consequences of a change in policy might be for the markets.

Anderson: What are your thoughts on the Fed rate increase? When [do you think that will occur] and by how much?

Landmann: We're thinking two rate increases, which is now becoming the consensus. There have been a couple of governors who have come out and sort of validated the notion of two rate increases this year. Certainly, the U.S. economy seems to have pretty good fundamental strength to it, and the Federal Reserve--although they could never say this--I think they would like to get a little bit of a cushion in there, because at some point there will be another downturn. We are now coming up on seven years into what has been a very slow and arduous upturn in the U.S. economy; there will probably be another year or so of faster growth, but the Fed has to prepare itself for that next stage of the cycle.

Anderson: Could you talk a bit about how the Total Return fund has been positioned, given your view on where we are in the credit cycle?

Landmann: I think we are patient value-oriented investors at the end of the day. Great value was created for all fixed-income investors by the Fed's activities post-2008. As we look at the risk premiums today and at what certainly has to be a distorting effect on asset prices caused by the Federal Reserve's policies and the quantitative easing that occurred and what continues to occur in Europe, we have to be defensive, we think, in this sort of environment.

You can't argue with the fact that these policies have inflated asset prices more than they otherwise would be and, because of that, we are cautious on duration--that is, we do believe rates will move higher. The market right now believes that the Fed will move rates up much more gently than even the Federal Reserve is saying, and we tend not to believe that point of view. We tend to believe that, at some point, the Fed will realize they are behind the curve and will actually move a little bit faster.

The second point is on credit. Credit, to us, feels like it's becoming frothy, and we do believe there will be more volatility in the credit space. We're very cautious toward our corporate high-yield positioning. Even on the mortgage side of the equation we've become somewhat more defensive.

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