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Stanek: Corporate Bond Market Off the Mat

Sonya Morris, CFA

Sonya Morris: Hello, I'm Sonya Morris, editorial director with Morningstar's mutual fund research group. I'm here with Mary Ellen Stanek of Baird Advisors. Mary Ellen is the chief investment officer of Baird. She has 30 years of experience managing fixed income portfolios, and she manages several Baird bond funds including Baird Aggregate Bond.

Mary Ellen, thanks for joining us today.

Mary Ellen Stanek: Thanks, Sonya.

Morris: I'm sort of reminded of that old Chinese curse, "May you live in interesting times." It seems like bond managers have certainly lived in very interesting times for the past several months. I wonder if you could talk about some of the challenges you faced in 2008, and compare that to what you're seeing today.

Stanek: Sure. As we like to tease each other, we can't wait until bonds are boring again.

Morris: [laughs]

Stanek: And certainly when you look at 2008 and look at 2009, in a lot of ways they're mirror images of one another. In 2008, we saw spreads get very wide, liquidity get very challenged to nonexistent, and so you saw just incredible volatility, even in the highest-quality bonds and the highest-quality sectors.

In 2009, as much as investors were running away from risk in 2008, we have seen them start running back towards areas in the bond market that they had virtually gone on strike or abandoned.

And so we've seen a lot of what we call the spreads, or the additional yield available versus Treasuries, go from very, very wide levels, historic levels near the end of last year, to what we consider more fair value levels in many of the sectors.

So it's been an interesting time and while liquidity is better, we're seeing better issuance, certainly the market environment is still fragile.

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Morris: You mentioned spreads tightening. We've certainly seen that, particularly on the credit side, on the corporate side. I wonder if you could talk about that a little bit more. What are you seeing in the way of valuations, and are there any areas that do look attractive to you?

Stanek: Sure. First, on the corporate side of the equation we've seen record corporate bond issuance. So we've seen a lot of money moving into the market on the buy side, on the demand side, but we've seen a lot of supply as well.

And we have been pleasantly surprised how quickly the corporate market overall has opened back up for investors and for issuers. And the price at which those bonds have to be issued or priced or actually those spreads, those yield differentials are coming in pretty substantially.

So overall, we think the credit environment is closer to fair value, certainly not rich but closer to historic averages in many of the sectors. Where we still see value is selectively in certain names and particularly in the financial intermediaries.

That was one of the sectors that got hit the hardest in 2008, took the longest to come back in 2009, and really didn't start participating in a big way in the corporate bond rally until the later part of the spring. But we continue to see spreads or the additional yield wider and find good opportunity particularly in many of those intermediate names.

Morris: Are there any particular characteristics that attract you to those financial intermediaries?

Stanek: Sure. One of the reasons we have always like that sector of the corporate bond market--and this goes back over a couple of decades, really-- is because inherently we're better protected as a bond investor.

What do I mean by that? So often when you look at so many corporate management teams, they're incented based on how their stock price does. And so the response over the last several decades was to leverage up their balance sheet, the corporate balance sheet, to try to drive more earnings per share growth.

At times that was very contrary to the bondholder's interest, if you were an existing bondholder.

So we look for names and companies and sectors where we're inherently better protected as a bondholder, where there's a huge incentive to stay investment grade rated. And the financial intermediaries are a perfect example of that. They need to maintain investment grade credit ratings to be able to fund their activity and their balance sheets.

And so we as an investment-grade buyer, we sleep better at night knowing that our interests are better aligned with the incentives of that entity and that corporate management team.