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Woodruff: Treasury Bull Run May End Soon

Josh Charney, CFA

Josh Charney: Thank you for joining us today. My name is Josh Charney. I'm an alternatives analyst here at Morningstar. With me today I have Bill Woodruff, who is the portfolio manager for Bandon Isolated Alpha Fixed-Income.

Bill, thank you for joining us today.

Bill Woodruff: Thanks for having me.

Charney: So Bill, with the Fed's QE1, QE2, and now their latest Twist, what can investors look for when investing in the traditional bond market?

Woodruff: That's a good question. It's a very challenging environment for sure, and I think that the challenges are ... I think it's really complacency that we're seeing from a fixed-income investor's perspective, and perhaps supported by the Fed, there's a general perception that rates will stay low through mid-2013, because of a Fed statement. Obviously, the Fed is attempting to flatten the curve, support long-term yields, keep those low. The question really is, will they be successful? And that's something I think that is completely uncertain and unknown, and ultimately will be very impactful to fixed-income investors.

Charney: So, should investors be worried about the bond allocations in their portfolio, if the 30-year bull run in Treasuries comes to an end soon?

Woodruff: We think so, absolutely. The idea that the Fed is supporting long-term rates, I think, fuels a fire that's challenging, and that's that complacency I referred to.

We don't think that just because the Fed is participating and buying maturities that are later dated that they'll be successful in holding rates down. So with yields very low and the potential for rising rates, it's something that we don't think is forecastable over the intermediate to longer term.

There are a lot of challenges out there, and whether you believe interest rates are going to rise or not, the bottom line, I think, with fixed income is that yields are very low--that presents separate challenges. I think those that don't understand fully what interest rate risk is and what might happen to a fixed-income portfolio that's buy-and-hold oriented with the significant amount of interest rate risk, I think there are some potential challenges there on top of simply just low yields in the portfolios.

Charney: So, with all these new alternative products coming to market, what should investors really be looking for when investing in alternative bond funds?

Woodruff: So far in terms of this emerging category and space, it's very fragmented, and we're seeing a lot of different participants do a lot of different things. Ultimately there are themes, and I think some of the themes present some characteristics that are unattractive in terms of asset allocation. So, if you think about a rising rate solution, I think there's a natural tendency to want to go towards greater credit risks, and then potentially reduce duration. And ultimately both of those things in our mind are exposures that if you have on, on a static basis, they'll probably do well during periods of rising interest rates, but ultimately they are going to have a higher degree of correlation to risk assets, which we think is a challenging thing from a portfolio perspective. So as you go from high-quality fixed income that's very interest rate sensitive and deviate from that, and you do so with an alternative fixed-income fund that possesses correlation-to-risk assets, we think that's a trade-off that needs to be taken with very serious considerations.

Charney: So would you caution investors who are looking to invest in a rising interest rate fund?

Woodruff: I don't know that caution is necessarily a right word. Definitely think through how I am using this in the portfolio, and if I am going to be significantly reducing high-quality fixed income in favor of an alternative fixed-income fund that possesses biases to that trade that I mentioned, really think through that process.

I think what we try to do with our fund is provide characteristics that are truly unique and don't have that static trade on, or that risk to or correlation to risk assets, and most importantly during periods of market stress. So I think looking for alternative fixed-income funds that truly provide an alternative source of return is the key.

Charney: So can you touch on the dual nature of your portfolio, both the credit and the interest rate side of it?

Woodruff: Absolutely, I think that's a real key for why we're very different than our peers. Essentially, it's our belief that the skill sets needed, as you deviate from a benchmark, to be successful alternatively or within an absolute return mandate, managing credit risk versus interest rate risks are very, very different, and so our approach has been to hire specialist managers or subadvisors to our mutual fund to address both of those topics independently of each other, and we have isolated the capabilities of two specialist managers and think that approach is a more viable one in terms of achieving some of our objectives.

Charney: OK, and can you touch just a little bit on the interest rate side in predicting interest rates in the short-term?

Woodruff: Absolutely. The subadvisor on that side takes a very, very different approach. It's one that doesn't have a long-term view. It's not six to 12 months or longer, which is a timeframe we think is difficult if not impossible. It's a monthly orientation to interest rate forecasting, and it's a systematic process. The overall duration for a fund is positive five years to negative five years, and there is no bias directionally. So unlike, I think, the average fund, which will likely have a bias to having positive duration, we have got a very unique unbiased approach.