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A Dress Rehearsal for the End of QE3?

Miriam Sjoblom, CFA

Miriam Sjoblom: Hi, I’m Miriam Sjoblom, associate director of fund research at Morningstar, and I am here at the 2013 Morningstar Investment Conference with Tad Rivelle, who's the CIO of fixed income at TCW.

Thank you for joining us, Tad.

Tad Rivelle: Thank you.

Sjoblom: Tad, to start off, it's been a turbulent several weeks for fixed-income investors, and it will be great if you could put some context around that for us.

Rivelle: Well, I think, largely what we saw was a backing out of probably accessibly optimistic views that had been expressed in the fixed-income market. These views essentially pertain to the belief about how long the Fed would likely leave the quantitative easing in place and how much longer it would continue zero rates. Well, remember that late last year, we heard statements coming out of prominent Fed officials, Janet Yellen, being among them to the effect that QE is a fixture or is going to be fixture of Fed thinking for many years to come, until we see unemployment perhaps below 6.5%. Some thought by using that metric that we could perhaps see a continuation of the financially repressed environment until 2017.

So, to a certain degree, I think, that the volatility that we've seen is really just the market in a sense waking up from a slumber that it was put under late last year and is now perhaps a little bit more fairly valued in light of statements that came from Fed chairman Ben Bernanke and other Fed officials. [These statements are] to the effect that indeed Fed policy is not necessarily contemplating many, many years into the future with respect to a potential tapering of QE, but rather that a tapering of QE is something that, while not immediate and while not necessarily even a 2013 event, would none the less happen sooner than the market expected. And I think that's why you saw rates go up as much as they did. So, call it the dress rehearsal for the end of QE, that's what May, and June so far, I think have represented.

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Sjoblom: Stepping back from the past several weeks, maybe you could talk about how you've been looking at Fed policy and how it's been affecting your investment strategy?

Rivelle: Well, the Fed casts a very long shadow over not just the fixed-income markets, but all of the capital markets. And I think one way to recognize that or understand that is to look at the Treasury market, the benchmark for all valuation in fixed income, and given the Treasury market out to 10 years--while a month ago was a 1.6% yield that we we're looking at and as of today maybe we're talking about a 2.2% yield--for most of this period and for most of the Treasury yield curve, we're talking about a negative-real-rate environment, with yields of less than that of the underlying rate of inflation.

I think that a moment's reflection tells you that the only reason that the bond market was able to price itself to a negative-real-yield construct was simply because the Fed punished you, by basically giving you 0% on your money markets or 0% on your bank account, and consequently, there were people willing to extend out on the yield curve, with the thought process I suppose being that 1.6% may stink, but at least, it's quite literally better than nothing, at least it carries positive, relative to cash.

What it suggests to us is that investors do need to prepare themselves ultimately for the end of QE because I think it's going to cost a sea change in valuations. The Fed I think has laid out a very academic program in the sense that they say, "We'll taper. We'll do it gradually. No one will panic." And I think that the history is that when people are faced with the prospect of potentially losing money, particularly in parts of their portfolio that they view as relatively stable, you can see a rather rapid adjustment actually occur.

Sjoblom: And what are you doing in your portfolios to prepare for this eventuality? I'm thinking of the MetWest Total Return Bond fund, in particular?

Rivelle: Several things. One, of course, is to minimize duration, so to reduce the amount of interest-rate sensitivity in the portfolio.

A second element is to reduce the amount of longer maturities in the portfolio because our expectation is that as policy starts to unwind at some point, we're not saying tomorrow, we're not saying 2013 necessarily, but when it ultimately does unwind, it probably unwinds with the configuration that QE gets tapered or disappears first, and the zero-rate policy will stay in place longer. Zero rates will anchor yields at the shorter end much more effectively. The end of QE is likely to cause a decoupling and longer rates, are likely to move quite a bit higher in yield, therefore lower in price.

The third thing that you can do and that we are doing is to buy insurance; insurance in the form of swaptions, basically that are contracts that contingently provide the fund with payments in the event that interest rates go above a certain level.

And a fourth thing is to focus on asset classes that will probably have less correlation with the Treasury rate. These are things like nonagency mortgages, which is one of the largest overweightings in the fund; bank loans, which are floating-rate as they are by nature; and some other strategies that are derived from the asset-backed market and the commercial mortgage market, as well.

Sjoblom: Well, Tad, thank you for sharing your insights with us today.

Rivelle: Thank you.