'Sleep Insurance' Bonds

Michael Herbst: Good morning. I'm Michael Herbst. I'm a mutual fund analyst with Morningstar, and we are broadcasting this morning from the 2009 Morningstar Investment Conference in Chicago.

This morning I have the honor to be joined by Mary Ellen Stanek, the director of asset management and chief investment officer of Baird Advisors, where she and her team oversee the firm's suite of fixed-income funds. Mary Ellen, thank you for joining us this morning.

Mary Ellen Stanek: Thank, Michael. Great to be here.

Herbst: You have described your team's style, essentially, as serving as the core of the core of an investor's bond portfolio. Could you touch down on that a little bit just so we get a better sense of what that means to you?

<TRANSCRIPT>

Stanek: Sure. We tend to be investment-grade at the time of purchase. We run portfolios along the risk spectrum or the duration or the time curve and really try to be as one investor once said to us a long time ago: "You're my sleep insurance."

He thought I'd be offended by that, and I actually said, "No, I understand that exactly." That we try to make sure the risk we take is commensurate with the risk that's expected in terms of a core bond offering that can be there. You set it and forget it in terms of your asset allocation.

Herbst: In terms of risk, what people might have thought of as risky in 2007 or 2008 has changed a great deal in 2009. The idea there being that Treasuries and government securities, generally speaking, did very well during the market's turmoil in 2008, but it seems that market conditions have changed enough since then that that might not be as clear cut an assumption at this point.

Stanek: Sure. In 2008 there was such a flight to quality in liquidity, and basically the major beneficiary of that move was the U.S. Treasury sector. If you owned anything but Treasuries, you underperformed, and, effectively, yield spreads widened under the additional yield you got on investing in those sectors, corporate bonds, mortgage-backed securities, asset-backed securities.

And, so we see now the flip side of that, that yields on Treasuries are starting to rise in here. Some of that is reflective of better market conditions, better liquidity, but also a reflection of more supply. There will simply be more Treasuries, given the deficit that we're running right now.

So, we look at it and we say, "Alright, the economy--we are in better shape." It's still fragile but we are better. We don't seem to be declining further in here, and we look at it, and we say the price at which, or the additional yield at which you can buy high-quality investment-grade fixed income is very attractive versus the risk.

And so, we see so far in 2009, particularly with the month of May as you saw financial bonds do better, the financial intermediaries, we see the investment grade sectors doing very well across the board.

Herbst: Are there pockets of other riskier kinds of assets that you're finding attractive at this point given your style?

Stanek: Well, in terms of, I would say misunderstood or mispriced, in terms of the entire market repriced risk over the last couple years, as we went through so much financial volatility--financial market volatility--as well as the economy, where we would say we're seeing particular value is still in the residential mortgage-backed area, the triple-A rated non-agency mortgages, in particular, and many of the asset backed structures as well.

We also think there's still very compelling value in investment-grade corporates, particularly the financial intermediaries is where there's better liquidity, and you've seen actually the ability to issue a lot more debt and the ability to get access back to the capital markets which just a few weeks ago, even months ago, was questionable.

So, we look at the additional yield available on the securities as very attractive versus risk.

Herbst: And, are you also looking outside of the taxable space? Are you finding opportunities right now in the municipal space, for example?

Stanek: Yeah, on the municipal side, here's the way we approach the tax-exempt bond market. Clients who are investing, shareholders who are investing with us on the tax-exempt bond side already have amassed wealth. Our job, as we like to say, is to keep that wealth intact, and so we look for quality and for intermediate kinds of investment opportunities.

So many of the investors on the municipal side buy yield or invest looking for yield, and that tends to take them to the longest duration or the longest maturities and often down in quality. We don't think that's necessarily commensurate with the risk that tax-exempt investors are looking to take, so our portfolios tend to be very biased to the intermediate side and very biased to quality.

The big risk in the tax-exempt market, we think, isn't so much default risk. There's going to be a lot of issuance of tax-exempt bonds. It's going to be, potentially, downgrade risk, and by that we mean, as bonds are downgraded, they're downgraded to higher yield points, so your price declines are commensurate, and we think that's a bigger risk.

So, right now stay with quality and stay liquid. It's a tough market to do it yourself and buy individual securities. Buying well-diversified, liquid, high-quality bond funds, we think is a better way to go.

Herbst: Well thank you so much for sharing your time and your insights this morning.

Stanek: Thanks, Michael.