Gauging the Risk of Rising Rates

Michael Herbst: Now with the rates having remained at near-historical lows for such a long time, everybody now is thinking about what will happen when rates rise, how quickly they may rise or when they may rise. How does that factor into how the Western Asset portfolios are positioned today, and how do you think that they are equipped, essentially, to navigate a rising rate environment?

Steve Walsh: Well, longer-term history with our funds would demonstrate they can actually perform quite well on a relative basis in a rising rate environment. I would never position Western as a bologna manager, in other words, we only do well when rates are flat or falling. We tend to be able to have pretty active interest rate strategies and can maneuver the fund fairly meaningfully if necessary if we did see a rising rate environment coming.

The way we think about the world is actually we're not as fearful as everyone else is about rising rates, first of all. Our general thought is that the U.S. economy will do pretty well in here, as will the global economy over the course of the next two to three quarters, and after that faces some pretty meaningful challenges, one of those being fiscal that we just talked about. That would have the tendency to dampen growth in the United States. Thus, with the fairly modest recovery in the U.S. economy going on right now, and after that a fairly prolonged time of pretty challenged growth, we don't think the fundamental backdrop supports meaningfully higher rates.

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The other element that comes into how to determine where rates might go is inflation, and we're not a big believer that inflation in the intermediate term here, near term, is going to be a big concern for markets. There's huge labor capacity that's available, and there's great under-use of manufacturing capacity. With the fairly below-trend rate of growth over longer periods of time we don't see the inflation pressure really meaningfully coming up.

So modest growth, not a real inflation problem, if you knew nothing else, would tell you rates shouldn't rise meaningfully. I think the thing that's got everybody excited is, "Oh gosh, we've got to borrow so much money!" It's true that none of us can look back and think of when the United States government had to borrow as much money as they do today. So the thought process then goes that, "Gosh, we're going to have to raise our interest rates to attract investors!"

That's a nuance that's certainly reasonable to think about, because it has to have some influence on the market. But what I think it misses a little bit here, especially near term, is that private demand for capital has fallen off a cliff. Both households and businesses have meaningfully brought down their need for capital. The government has come in to fill that void, so on net, there hasn't been this big crowding out that would cause interest rates to be a lot higher. So our thought is that rates generally will tend to stay in a lower zone.

If rates did rise, I think our ability to maneuver in that would be pretty good. Obviously we're not taking a lot of interest rate risk versus the Lehman Aggregate today. We're just a little bit long the market. Importantly, I think you'd have to ask why are rates rising, and if rates are rising because our economy is doing better and recovering a lot of the other strategies in our Western Asset portfolio are going to do quite well. Corporate bonds ought to do great. Our residential mortgage securities ought to do quite well in the non-agency space, as well as high yield.

I would tend to think we'll perform pretty well in a rising rate environment, as a number of strategies in the fund would offset any impact we have from being a little bit long the market. I'd also expect that we might be able to respond to it and anticipate the rise in rates.

Herbst: Great. Well, thank you so much for taking time to speak with us today.