Dialing Down Bond Risk

Michael Herbst: Hello, I'm Michael Herbst, mutual fund analyst with Morningstar. Today in our studio we're visiting with Steve Walsh, Chief Investment Officer of Western Asset Management and also portfolio manager on the Western Asset Core and Core Plus funds. Good day, Steve.

Steve Walsh: Good afternoon, Mike.

Herbst: Steve, as we were speaking a little bit earlier today, in the recent months Western Asset has been speaking quite a bit about some of the risk reduction efforts that it has taken, especially in the Core and Core Plus accounts, and I'm wondering if you could describe to our audience what those efforts have been and what the thinking was behind those moves.

Walsh: Sure. Obviously over the course of the last three or four months, I've begun a process to pretty meaningfully bring down the risk exposure in the portfolios. Western Asset has, as I'm sure you're aware, got into risk a little bit before the crisis, so a little bit early, and we stayed with that in the early part of 2009. But as 2009 progressed, and given the huge run-up in price in most of these asset classes, we felt it appropriate to begin to reduce risk.

<TRANSCRIPT>

We've done it in a number of areas. We've done it in the high-yield sector. We might have gotten as high as 13 or 14 percent in high-yield bonds. We're down to about 8.5 today. We did it in the investment-grade sector, where we cut our overweight by about 25 percent. We've taken agency mortgages from a pretty meaningful overweight in the portfolio to a pretty decent underweight in the fund.

Each of these different sectors in the marketplace, certainly in the credit sectors, we continue with an overweight but have reduced pretty meaningfully the size of that position. Again, it comes about from two reasons. One: recognizing the huge run-up in price. These sectors have been revalued pretty meaningfully. Secondly: the outlook still is pretty cloudy, and not just on where the U.S. economy might be over the course of the next six to nine months.

But there are a great deal of issues that confront investors today: What's going on in China, for example, and how policy makers will try to slow that economy down without running it into the ditch; what's happening in the EMU, which of course has been big over the course of the last few weeks with respect to how it treats its peripheral countries and does it support them or doesn't it support them, and even here in the U.S., with the talk of regulatory reform and financial regulations and the Volcker Rules, let alone how Bernanke maneuvers in this current period of possibly exiting from his combinative strategy.

There are a lot of issues around the globe with policymakers in charge, and we just see the possibility for a slowdown in the improvement in the risk assets.

Herbst: The idea that Western Asset chose to reduce risk in the Core and Core Plus funds theoretically at least should give those two funds more flexibility to navigate an uncertain environment. Could you speak a little bit to that idea?

Walsh: Sure. It does give us more flexibility in that obviously we try to manage risk within a fund within certain boundaries, and we have capacity to add risk or we don't have capacity to add risk. By having made pretty meaningful cuts in most sectors of the marketplace in terms of risk in our portfolios, we feel as if that would give us the opportunity to take advantage of situations should attractive investment opportunities come up.

Contrast that with a year ago when we felt pretty full on risk in our portfolios and didn't feel in early '09 that we had the ability to add risk given a pretty full position. Today I think it does give us more flexibility. We have more government securities in the fund today than we probably had in the last 10 years. That gives us the ability to redeploy those assets should we find attractive opportunities.