Landmann: Tread Carefully in Today's Bond Market

Karin Anderson: Hi, I'm Karin Anderson, a senior analyst with Morningstar. I'm joined today by Laird Landmann, who is co-director of fixed income at MetWest TCW and one of the managers on Metropolitan West Total Return Bond (MWTRX).

Hi, Laird--how are you today?

Laird Landmann: Very well. Thank you for having us here at the Morningstar Conference.

Anderson: Thanks very much for coming. We've seen a lot of volatility in the global bond markets so far this year. What are the potential risks you see if and when the Fed starts hiking rates later this year?

Landmann: Well, I think you touched on the first one: volatility. If you think about it from a theoretical perspective, if the Federal Reserve and other central banks promise to keep short-term rates at zero or close to zero, they're in effect milking all of the volatility out of the system--since volatility, up and down the yield curve, really starts with short-term interest rates. So, I think the market is trying to adjust to the idea that this is no longer going to be the policy and what the unintended consequences of a change in policy might be for the markets.

Anderson: What are your thoughts on the Fed rate increase? When [do you think that will occur] and by how much?

Landmann: We're thinking two rate increases, which is now becoming the consensus. There have been a couple of governors who have come out and sort of validated the notion of two rate increases this year. Certainly, the U.S. economy seems to have pretty good fundamental strength to it, and the Federal Reserve--although they could never say this--I think they would like to get a little bit of a cushion in there, because at some point there will be another downturn. We are now coming up on seven years into what has been a very slow and arduous upturn in the U.S. economy; there will probably be another year or so of faster growth, but the Fed has to prepare itself for that next stage of the cycle.

Anderson: Could you talk a bit about how the Total Return fund has been positioned, given your view on where we are in the credit cycle?

Landmann: I think we are patient value-oriented investors at the end of the day. Great value was created for all fixed-income investors by the Fed's activities post-2008. As we look at the risk premiums today and at what certainly has to be a distorting effect on asset prices caused by the Federal Reserve's policies and the quantitative easing that occurred and what continues to occur in Europe, we have to be defensive, we think, in this sort of environment.

You can't argue with the fact that these policies have inflated asset prices more than they otherwise would be and, because of that, we are cautious on duration--that is, we do believe rates will move higher. The market right now believes that the Fed will move rates up much more gently than even the Federal Reserve is saying, and we tend not to believe that point of view. We tend to believe that, at some point, the Fed will realize they are behind the curve and will actually move a little bit faster.

The second point is on credit. Credit, to us, feels like it's becoming frothy, and we do believe there will be more volatility in the credit space. We're very cautious toward our corporate high-yield positioning. Even on the mortgage side of the equation we've become somewhat more defensive.

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Anderson: Could you talk nonagency mortgages as well and how that fits into the equation right now?

Landmann: Nonagency mortgages are one of the few asset classes in fixed income that are, first of all, not that highly correlated with Treasuries. So, as rates rise, you're probably not going to see as much detrimental effect in that area. We do like it; however, prices have risen quite nicely in the last four or five years in that area. So, we've become more defensive there. We've reduced our exposure from about 13% down to about 10%. And as part of that--and probably more importantly--we've increased the quality of those holdings.

So, what that means is we've been going up higher in the capital structure of those mortgage-backed securities, and we've been getting more and more subordination underneath them. So, today, we're holding securities that, even if the housing market was to turn down 25% or 30%, would still have positive returns over their holding period.

Anderson: One last question for you: Liquidity concerns are top of mind, it seems, across the bond market. What areas are you really concerned about right now? What pockets are running that risk?

Landmann: There are liquidity concerns all through the U.S. bond markets. U.S. Treasuries are trading with less liquidity than we've ever seen before. Certainly, corporate bonds, high-yield are feeling the pinch there. But you don't see it day to day because there's no crisis to catalyze a big move in prices. When that happens, certainly, there could be some market failures that will be involved--particularly, perhaps, in the high-yield area, perhaps in some of the more exotic areas of the mortgage market, maybe even more exotic areas of the high-yield market.

But we're not policymakers at the end of the day, so we can't fix the liquidity problem in the marketplace. We know we have peers who have put together various proposals. There will not be a change in the way fixed income is transacted until a crisis catalyzes everyone into getting on the same page, so to speak. That tends to be the way this works.

So, in the meantime, being a prudent manager that wants to protect our investors, what's important to us is that we manage the portfolio with more liquidity than we otherwise would, recognizing that there is a very large probability that there will be a liquidity crisis in fixed income at some point in the next year or two.

Anderson: So, does that mean [you will hold] more cash?

Landmann: It means a little bit more cash. It means a lot more Treasuries than we normally hold, because while Treasury liquidity is impinged somewhat, when we talk about that, we're talking about trading going from less than a 30-second bid-ask spread to maybe two 30-seconds in a big crisis. When we're looking at some of the more exotic corporate bonds, high-yield bonds, you're talking about perhaps not even being able to sell in a very bad liquidity crisis. So, having that large pool there protects us, and we're basically focusing on a lot of government-guaranteed types of assets in the mortgage, commercial mortgage, and in the asset-backed space.

Anderson: Great. Thanks so much for your insights today.

Landmann: Thanks for having me in.