Stanek: A Tug of War in the Bond Market

Alaina Bompiedi: I'm Alaina Bompiedi with Morningstar. I'm joined by Mary Ellen Stanek, chief investment officer of Baird Advisors.

Mary Ellen, thank you so much for joining me.

Mary Ellen Stanek: Thanks, Alaina. Great to be here.

Bompiedi: The U.S. bond market has had many different things thrown at it this year from the Fed continuing to raise interest rates, to strong U.S. economic data and the strengthening dollar, to more recently tariffs. I'm wondering what should long-term bond investors really be focused on right now.

Stanek: Bond investors--we always step back--why do people own bonds? They own them for the predictability, the consistency, the cash flow or income. They want to lower overall volatility of their total portfolios. What we want to do is make sure we execute strategies that provide that consistency and predictability that investors desire.

There's plenty of things to think about right now in terms of the economic landscape, the capital market landscape, the global landscape--lots of things. But we'd set it up as a tug of war right now between the cyclical forces here in the U.S. that are strengthening and actually creating a pretty good economic environment with those secular headwinds that are certainly going to dampen economic growth.

Bompiedi: Baird Aggregate Bond and Baird Core Plus are both kept duration-neutral to their benchmarks. I'm wondering what your thoughts are on where it's worth taking risk right now. High-yield has continued to do well this year, albeit not with the same momentum that it had performed last year and in 2016. Investment-grade struggled at the start of the year. In those funds with setting duration aside, where do you think it's worth taking risk?

Stanek: We stay duration-neutral because we don't believe we can consistently add value that way, and most investors don't add value that way consistently by trying to forecast interest rates and move duration around. That said, we neutralize that decision and then we spend our time and attention on yield curve positioning, sector allocation, individual security selection.

How do we build the portfolios to try to outperform their benchmarks and pay for our expense ratios and then some? We do it a couple of ways. One thing right now that we are doing is underweighting our agency pass-through positions. We've got about 75% of the weight of the benchmark in what is a very big sector for the benchmark. Why are we that underweighted? For us, it's pretty significant underweight and we've had that on for a while is because as the Federal Reserve continues to normalize their balance sheet, we believe that there will be underperformance in agency pass-throughs.

How do we fill that bucket? We overweight credit, although we have been reducing that overweight slowly over time, but we are still overweight credit. On the mortgage-backed and asset-backed side, certainly, asset-backed securities, commercial mortgage-backed securities--all very high-quality senior in the capitalization structure. We have slight yield advantages on the portfolios, but we think we are in an environment where managing risk carefully is going to be very important. But we are not battening down the hatches on the credit side. We still see fundamental value there, and in fact, many of the fundamentals are actually encouraging.

Bompiedi: The two funds, Baird Aggregate Bond and Baird Core Plus, both maintain mostly exposure in investment-grade bonds with little and below investment-grade. When you look at where opportunities are in investment-grade, what sectors or credit quality stick out to you as places for opportunity?

Stanek: The difference between the two funds is, in Core Plus Fund, we can own up to 20% below investment-grade. Currently, it's less than 6%, it's about 5.5% or so. That's equally split between nonagency mortgages and high-yield corporate, primarily fallen angels. We are underweight the benchmark there and we're underweight what we could do because we want to keep powder dry. We think that, as your question suggested, below investment-grade has had a very good run, spreads are tight, and while we think this economic cycle has ways to go and the environment actually is quite constructive, we don't think generally we are being paid to take that risk. Spreads are quite tight relative to historical averages. We see better value in carefully selected well-diversified BBB and have overweights there but well-diversified and tend to own our exposure short and intermediate in those portfolios.

Bompiedi: Mary Ellen, thank you so much for sharing your views with me today.

Stanek: Thanks, Alaina.