Bond managers get defensive

Bond managers are on the defensive, lowering the duration of their portfolios and investing in TIPS in anticipation of a hike in interest rates.

"We have been telling our clients since January that they should shorten their maturities and lower duration to five years or less," said Anthony Chan, chief economist at Banc One Investment Advisors Corp., Columbus, Ohio. "They should avoid durations over that because, as rates rise, they can get hurt." Banc One has $52 billion in fixed-income assets under management for tax-exempt clients.

Duration is the time it takes to recover half of the present value of the future cash flow of a bond or bond portfolio. When interest rates are rising, it's preferable to be invested in shorter-duration bonds because the market value of the bonds will fall. Those with longer maturity will be worth less by the time they mature.

He's also recommending clients tilt their portfolios toward equities. "Equities will benefit from an improved economy, and the economy is strengthening. Everybody's situation is different, but our generic advice is to increase equities by five to 10 percentage points, depending on their risk tolerance."

Mark Kiesel, executive vice president and a senior member of the investment strategy and portfolio management group at Pacific Investment Management Co., Newport Beach, Calif., believes it's the time to be defensive.

"We've been advising clients to limit their exposure to bonds to the short end of the yield curve. They shouldn't go beyond five-year bonds and they should avoid or underweight 10- to 30-year bonds," he said. PIMCO has $194.2 billion in bonds for tax-exempt clients.

PIMCO also has been using sector strategies, Mr. Kiesel noted. "We've been overweighting emerging markets, targeting 3% to 4% of portfolios to that sector. We like them because global growth is picking up, causing a higher demand for commodities; emerging market countries can benefit because they export commodities."

PIMCO also favors European government bonds, particularly in the five-year range. "Europe has been a laggard in the large global economy. As a result, the European Central Bank is likely to lower its rates in the next two years, which means the bonds will do much better and aren't likely to sell off," Mr. Kiesel said.

In addition, he is recommending Treasury inflation-protected securities "because we believe inflation is headed higher and these will outperform; and municipal bonds, even for tax-exempt investors."

Like PIMCO, New York-based BlackRock Inc. has been finding opportunities in European bonds. "We prefer them to U.S. bonds now because we expect they will outperform as rates rise," said Keith Anderson, chief investment officer. "Our portfolios are short duration relative to their individual benchmarks and are generally positioned for a flattening in the yield curve," he said. BlackRock manages $76.3 billion in bonds for tax-exempt clients.

Lex Huberts, CIO at Standish Mellon Asset Management Co., Boston, is partial to TIPS and high-yield bonds, which he prefers to lowering duration.

"If clients are nervous about rising rates, short duration is expensive. We think TIPS and high-yield strategies will do well in a rising rate environment, and are telling clients not to go short at this point because of the steep yield curve. We're managing portfolios relative to interim duration. We're duration neutral in total." The firm manages $9.5 billion in bonds for tax-exempt clients.

The debate about when the Federal Reserve might raise interest rates began to accelerate after an unexpectedly strong March employment report. While market fears abound that the rates could be raised within weeks, several investment strategists and economists interviewed predicted rates are unlikely to go up before the end of the year. But a few say the Fed could move sooner if economic data continues to be strong. Most forecast they would initially rise by 25 basis points, although a few said 50 basis points. They see them reaching 3% to 3.5% within 18 months.

Banc One's Mr. Chan was typical. "I don't think the Fed will move before the (Federal Open Market Committee) meetings scheduled for Nov. 10 or Dec. 14," he emphasized.

"The employment picture still has a ways to go before it would warrant raising rates. The economy should have created 5 million new jobs since the economic expansion began December 2001. Instead, we've lost 323,000 jobs since then. That tells me there is still a significant amount of catching up to do before rates would be raised."

The Federal Funds rate is the key borrowing rate and the basis for short-term rates. It has been at a 40-year low of 1% since June 2003. At the same time, the yield on the benchmark 10-year Treasury note has been rising in recent months, in response to stronger economic data. It reached 4.4% last week and could go to 5% by the end of the year, some experts said.

Mr. Kiesel of PIMCO concurred with Mr. Chan on the timing of the rise: "If the jobs data doesn't continue to show strength, the Fed will be on hold for the next 12 months. The Fed very much believes there's slack in the labor market, which is why they're being patient in the near term."

BlackRock's Mr. Anderson predicted that the earliest the Fed might tighten would be at the June 30 FOMC meeting, but it's more likely to be the August or November meeting.

"I think they should have been tightening three months ago, starting in January, but they have been holding out for confirmation that the economy is on sound footing and that employment growth is strong. They would like confirmation beyond the recent significant retail sales, (Consumer Price Index) and employment reports. They want to be sure these signify a trend and aren't one-time events." Like many of his peers, Mr. Anderson expects the increases will start slowly with 25 basis points and that the rate will rise to 3% within 18 months.

Tim Warrick, managing director and head of the portfolio management team in fixed income at Principal Global Investors, Des Moines, Iowa, observed the Fed doesn't move on interest rates until jobs reach their previous peak

He also noted the 10-year Treasury has been steadily rising in reaction to strong economic data. "The Fed won't pre-empt that, so it probably wouldn't move up the Funds rate until the 10-year note reaches 4.85% to 5%," Mr. Warrick said.

To deal with the changing rate environment, Mr. Warrick has been putting more focus than ever on the firm's flagship multisector portfolios. "We've been overweighting TIPS, high-yield bonds and corporate investment-grade bonds, which all perform well in rising rate environments." Principal doesn't manage duration actively, but has been duration-neutral so far in 2004. Principal manages $18.9 billion in bonds for tax-exempt clients.

Robert Calhoun, CIO of Tattersall Advisory Group, Richmond, Va., has found that the uncertainties about rates have created opportunities through mispricings, particularly in the mortgage market. Tattersall manages $18 billion in bonds for tax-exempt clients.

"Because of the expectation of higher rates, people have been reducing exposure by buying higher coupon paper, causing lower coupon paper to become a lot less expensive."

"Our strategy is to outperform if yields rise and to be participants if yields fall …. We're not making big interest rates bets, but are slightly short the market."