Gossard is a portfolio manager responsible for $500 million in investment-grade fixed-income at Mesirow Financial in Chicago. He focuses on the domestic part of the high-grade market, specifically on Treasuries, agencies, corporates and mortgage-backed securities.
How do you respond to rising interest rates?
Generally speaking, through a shorter duration. We figure that return will come from income rather than from price changes, so we build in as much yield as we can without accepting a lot of duration risk. Our duration is currently 85% of our benchmark, the Lehman Brothers Aggregate Bond Index. To get yield, we're using short mortgage instruments such as 10-year amortizing mortgages, 15-year mortgage paper and short-term corporates. We think the economy is in a slow period that will recover and begin to expand again. With rising interest rates, inflation picks up, business picks up and loan demand picks up.
Where can one find relative value these days with
spreads so tight?
We've held puttable bonds with a long stated final duration. Different bonds allow you to put them back at par in two, three or five years. As interest-rates rise, a bondholder can put that bond back at par and get money to reinvest. The value and duration move in bondholders' favor.
We've also looked at corporate Consumer Price Index-linked floating-rate bonds. The coupon is re-set every month through a formula whereby it's re-fixed at CPI plus 2%, which assures you of a real return of 2% over inflation. We were buying them in January and February at 4% coupons, and they're now at 5 1/4%. Some companies that have issued them include Morgan Stanley, Sallie Mae, Fannie Mae and Pacific Life Insurance. The coupons have risen over 1% while prices remain around par, which is want you want in a rising rate and expanding economic environment. High oil prices will eventually feed into a higher CPI and if the economy stalls, you get a higher inflation rate. But I don't think inflation will get out of hand.
It's tough for an investor right now. You cannot expect a lot out of bonds. Now is a time for a person to avoid mistakes rather than to be aggressive. I think the agency sector is suspect because of Fannie Mae and Freddie Mac's accounting problems. Many investors suppose they are too big to fail and because of their association with the government, many portfolios hold them. But too heavy an agency concentration could be a mistake.
Agencies currently represent about 18% of our portfolio and we will gradually reduce that down to below 10% and we'll be replacing them with agency mortgages. In other words, we'll sell a Fannie Mae debt instrument and buy a Fannie Mae mortgage-backed instrument. It used to be that you looked to the agency for credit security, but now we are looking at the mortgages as the security.
What sectors do you find most attractive and what are you planning to do to your corporate allocation?
We had been overweight in corporates for the past several years, but we've been gradually leaving the corporate sector and increasing our mortgage allocation. Corporate spreads are so tight and the potential for them to get tighter is not that great.
Companies have healthy balance sheets, good earnings and they have accumulated cash. They're not using the cash for capital expenditures but for shareholder-friendly behavior, which is often unfriendly to bondholders. Our general plan is to reduce corporates over time from 40% down to 25% and to increase mortgage-backed securities up to 35%. Within a year we should hold around 25% in corporates.
How do you think the continuing fear of terrorism is affecting the capital markets, and in particular the bond market? Does it support Treasury prices?
Terrorism is on everybody's mind. It keeps the Treasury market well-bid every Friday, because people want to hold Treasuries over the weekend. It also contributes to the inertia of the economy in the sense that a chief executive officer of a company is going to be hesitant to build a new plant or to start hiring.