Where do you see value in the market?
We still believe there are a lot of good things going on with financial conditions improving for U.S. corporations. We believe there are opportunities in high-yield corporate bonds based on experience that companies in the Standard & Poor's 500 Index will continue to de-leverage their balance sheets and have 13% growth.
There's more value in high-yield than investment-grade corporate bonds. However, we do see value in the investment-grade world in being patient and waiting for volatility to pick up. Volatility creates opportunities for better investments.
But there are certain names we want to avoid, like Cox Communications and such where they were closely held to start with and have a possibility to try to acquire a majority holding. That risk will continue to permeate the industry. We focus on those companies that haven't had those issues. Cox already caused considerable widening in the media cable industry. The spreads of Comcast and Time Warner widened in conjunction with Cox and we took that opportunity as risk premiums increased and their bonds cheapened.
In the insurance sector, the Marsh & McLennan investigations are ongoing and bonds in those sectors widened out considerably. There could be opportunities in bonds of insurance providers, both in property and casualty, and potentially health. We find value when spreads widen and when that widening is caused by things outside of what should directly impact them. You have to have a lot of good analysts looking into where real risk is warranted and what should be priced into those bonds. Momentum trading causes prices to overreact, especially with those short-term oriented investments.
How do you think the economy will perform in the third and fourth quarters?
We believe that gross domestic product growth will be around 4% in the third quarter with consumers stepping up from the soft patch. The economic growth is slightly above the long-term growth trend line and will continue to be around 3.5% for the fourth quarter.
One thing that has picked up is interest-rate volatility. We forecast a 2% target rate by November. Following the presidential election and the Federal Reserve's decision, we could see a pick up in rates. There's a lot of foreign investing right now. Foreign investors are definitely keeping rates lower than they would otherwise be.
Volatility in interest rates will create cheapening in mortgage-backed securities. In addition, we would expect sectors such as asset-backed and corporate mortgage-backed securities and agencies to be tight to swap spreads, but we think swap spreads will widen out. So we've taken our weighting back down to neutral for asset-backed and CMBSs.
Where do you see value in investment-grade bonds?
Looking out over investment grade in general, there isn't much value. You still have a lot of compression between triple-Bs and single-As. That was played out tremendously in 2003 and 2004 year-to-date. There will still be a convergence of risk premiums as long as overall fundamentals play out in improving financial conditions.
The actual defaults on single-A and double-As have trended down tremendously. There's a lot less financial risk in markets. We expect that defaults will bottom out starting in 2005, especially as the Federal Reserve starts being less accommodative. The Fed is still fairly accommodative at 2% or 2.25% for the first quarter of 2005. When the Fed Funds rate goes above the inflation rate, risk aversion will increase and likely that will have already begun.
How will the flattening of the yield curve affect your strategy?
A lot of flattening in the yield curve has already been priced in. We believe the curve can flatten a lot further. We continue to expect further tightening, which is likely to promote a barbell strategy. We don't expect to have a lot of excess performance on the short end. Predominantly, some performance will come from duration and our position along the curve; we don't expect anywhere near the same performance from sector allocation. We feel that creates more volatility, so we focus on intermediate and long-term economic growth globally and domestically in the next six to 12 months and long-term movements beyond 12 months.