NL Capital Management is looking to reduce its allocation to investment-grade corporates and increase exposure to mortgage-backed securities. Kenneth Hart, portfolio manager of a $100 million total return spread product fund, which is part of the firm's $6 billion in assets, says he would make the move if bond yields continue to shrink.
He would move money into MBS to protect against a backdrop of higher rates, which he expects will occur. "We believe interest rates are poised to increase in the second half of this year and are therefore positioning the portfolio accordingly. Should rates rise substantially and quickly we may consider buying longer duration securities if we think the move is overdone," he says. Hart says he wants to stay in spread products to maximize income and that he will shy away from corporates as yields lower. On the flip side, he expects MBS will have a better total return as interest rates rise, which he expects will happen later this year or next.
Specifically, Hart says the yield on the 10-year Treasury would have to drop to 3.5%, or another 25 basis points from where it was on March 22, before he would consider moving 5-8% of his portfolio from corporates into mortgages. Hart says if he puts on this move, he will try to maximize income on the front end of the yield curve and will look at buying collateralized mortgage obligations and seasoned paper without a lot of prepayment risk. He recently sold higher-quality, shorter corporates that are trading tight, including financials such as the Wells Fargo '07 and the Bank of America '08 notes and replaced them with short term mortgage backed securities that yield roughly 125 basis points more.
Likewise, if the 10-year yield backs up to 4.5%, Hart says he would reverse his position and add higher-quality corporates. The fund currently allocates 60% to mortgages and 40% to corporates. It is benchmarked against the Lipper Corporate Debt Funds A-Rated Index and is roughly neutral in duration at 3.75 years.
Hart invests almost fully in investment grade and concentrates in the mid triple-B names. The fund allocates only 1-2% in high yield names. In investment grade, he stays in the higher-beta, wider names and is fully allocated in the auto sector and invests in such names as Tyco International, Wyeth Inc. and AT&T Inc. He also participated in the recent Pacific Gas & Electric deal.